DEFINITION of 'Solow Residual'

The Solow residual is the portion of an economy’s output growth that cannot be attributed to the accumulation of capital and labor, the factors of production. It is a measure of productivity growth that is usually referred to as total factor productivity (TFP).

BREAKING DOWN 'Solow Residual'

The Solow residual is based on the work of Nobel prize winning economist Robert Solow, whose growth model defined productivity growth as rising output with constant capital and labor. It tells you whether an economy is growing because of increases in capital or labor, or because those inputs are being used more efficiently. Solow found that only one-eighth of the increase in labor productivity in the United States between 1909-49 could be attributed to increased capital. America, in other words, became great because of American know-how.

Total factor productivity is affected by a huge variety of technological, economic and cultural factors. Innovation, investment in more productive sectors, and economic policies aimed at liberalization and competition all boost TFP. Conversely, underdeveloped financial markets that fail to allocate capital efficiently, restrictive labor practices, environmental regulations or anything else that affects the aggregate productivity of the economy, reduce it. Thus, TFP has become a proxy for technological progress. Differences in economic development are primarily explained by differences in countries’ TFP levels.

Right now, China is running out of steam because it has a major productivity problem. Its growth ‘miracle’ has been the result of rapid capital accumulation and shifting underutilized labor into a modern capitalist economy, rather than a rise in productivity. Its TFP has actually been shrinking since 2015, according to the Conference Board, because it has wasted huge amounts of financial resources on inefficient state-owned enterprises in industries like steel, coal and cement, and excess infrastructure.

As China’s labor force contracts, due to its decades-long “one-child” policy, China’s economic growth rate looks unsustainable. Given that the fate of the global economy depends on whether China can increase TFP, investors should expect to hear this term used a lot more in the coming years. Unless China implements free-market reforms and truly opens its markets, it may become cheaper to manufacture in the United States. Any trade war with China has to be seen in this context.

  1. Robert M. Solow

    Robert M. Solow is an American economist who spent his career ...
  2. Growth Accounting

    Growth accounting is a method of measuring economic growth where ...
  3. Productivity

    Productivity measures the efficiency of production in macroeconomics, ...
  4. One-Third Rule

    A rule of thumb that estimates the change in labor productivity ...
  5. Labor Productivity

    Labor productivity is a term for the output of a country's economy ...
  6. Residual Value

    Residual value is the value of an asset at the end of its lease ...
Related Articles
  1. Insights

    3 Ways Robots Affect the Economy

    Robotics is increasingly shaping the way that many industries operate, and is impacting employment. Its usage has both positive and negative effects.
  2. Tech

    China's Economic Collapse Good For the U.S.?

    After years of unprecedented expansion, growth in China has finally begun to slow. Does the United States need to worry or can it benefit?
  3. Investing

    Problems Loom For The Chinese Economy

    In 2010 China became the world's second largest economy, yet some analysts see problems ahead. Find out why.
  4. Insights

    5 Things to Know About the Chinese Economy

    China's once fast-moving economy has slowed in recent years, but it still has a lot of room for growth.
  5. Insights

    The Economics of Labor Mobility

    Loosening labor restrictions, which allows for geographic and occupational mobility, has both good and bad effects on a country and its workers.
  6. Insights

    Factors Of Production

    Factors of production is an economic term describing the general inputs used to produce goods and services to make a profit. Under the classical view of economics, the factors of production consist ...
  7. Insights

    4 Economic Challenges China Faces in 2016

    Learn about the four economic challenges China faces in 2016 and what China's leaders plan on doing to tackle a slowing economy and high corporate debt.
  8. Insights

    One Reason Jobs Shrink: Superstar Companies

    Are superstar companies that dominate their industries but employ relatively few workers to blame for labor’s falling share of GDP?
  9. Insights

    Eyeing China? Consider These Economic Indicators

    If you're considering investing in China and want to know when to buy, sell, hold or stay away, consider these economic indicators.
  10. Insights

    How Demographics Drive The Economy

    Demographics can have a profound effect on the economy. An aging population coupled with a declining birthrate points to a decline in economic growth.
  1. How is residual value of an asset determined?

    Understand what the residual value of an asset is and how the residual value of an asset is calculated. Learn how residual ... Read Answer >>
  2. Why are the factors of production important to economic growth?

    Find out why the factors of production are critical for real economic growth, where wages rise and consumer goods costs fall ... Read Answer >>
  3. What is 'capital' in relation to the factors of production?

    Find out what economists mean by physical capital, how it contributes to the productivity of labor and why it is a crucial ... Read Answer >>
  4. How is an economy formed and why does it grow?

    Find out how an economy forms and why it grows, including the role that financial markets play and how productivity increases ... Read Answer >>
  5. What are some advantages of a market economy over other types of economies?

    Learn what a market economy is, the main assumption behind a market economy and some important advantages it has over other ... Read Answer >>
  6. Which Countries are Most Important in Electronics?

    Learn how China, America and Germany are contributing to producing and exporting electronics globally as the top countries ... Read Answer >>
Trading Center