Final answer:
Total factor productivity growth represents the portion of economic growth not explained by increases in capital or labor but is attributed to improvements in technology, efficiency, and innovation. It is a critical component distinguishing long-term economic growth and higher wages in an economy.
Step-by-step explanation:
Total factor productivity growth is that part of economic growth that is neither due to capital growth nor labour growth. Instead, it is the growth that can be attributed to factors beyond the mere accumulation of capital and labor input increases. Economic growth can often be characterized by improvements in physical and human capital deepening as well as advancements in technology.
The commonly used framework to analyze economic growth is an aggregate production function, which tries to estimate how much of per capita economic growth is due to growth in physical capital and human capital. When the growth in output is not fully explained by the increases in measurable inputs like capital and labor, the difference is often referred to as the 'residual'. This residual is typically attributed to total factor productivity growth, which includes elements such as technological progress, organizational improvements, and other forms of innovation that enhance the efficiency of capital and labor.
In the long run, the rate of productivity growth is the primary determinant of an economy's rate of economic growth and higher wages. This is because small percentage changes in growth rates can lead to significant impacts on the GDP per capita over time, highlighting the importance of productivity rates similar to compound interest and growth rates. Hence, total factor productivity growth is an essential component of a healthy economic growth climate, consisting of improvements in human capital, physical capital, and technology within a market-oriented environment with supportive public policies and institutions.