Julius Probst

julius.probst@ekh.lu.se
Economic History Department, Lund University

A technical note on growth accounting:

1. Growth accounting based on factor quantities

Growth accounting is an exercise that allows you to determine the growth rate of
output (GDP) into contributions of individual factors of production. The main
point is to figure out the contribution of Total factor productivity (TFP), a broad
measure for technological change in the economy. One should note though that
TFP is the residual, i.e. the leftover after other factors of production have been
accounted for. The Solow residual also comprises a variety of factors other than
just technological change, such as quality changes in capital and labor, quality
changes in production, changes in resource allocation and and
structural/organziational change. Abramovitz thus calls TFP " measure of our
ignorance". Technological progress is crucual for economic growth since factor
accumualation faces the problem of diminshing returns.
There are two ways to determine the rate of TFP growth. The first one is based
on the Solow model. You might call it the quantity approach since it is dependant
on quantities of different factors of production (capital, labor, etc.). Those
quantities, especially capital, are not always easy to measure.
For that reason, economists have determined a different way to measure TFP,
which is based on the prices of the different factors of production. Prices (wages,
interest rates) are more easily available in a market economy.
The Solow model is a very simplistic growth model with just two factors of
production, capital K and labor L, as well as technology.
The production function is Cobb-Douglas, i.e. the exponents sum up to 1 and
deteremine the factor shares. Historically, economists have simply assumed that
the labor share of GDP is about 2/3 and the capital share of GDP is about 1/3.
Recent research, however, has put this assumption into doubt. In practice, factor
shares have fluctuated quite a lot. Furthermore, the capital share of GDP seems
to have increased worldwide in many countries over the last few decades.

Cobb-Douglas porduction function:

Y = AKαL1 – α

Y = GDP
A = "stock of technology"
K = capital stock
L = labor stock
α and 1- α are usually 1/3 and 2/3, respectively

We then take the logarithm of the production function to get the following
equation.
ln (Y) =+ln (A)+ α ln(K) + (1 − α) ln(L)

Remember that all the variables in our equation are a function of time and that
the logarithmic difference of two variables is an approximation of the growth
rate (g).
𝑌𝑡+1 −𝑌𝑡
GDP growth = gy ≈ Δln(Y) ≈ 𝑌𝑡

Taking the logarithmic difference, we thus get the following equation:

Δln(Y) = ΔlnA +α Δln(K) + (1 − α)Δln(L)

This expression tells us that GDP growth is the sum of TFP growth plus the
growth in the two factor inputs weighted by their contribution to GDP. The last
equation is thus similar to the following:

gy = gA +α gK + (1 − α) gL

Using this equation, we can thus determine the contribution of TFP to the total
growth rate in the economy. We can measure real GDP as well as the capital
stock and the labor stock at any moment in time t. We also have number for
annual growth rates. As an example, let's say GDP growth gy is about 2%, similar
to the long-run historical average of US GDP growth since about 1900. If labor is
growing at 0.3% and capital is growing at 0.6%, then we can figure out the
"Solow residual", i.e. TFP growth as follows.

2% = gA+1/3 *0.6% + 2/3*0.3%

gA = 2% - 0.2% - 0.2% = 1.6%

In this example, TFP growth is the largest contributor to economic growth

whereas growth in the capital stock and labor stock are not very significant.
While capital accumulation might account for significant growth in some
economies (East Asian growth miracle), TFP is far more important in advanced
economies which are close to the so-called "technological frontier" (theya are in
the steady-state of the Solow model).
Note that the contribution of TFP shrinks somewhat if we include other factors
of pruduction in the model. This could be human capital (education), energy or
land.

2. Growth accounting based on the dual approach to TFP (based on factor prices)

An alternative method to determine TFP growth is called the dual approach. It is

based on qua factor prices instead of factor quantities. While some quantities, i.e.
the capital stock or education, are not very easy to measure, prices are more
easily available in a market economy (interest rates and wages). The dual
approach is based on the following accounting indenty:

GDP = sum of all capital income + sum of all labor income

We start with the following production function where every variable is a
function of time t:

Y (t) = r(t)* K(t) + w(t) * L(t)

r is the interest rate
w is the wage rate

We now differentiate the last expression with respect to time t. Please remember
the product rule when taking the derivative.

