What Is Behind Latin America’s Big Efficiency Gap

Countries in Latin America and the Caribbean (LAC) could have been twice as rich, had they enjoyed the same level of efficiency in capital and labor use as the United States of America.

That’s the stunning finding in a World Bank study Understanding the Income and Efficiency Gap in Latin America and the Caribbean.

As I discussed in a previous blog post, the fast growth of the 2000s allowed the region to achieve some degree of per capita income convergence compared to the United States. However, with the commodity boom now over, and in light of widespread fiscal imbalances, the region is struggling to find its footing.

Consequently, it’s unsurprising that long-term productivity is back on the region. But why is it that LAC has failed to systematically move towards the income levels of the developed country, as traditional growth theory would imply?

How big is LAC’s efficiency gap?

Let’s start by clarifying a couple of concepts. The “income gap” measures how far away LAC’s per capita income is from, say, that of the United States. Our study argues that the region’s workers produce on average just a fifth of the output of a US worker. Such a massive income gap could result from differences between the existing stocks of physical, human and natural capital in LAC and the US. That is, LAC is “capital poorer” than the US.

But it’s not quite that simple. Alongside income, efficiency – that is how well a country harnesses its labor force and its capital stock – is a major factor. In the economic growth literature, efficiency is also known as total factor productivity (TFP). On average, LAC countries are about half as efficient as the US in use of factors of production. This difference is known as the “efficiency gap”.

Low efficiency tends to perpetuate low productivity: lower returns reduce incentives to invest in new equipment, infrastructure, and schooling and, in turn, slow physical and human capital accumulation.

And whereas closing the capital gap requires a level of savings and investment that may be out of reach for many Latin American countries, improving efficiency, can be, in many ways, a lower-cost route to improving productivity.

But what is behind LAC’s efficiency gap?

To understand this, we first need to “unpack” the causes of low efficiency.

One possibility is the slow adoption of new technology from abroad. In this case, policy focus should be on removing barriers, such as increasing international integration or improving human capital.

In particular, the study noted that shocks to productivity growth in the frontier country (the United States) – for example, the introduction of a new technology – affect adopting countries (LAC) with a lag.

At the macroeconomic level, however, this lag is not very long: Only 8 years on average, which does little to explain the observed efficiency gap at a macro level. And while micro-level evidence points to longer delays, the seemingly contradictory results from micro and macro studies can be reconciled. Consequently, we cannot put technology adoption delays completely aside as an explanation for the efficiency gap.

Nonetheless, the uncertainty as to the relative importance of technology adoption lags requires another explanation: Resource misallocation.

Reallocation of labor vs. productivity growth in LAC

When comparing firm-level manufacturing data from Colombia, Mexico, and the United States, we can see that, in the two Latin American countries, the main driver of productivity after 2000 was growth within firms and not transfer of factors or resources between firms and sectors, to the most productive entities. In fact, within-firm productivity accounts for over two-thirds of total productivity gains in the two countries.

Changes in allocation of resources between firms accounted for just a fifth of overall productivity growth in Mexico, on average, and made almost no contribution at all in Colombia. This suggests that Mexico and Colombia did better during the 2000s in adopting technology, than on reducing resource misallocation, relatively speaking – and that the latter does a better job in explaining weak convergence to the frontier in those two countries.

The story is similar at the sectoral level. Millions of workers in Latin America have moved from the comparative high productivity of manufacturing to lower-productivity jobs in service sectors such as retailing, wholesaling, construction, and government.

In seven of nine countries sampled in the region between 1990 and 2005, this structural shift resulted in lower value-added per worker, dragging down the average labor productivity of the entire country (recent work by Dani Rodrik and his colleagues confirm this pattern). In Argentina, for example, several large service sectors have swelled in recent years, notably government employment. While these sectors provide many jobs, they are largely insulated from competition – both domestic or international – meaning there is little potential for market pressure to improve productivity and their value- added..

It’s expected that in a properly functioning economy, market forces steer workers toward higher-productivity sectors. The fact that this has failed to happen in so many of the region’s countries suggests the presence of distortions leading to resource misallocation.

Costa Rica, however, demonstrates that growth in services doesn’t have to equate lower productivity overall. Here, resource shifts towards service sectors tended, in fact, to increase overall labor productivity. Since Costa Rica’s economy is more open than most in the region, the presence of large foreign chain stores may have driven up formal employment, which is normally a prelude to higher productivity. And while manufacturing’s share of the total jobs pool shrank, the net effect of the labor structure shift was an overall boost in value-added per worker in the economy at large.

What’s next?

Understanding the reasons behind the income gap in Latin America and the Caribbean is a necessary step toward designing appropriate growth strategies. In my next post, I will focus on what can be done to help close LAC’s big efficiency gap.