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Updated at 2018/07/12

The level of productivity is the most fundamental and crucial determinant of a standard of living. Increased productivity allows people to get what they want faster, or to get more of what they want in the same amount of time. Supply rises with productivity, dropping real prices and increasing real wages; it lifts people out of poverty and allows them to focus on efforts beyond mere survival.

In economics, physical productivity is defined as the quantity of output produced by one unit of input within one unit of time. The standard calculation for economic productivity involves dividing output value per unit of input (e.g., 5 tons per hour). An increase in physical productivity causes a corresponding increase in the value of labor, which raises wages. This is why having an education or on-the-job training is sought after by employers; it increases the productivity of the workers and makes them more valuable assets for the firm.

To see how productivity raises wages, consider the following example. An employer offers you $15 to dig a 25-square foot hole in his backyard. Suppose that you have insufficient capital goods (your bare hands or a spoon), and it takes you three hours to dig the hole to his specifications. Your labor output is worth $5 per hour. If you had a shovel instead, it may have only taken you 30 minutes to dig the hole; your labor output just rose to $30 per hour. With a big enough crane, you may have been able to dig it in five minutes with a labor productivity of $180 per hour.

Capital goods – machines, technology, improved techniques – are crucial factors in determining productivity. To take a historical example, consider the economy of the United States in 1790 when nearly 90% of the working population was involved in agriculture. Fast forward to 2000 and, according to the U.S. census, less than 1.5% of the population was involved in agriculture. By percentage, agriculture consumed some 60 times as much labor in 1790, yet agricultural output is significantly larger today than in the 18th century. This makes food prices much less expensive today, and it frees up hundreds of millions of labor hours that can be employed towards other ends. This is how an economy grows.

Growth in productive capital requires periods of underconsumption. To take the time to build a better machine or lay infrastructure, producers must necessarily devote less energy towards making immediately consumable goods – the fisherman isn't catching fish while he is mending his fishing net, for instance. These periods of underconsumption need to be funded, which is why businesses need investment for new capital projects. To supply this investment, consumers delay their own satisfaction and provide funding for businesses in exchange for (expected) greater levels of future consumption. This way, capital investment leads to greater productivity and future economic gains.

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