Product rule:
Let's have a function f (t), which is equal to the product of two other functions
x(t) and y(t).
f(t) = x(t) * y (t)
The derivative of f (t) is then as follows:
f ' (t) = x'(t)*y(t) + x(t)*y'(t)

Consequently, we can express the time derivative of GDP as follows:

Y'(t) = r'(t)*K(t) + r(t)*K'(t) + w'(t)*L(t) + w(t)*L'(t)

Note that the derivative of a function is equal to the marginal change (slope) We
can thus obtain an expression for the growth rate by dividing the marginal
change by the initial quantities.

𝑌𝑡+1 −𝑌𝑡 Y′(t)

gy ≈ Δln(Y) ≈ ≈
𝑌𝑡 𝑌𝑡

We now divide the entire expression by Y(t) in order to obtain the GDP growth
rate on the right hand side of the expression:

Y′(t) r′(t) ∗ K(t) r(t) ∗ K′(t)) w′(t) ∗ L(t) w(t) ∗ L′(t)

= + + +
𝑌𝑡 𝑌𝑡 𝑌𝑡 𝑌𝑡 𝑌𝑡

We add several terms to this expression in order to get an expression with

growth rates, which is what we want.

Y′(t) r′(t) ∗ K(t) 𝑟(𝑡) r(t) ∗ K′(t)) 𝐾(𝑡) w′(t) ∗ L(t) 𝑤(𝑡) w(t) ∗ L′(t) 𝐿(𝑡)
= ∗ + ∗ + ∗ + ∗
𝑌𝑡 𝑌𝑡 𝑟(𝑡) 𝑌𝑡 𝐾(𝑡) 𝑌𝑡 𝑤(𝑡) 𝑌𝑡 𝐿(𝑡)

We can now simplify the expression as follows:

r(t) ∗ K(t) r(t) ∗ K(t) w(t) ∗ L(t) w(t) ∗ L(t)

𝑔𝑦 = 𝑔𝑟 ∗ + 𝑔𝑘 ∗ + 𝑔𝑤 ∗ + 𝑔𝐿 ∗
𝑌𝑡 𝑌𝑡 𝑌𝑡 𝑌𝑡
 r∗K w∗L
Note that 𝑌 is the capital share (capital income as a total of GDP) while 𝑌 is
the labor share (labor income as a total of GDP). These two expressions thus
denote the factor shares, which I will call 𝑠𝑘 and 𝑠𝐿 , respectively.

We can thus rewrite GDP growth again as the sum of the following growth rates,
weighted by the factor shares:

𝑔𝑦 = 𝑠𝑘 ∗ (𝑔𝑟 + 𝑔𝑘 ) + 𝑠𝐿 (𝑔𝑤 + 𝑔𝐿 )

GDP growth is thus a weighted average of the growth rate of the interest rate and
the capital stock, both weighted by the capital share, and the growth rate of the
wage rate and the labor stock, both weighted by the labor share.

As a final step, we want to figure out the rate of TFP growth (technology). This is
possible even though A is not part of the production function. Similar, to what we
did in the first part, the Solow residual is simply the amount of GDP growth that
is leftover after we accounted for the growth in factor quantities. Since we have
the growth rate of factor quantities in the last expression, we simply subtract
them from 𝑔𝑦 in order to get an estimate of 𝑔𝐴 .

𝑔𝐴 = 𝑔𝑦 − 𝑠𝑘 ∗ 𝑔𝑘 − 𝑠𝐿 ∗ 𝑔𝐿 = 𝑠𝑘 ∗ 𝑔𝑟 + 𝑠𝐿 ∗ 𝑔𝑤

This expression thus tells us that TFP growth can also be measured as a
weighted average of input prices (r and w). This method might be superior to the
first one as prices are more easily measured than quantities in market economy.
The dual method is thus an alternative concept on how to measure TFP growth
(the growth rate of technology). In a world with perfect data, there should be no
difference between the two approaches. In reality, however, because of
measurement errors the methods can come to strikingly different conclusions
with regard to the pace of technological change for some countries.

Further discussion:

 Abramovitz, Moses. "Catching up, forging ahead, and falling behind." The Journal of
Economic History 46.2 (1986): 385-406.
 Aghion, Philippe, and Peter W. Howitt. The economics of growth. MIT press, 2008.
 Barro, Robert J. "Notes on growth accounting." Journal of Economic Growth4.2
(1999): 119-137.
 Hsieh, Chang-Tai. "Productivity growth and factor prices in East Asia." The American
Economic Review 89, no. 2 (1999): 133-138.
 Young, Alwyn. "The tyranny of numbers: confronting the statistical realities of the
East Asian growth experience." The Quarterly Journal of Economics110.3 (1995):
641-680.