1 Innovation, Productivity and Welfare - Marcel Timmer Groningen Growth and Development Centre University of Groningen Presentation for the 2008 World Congress on NAEP Measures for Nations

2 Motivation  Imagine a small open economy with two sectors:  Stagnant services sector (producing for domestic demand)  Dynamic Telecommunication equipment manufacturing (mainly for export)  Do workers gain in welfare when productivity growth is high in telecom?  Innovation can have two counteracting effects on welfare  Improve productivity  Declining terms-of-trade

3 This paper  Trace the contributions of individual sectors to overall real income growth  Productivity growth in a sector will contribute positively, but part of gains might spillover to foreigners. This will depend on share of exports and on terms-of-trade (price exports over price imports).  Use two approaches:  GDP function approach (Kohli, Diewert)  Production possibility approach (Gollop)  Empirical application to Finnish economy

4 Real Production versus Real expenditure

5 Decomposing real GDP growth  GDP (net output) function : Kohli (1990); Diewert and Morrison (1986). Follow Kohli (2004)  Q (real income) is nominal GDP divided by price of domestic expenditure, while Y is nominal GDP with X and M deflated seperately (real production).  NB Prices of exports and imports relative to price dom exp

6 Prices and Real GDP in Finland

7 Sectoral contributions  Breakdown aggregates into sectoral contributions (in the spirit, but not equal to Diewert, 2008):  Define aggregate technical change (A) and Export prices as Tornqvist volume aggregation of sectors

8 Data  Need value added, labour, capital and MFP (technical change) by industry  EU KLEMS database (  Need export values and prices by industry  Not available. Use Input-output table to divide industry output into X and F (from Eurostat IO-database)  Assume price of industry output is the same for all uses.

9 Finland, Contribution to real income (%-points),

10 Alternative approach  Net output approach ignores role of intermediate inputs. Technical change only affects K and L.  Following Gollop (1982), our model of an open economy is set up by defining sectoral production possibility frontiers for each sector j as follows:

11 Sectoral frontiers

12 Aggregation

13 Decomposition of growth in real expenditure F  Advantages above GDP approach:  More general definition of technology  Industry deliveries to real expenditure rather than to real income  Role of prices?

14 Concluding remarks  Advantages of production possibilities frontier approach above GDP approach:  More general definition of technology  Industry deliveries to real expenditure rather than to real income  Innovation gains can spill over internationally  Decomposition is silent on causality: Why do export and import prices change?