Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs 85
simplicity. The approach requires that an assumption be made regarding the
mathematical form of the production function. Typically, the Cobb-Douglas and
CES specifications are used as well as a variety of more flexible forms, though
economists have had a great deal of difficulty agreeing on which form is best.
Furthermore, in addition to the need to measure the quantity of inputs used
in the process (which, as already outlined, is a feature of structural approaches),
the approach also requires that some estimate is made of the quality of factor
inputs. Studies as early as that of Solow (1957) have found that the physical
quantity of inputs provides a poor explanation of actual movements in output.
Indeed, this study found that factor inputs could explain only one-third of
growth with the ‘Solow residual’ or total factor productivity accounting for the
remainder. It is this residual that captures changes in the quality of inputs and
production processes. As Laxton and Tetlow note:
One important advantage of the production function approach over the time trend
approach is that it is easy to keep track of the major contributing factors to potential
output. That is, variations in its underlying determinants such as labour force
growth, capital formation, and trend total factor productivity. For this reason the
production function approach was seen as an attractive framework for organising the
data. However, there remained a problem. Since economists had no useful model of
the determinants of productivity, the resulting estimates were still essentially
exogenous time trends (p 7).
The use of ad hoc polynomial time trends as regressors in production functions
to explain productivity (see, for example, Perloff and Wachter, 1979), together
with their quantitative importance to the results, constituted a very significant
weakness in the empirical application of the production function approach.
Moreover estimates derived from these techniques proved to be very sensitive
to the type of approach used. Together these factors severely limited the practical
usefulness of the estimates.
Although the recent theoretical development of the endogenous growth
literature has provided some insights and stimulated debate regarding the
determinants of long-run growth, endogenous growth theory has received little
attention in empirical research to date.
Partly in response to the above problems, a new literature emerged in the
early 1980s in which changes in potential output and the natural rate of
unemployment were treated as stochastic (rather than deterministic) phenomena.
3.3 Stochastic filtering techniques
Laxton and Tetlow (1992) argue that there is insufficient knowledge about the
true structure of the economy to make the structural approach practical.
Moreover, researchers using structural techniques have tended to concentrate on
highly stylised models focusing on specific, easily identifiable shocks, and have