FRBSF Economic Letter
2002-33; November 8, 2002
Productivity in the Twelfth District
The Regional Report appears on an occasional basis. It is prepared under
the auspices of the Financial and Regional Analysis Section of the FRBSF's
Economic Research Department.
Labor productivity, that is, real output per worker (or per worker hour),
is a primary determinant of our long-run standard of living. More output
per worker translates into higher profits, higher wages, or lower prices—or
a combination of the three. Therefore, understanding why labor productivity
is higher in one firm (or city, state, nation, industry, etc.) than another
is of vital importance. This Economic Letter looks at the levels
of output per worker in the Twelfth District, with an emphasis on California,
compared to that of the rest of the nation and discusses the possible
causes of regional differences in labor productivity.
Productivity in the Twelfth District vs. the
rest of the nation
To see how Twelfth District states compare to the rest of the nation,
I examine state-level data on real value-added (output) per worker. The
value-added measure is inflation-adjusted Gross State Product (GSP), which
is the state counterpart to the nation's GDP. The most recent data on
GSP are for 2000.
Six of the District's nine states are in the top 40% of all states in
terms of the level of output per worker in 2000. Alaska leads the nation,
largely due to the prevalence of a few industries with very high value-added
per worker (as well as high capital per worker), such as pipelines and
extraction of oil and natural gas. Washington and Oregon also rank fairly
high on the list, at 10th and 21st place, respectively (both above the
California, the largest District state, ranks sixth in the nation in
labor productivity. Figure 1 shows that, despite the high output per worker
in some other District states, on the whole, the rest of the District
has had a much smaller productivity advantage relative to the nation than
California has had. Moreover, California's advantage has been persistent,
whereas the advantage of the rest of the District is quite recent.
The size of California's productivity advantage has fluctuated over the
business cycle. California stretched its advantage over the national average
during the late 1980s and early 1990s only to give some of it back around
1993-1995. This reflects the fact that the recession of the early 1990s
hit California a bit later and was much longer and deeper than in the
rest of the nation (see Daly and Hsueh 2002); output per worker tends
to fall during recessions because firms tend not to cut employment as
readily as they cut production. After 1996, however, California extended
its productivity advantage. It remains to be seen how the downturn since
2000 has affected this advantage.
Where does the productivity advantage come
When accounting for California's considerable and persistent productivity
advantage, there are two components to consider. One component is the
industry composition in California—that is, California simply may have
more of its employment in higher-productivity industries (as Alaska does).
Another component is the performance of California business establishments
within the same industries—that is, California establishments may be
more productive than establishments in the same line of business elsewhere.
"Establishment" here means a store, office, plant, or other
single-location facility operated by a firm.
Figure 2 shows that in 1986 each component contributed about equally.
But from then on, the within-industry component became more dominant,
and by 2000 it was nearly the entire explanation for California's productivity
advantage. This implies that, on average, business establishments in California
have been more productive than establishments in the same industry elsewhere
in the nation.
One could argue with this conclusion, as the data on which it is based
are available only at a fairly aggregate level. Specifically, the data
are broken into 57 broad industry classifications, and these classifications
may be so broad that they fail to capture fully the effect of industry
composition on productivity differences. For example, the classification
"business services" includes businesses ranging from temporary
employment agencies to software development firms.
But three facts tend to support the conclusion that California business
establishments do have productivity advantages over those elsewhere in
the country. First, California's productivity advantage is quite broad-based.
Two-thirds of the 57 industries have higher productivity in California
than in the rest of the nation. Second, California has a productivity
advantage in industry classifications where the work is fairly well-defined,
for example, retail trade, construction, wholesale trade, and health services,
just to name a few. Furthermore, these well-defined industry classifications
generally have much larger employment shares than do industry classifications
covering more diverse businesses, such as "business services."
Therefore, they weigh more heavily in the evidence on the effect of industry
composition on productivity. So, while some portion of California's within-industry
advantage may reflect higher productivity industries, the majority almost
certainly reflects advantages at the level of business establishments.
