Measures of allocative efficiency
Wed 19 Mar 2008 by David Grimmond.

In the last few weeks my colleagues, Gareth Kiernan and Adolf Stroombergen, have discussed the importance of what economists call allocative efficiency — ensuring that the nation’s resources flow into those activities where they are most valued.   I continue with that theme.   My aim is to present a measure of how big a deal allocative efficiency is for the New Zealand economy.  

To what extent is the allocation of resources in New Zealand responsive to economic performance?   Does investment in New Zealand tend to gravitate towards more productive activities?   Does our economy reward efficiency or are other factors such as luck, privilege, tax rules and regulations distorting investment behaviour?  

To investigate this issue I have developed a simple and quite crude indicator of allocative efficiency.  The measure compares national labour productivity (output per employee) with the unweighted average of labour productivity in seventeen industries (eg construction, retail, government etc).   If labour was shared evenly in each industry (i.e. employment in each industry would equal one-seventeenth of national employment) the index would equal one.   One would hope, perhaps naively, that economic and government forces would result in greater job opportunities in industries with high levels of labour productivity and, as a result, that the value of this measure would typically be greater than one.  This is not the case.   My allocative efficiency indicator has averaged 0.61 since 1998 for New Zealand, and was still close to this average level in 2007 (see graph).

So what gives?   Similar measures for Australia are higher, averaging 0.73 since 1998 and reaching 0.79 in 2007, but still well below one.   So a measure below one is not something unique to New Zealand.   Indeed it could well be typical of modern economies as the measure we use is based on labour productivity, not total factor productivity.   This means that low values in New Zealand will to some degree simply reflect low levels of capital intensity in desired service activities.   There can also be real world constraints that place limits on production levels in profitable activities.   For example, primary production is limited by the availability of suitable land and the stock of natural resources like fish and minerals.   In addition external constraints can also reduce opportunities in what otherwise should be profitable activities, the obvious example being the imposition of trade restrictions on agricultural products by other countries.  

Despite these caveats, I consider that the measure presented here provides strong circumstantial evidence that there are serious allocative efficiency problems in the New Zealand economy and that these problems have potentially a very large impact on the wellbeing of New Zealanders.   This view is based on the rules, laws, and regulations that exist in New Zealand that are likely to distort investment and employment decisions.   For example, a lack of capital gains taxes or inheritance taxes encourage investment into land based activities, GST rules favour goods exporting ahead of service exporting, regulations that impose high compliance costs on businesses are likely to impose a higher burden on small businesses, and so on.  

Despite a commodity price boom in recent years, which is likely to favour production in more capital intensive activities, there has been no increase in the New Zealand allocative efficiency measure in recent years — a trend very noticeable across the Tasman.

So how important is allocative efficiency for wealth creation?   In the nine years to June 2007 real GDP in New Zealand expanded by 34%.   Yet had production in New Zealand reflected the average productivity of each industry (i.e. had an index level of one prevailed over this time period),economic growth could have been 48% over the same period.   The implication is that even within this small time frame, national income levels would have been 10% higher today than they currently are.  

Matching Australia’s allocative efficiency might be considered a more realistic ambition.   An allocative efficiency measure of 0.73 in New Zealand, the average for Australia in the nine year period, would have implied economic growth in New Zealand of 41% and national incomes levels already 5% higher than they now are.  

To illustrate in another way, shifting 10,000 workers (half of one percent of the New Zealand workforce) from the industry with the third lowest level of labour productivity, education, to the industry with the third highest level of labour productivity, communication services, would theoretically raise the level of GDP by 2%.

We already have the technology to significantly improve our wealth without working any harder.   We just need to ensure that the rules that influence people’s economic decisions more accurately reflect their economic consequences.

We constantly talk about working smarter, but what it really means is not so much about working any smarter within any individual firm or organisation, but organising our societal rules so that the more productive receive the rewards of their greater productivity.  



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