50 years of Solow growth model…implications and impact

A nice interview of Prof. Robert Solow in McKinsey Quarterly (MQ). The interview celebrates 50 years of both the model and MQ.

The best thing about the interview is that it discusses how Solow model was actually applied to the real industries. What is Solow model? Well it says what matters for growth is not labor or capital but technology. What did the actual evidence show?

The Quarterly: What, if anything, surprised you about the findings of the early MGI studies?

Robert Solow: What came as something completely new to me was that if you looked at the same industry across countries, there were almost always dramatic differences in either labor productivity or total factor productivity. To my surprise, it turned out that most of the time, certainly more often than not, the difference in productivity—in the auto industry or the steel industry or the residential-construction industry in the US and in countries in Europe—was not only substantial but couldn’t seriously be explained by differences in access to technology.

We also found that the productivity differences could not be traced to differences in access to investment capital. The French automobile industry, much to my surprise, turned out to be more capital intensive than the American automobile industry. So it was not that either. The MGI studies instead traced these differences in productivity to organizational differences, to the way tasks were allocated within a firm or a division—essentially, to failures in managerial decisions.

I was, of course, instantly suspicious of this. I figured to myself, “What do you expect a bunch of management consultants to find but differences in management capacities? That’s in their genes. That’s not in my genes.” But MGI made a very convincing case for this. And I came to believe that it was right.

🙂 Gave some legitimacy to the consulting industry..

What drove management? Competition..

The Quarterly: So management was the primary factor in productivity differences?

Robert Solow: Yes, and there was another surprise, for which there was partly anecdotal, partly statistical evidence. If you asked why there were differences that could be erased or diminished by better management, the answer was that it took the spur of sharp competition to induce managers to do what they were in principle capable of doing. So the idea that everybody is everywhere and always maximizing profits turned out to be not quite right.

MGI made a very good case that what was lacking in these trailing industries in other countries—or in the US, in cases where the US trailed—was enough exposure to competition from whoever in the world had the best practice. And this, of course, can apply within a country. We know that in any industry, there is a whole distribution of productivity levels across firms and even, sometimes, across establishments within a firm. And much of that must be due to the absence of any spur to do more.

So an interesting conclusion to me was that international trade serves a purpose beyond exploiting comparative advantage. It exposes high-level managers in various countries to a little fright. And fright turns out to be an important motivation.

The Quarterly: So competing against the global best-practice leaders is a way to encourage your own industry to use best practice?

Robert Solow: Yes, and it goes beyond that, even. Competing as part of the world economy is an important way of gaining access to scale. If you’re a Belgian company or even a French company, it may be that best practice requires a scale of production larger than the French domestic market will provide for French producers.

So it’s important for such companies to have access to the international market. That was not something I had thought of. And I don’t think anyone had—at least I had no reason to think, within economics, that there had been much thought about management activities as a big difference between best practice and less good practice. We had always thought, “Well, people seek profits. And if they seek profits, they’ll have to adopt best practice.” Not so.

He says the future research shd look at productivity in services sector:

The Quarterly: Looking toward the future, are there other issues in economics that MGI’s sector-level approach might be helpful for?

Robert Solow: I would like to see more work on the determinants of productivity and productivity increases within the service sector. To begin with, I don’t think we even have a very clear idea about the relative capital intensity within the service sector or between the service sector and goods-producing sector.

I remember I was once writing something in which I was describing the service sector as being of relatively low capital intensity. And then I stopped and remembered that the following day I had an appointment with my dentist and that my dentist’s office was as capital intensive a 500 square feet as I had ever seen in my life.

So I think the place where the MGI approach is most needed right now is in the service sector. There has been service-sector work within MGI, and outside of it as well, but not as much as is warranted in view of the 70 percent or more of all employment in advanced economies that’s in service industries.

The Quarterly: Are there particular places in the service sector where you’d look first?

Robert Solow: Well, that brings me to another MGI result that I found fascinating. At one point, we were trying to understand the industrial basis, the sectoral basis, for the acceleration and deceleration of productivity growth. And one of the things we found was that the two largest sectoral contributions to the acceleration of productivity growth when it was accelerating and, presumably, to the deceleration when it was decelerating came from wholesaling and retailing.¹ Both of them, at the time, were low-productivity sectors and low-productivity-growth sectors. But they employ so many people that a slight improvement in the productivity of retailing makes a large contribution to the increase in national productivity.

There has been some work on that, but I think the work is needed now more in personal services. God knows, in healthcare. And education. Or child care. All sorts of things.

Nice bit..Calls himself an ordinary macroeconomist…hope most of us really ordinary economists also believe the same..