What makes Californian establishments more
There can be any number of reasons for the difference in productivity
between any two establishments in the same industry. However, the sources
of productivity differences that could vary systematically across geographic
areas are relatively few. The economic literature on productivity suggests
six primary sources. The first, and possibly most important, source is
the quantity and quality of physical capital, particularly equipment,
used in the production process. Unfortunately, we have very little data
on capital investment at the state level, so it is difficult to quantify
The second potential source is more highly skilled labor, which tends
to be reflected in workers' compensation. In 2000, compensation per worker
was about $52,000 in California and about $44,000 for the U.S. outside
of California, indicating that more highly skilled labor is a likely contributor
to California's productivity advantage. To the extent that workers' compensation
reflects their marginal product (that is, their individual labor productivity),
the higher levels of compensation imply a higher skill level for the average
worker in California.
The next two items on our list of possible factors contributing to the
state's productivity advantage are very much intertwined: workplace practices
and institutional structure. Because of differences in business culture
and the like, firms in California may have organizational arrangements
that allow them to be relatively more efficient. Valletta (2002), for
example, argues that the business climate in California, particularly
in Silicon Valley, tends to put fewer restrictions on workers who want
to move from firm to firm or to leave to start up their own companies
than business climates elsewhere. This employee mobility fosters the rapid
diffusion of innovations and knowledge to other firms in the area. Such
features of business practice can be influenced by the institutional structure
of an area, e.g., its laws and financial institutions. For example, Valletta
argues that the high degree of employee mobility in parts of the tech
sector in California is facilitated by relatively unique features of California
employment law that allow departing employees to take valuable trade knowledge
with them to competing firms. The large number of venture capital funds
in Silicon Valley is another element of the institutional structure that
could confer productivity advantages to certain types of firms in that
area, though the causation can also work in the other direction with the
presence of high productivity firms drawing venture capital funds to the
Another source of productivity advantages at the establishment level
is inter-firm spillovers, which are the productivity benefits that accrue
to firms simply because of their proximity to other firms. For example,
if firms in the same industry are located near each other, that may lead
to increases in the interchange of ideas and talent, which then enhance
the productivity of every firm in the area. Such spillover effects frequently
are cited as a source of the success of Silicon Valley over the past several
decades. Similarly, density itself (aside from the concentration of firms
in a small number of industries) could lead to permanently higher output
per worker for an area because of lower costs of transportation from producers
to users and consumers (among other reasons). Thus, a state with a comparatively
large number of dense economic centers may have a persistent productivity
advantage. Ciccone and Hall (1996), in fact, estimate the extent to which
a state's production is generated in dense centers and find that California
ranks ninth among U.S. states.
Closely related to these five factors is the sixth factor, namely, the
choices firms make about where to locate specific activities. Large, geographically
dispersed firms may choose to locate their highest value-added per worker
activities (such as research and development), which also tend to be activities
that require highly skilled labor, in locations where labor quality is
high, knowledge spillovers are prevalent, and institutions are favorable
for fostering innovation. In addition, by taking advantage of the local
high-quality labor and favorable institutions, small, single-establishment
businesses may produce higher quality (and higher priced) products than
businesses elsewhere in the same broad industry produce.
It is clear that the Twelfth District as a whole has higher output per
worker than the national average, though productivity varies considerably
across District states. California stands out not only because of its
size, but also because it has had a productivity advantage relative to
the national average that is persistent, sizable, and expanding in recent
years. Moreover, the advantage appears to be due largely to advantages
at the level of business establishments.
The analysis here gives us a good handle on what the potential contributors
to productivity are, but the relative importance of each is still not
well understood. This is in part because both data constraints and conceptual
difficulties have prevented researchers from simultaneously focusing on
more than one source of the difference in regional productivity.
Without state-level data on capital investment, it is difficult to discern
how much of a state's productivity advantages are due to the more efficient
use of all resources as opposed to simply "buying" the higher
output per worker by giving workers more and better capital. Fortunately,
comprehensive firm-level data sets have become available recently, and
they are allowing researchers to overcome this hurdle and to gain a better
understanding of regional productivity differences.
[URLs accessed October 2002.]
Ciccone, Antonio, and Robert Hall. 1996. "Productivity and the Density
of Economic Activity." American Economic Review 86(1), pp.
Daly, Mary, and Lily Hsueh. 2002. "Recession
in the West: Not a Rerun of 1990-1991." FRBSF Economic Letter
2002-06 (March 8). http://www.frbsf.org/publications/economics/letter/2002/el2002-06.html
Valletta, Robert. 2002. "On
the Move: California Employment Law and High-Tech Development."
FRBSF Economic Letter 2002-24 (August 16). http://www.frbsf.org/publications/economics/letter/2002/el2002-24.html