History of Total Factor Productivity & Free Lunch Productivity

In his classic 1957 paper, Technical progress and the aggregate production function Review of Economics and Statistics, 39, 312-320 -- Robert Solow addressed the core question: Why are some countries poor, and other countries rich?  

Solow felt the answer lay in the growth of labor productivity. Poor countries had stagnant productivity; rich ones had high and growing productivity. In his 1957 paper, which later won him a Nobel Prize in Economics, he showed how the change in a country's labor productivity was driven by two separate factors:

a) capital deepening, i.e. a rise in the amount of capital per unit of labor; & b) exogenous "technical change", i.e. improvements in knowledge, methods, etc.

While (b) could not be directly measured, it could be inferred as a residual, by subtracting the contribution of "capital deepening" from the overall change in labor productivity. This method was widely applied to analysis of countries and industries. 

It became known as "total factor productivity" (TFP).

From Total Factor Productivity to Free Lunch Productivity
Together with a colleague, Prof. Hariolf Grupp, of Univ. of Karlsruhe, Prof. Shlomo Maital posited that Solow's method, applied at the country level, could be equally useful for benchmarking productivity change within individual firms. For countries, aggregate value added is simply Gross Domestic Product (GDP). For firms, value added is the difference between sales revenue and the cost of material inputs.  Grupp and Maital wrote a research paper, outlining the method, and did some preliminary calculations for individual firms. They then showed it to Solow, who thought this was a rather good idea.

Value added per employee for firms, as for countries, grows either because a) capital investment makes workers more productive, or b) better methods, technology, methods, incentives, motivation, etc., makes workers more productive without additional capital investment.

It is vitally important for managers, investors and for stockholders to know why labor productivity (value added per employee) has risen, or why it has not.  Labor productivity that grows because of factor (b) is a "free lunch", because it has occurred without costly capital investments. 

For that reason, we term TFP at the firm level, Free Lunch Productivity, or FLP.  It is directly related to a firm's bottom line, and hence, to the performance of its stock price.

Solow has shown that countries grew wealthy mainly through factor (b). If this is true, it must therefore be the case that for such wealthy countries, a significant number of the firms in these countries also have significant increases in factor (b). 

Maital's and Grupp's article on TFP for individual firms was published as Chapter 7 in their book: H. Grupp and S. Maital, Managing New Product Development & Innovation: A Microeconomic Toolbox  (Elgar: Cheltenham, UK: 2000).