Measures of allocative efficiency

In the last few weeks mycolleagues, Gareth Kiernan and Adolf Stroombergen, have discussed theimportance of what economists call allocative efficiency – ensuring that thenation’s resources flow into those activities where they are most valued.   Icontinue with that theme.   My aim is to present a measure of how big a deal allocativeefficiency is for the New Zealand economy.  

To what extent is theallocation of resources in New Zealand responsive to economic performance?   Doesinvestment in New Zealand tend to gravitate towards more productiveactivities?   Does our economy reward efficiency or are other factors such asluck, privilege, tax rules and regulations distorting investment behaviour?  

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

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

Despite these caveats, Iconsider that the measure presented here provides strong circumstantialevidence that there are serious allocative efficiency problems in the New Zealand economy and that these problems have potentially a very large impact on thewellbeing of New Zealanders.   This view is based on the rules, laws, andregulations that exist in New Zealand that are likely to distort investment andemployment decisions.   For example, a lack of capital gains taxes orinheritance taxes encourage investment into land based activities, GST rulesfavour goods exporting ahead of service exporting, regulations that impose highcompliance costs on businesses are likely to impose a higher burden on smallbusinesses, and so on.  

Despite a commodity priceboom in recent years, which is likely to favour production in more capitalintensive activities, there has been no increase in the New Zealand allocative efficiency measure in recent years – a trend very noticeable acrossthe Tasman.

So how important is allocativeefficiency 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 productivityof each industry (ie had an index level of one prevailed over this time period),economic growth could have been 48% over the same period.   The implication isthat even within this small time frame, national income levels would have been10% higher today than they currently are.  

Matching Australia’s allocative efficiency might be considered a more realistic ambition.   Anallocative 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% andnational incomes levels already 5% higher than they now are.  

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

We already have thetechnology to significantly improve our wealth without working any harder.   Wejust need to ensure that the rules that influence people’s economic decisionsmore accurately reflect their economic consequences.

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



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