Shefali is an emerging market economy where labor cost accounts for 35% of total factor cost. The long-term trend of labor growth is 2%. Capital investment has been growing at 1.5% but is expected to grow at 3% in the future. Shefalian economy is expected to experience annual growth of 2.5% in total factor productivity. The potential GDP growth rate for Shefali is closest to: Using the growth accounting equation: growth rate in potential GDP = long-term growth rate of technology + α(long-term growth rate of capital) + (1 − &aplpha;) (long-term growth rate of labor) = 2.5% + (0.65)(3%) + (0.35)(2%) = 5.15%
My question is- why do we adjust the long-term growth rate of labor and the long-term growth rate of capital in the above equation? The formula has us bring those growth rates down based on the percentage of total factor cost that labor makes up for in that country? That doesn’t make intuitive sense to me…if labor cost accounts for a large percentage of total factor cost, wouldn’t that make the long-term growth rate in labor LESS of a contributor to long-term growth rate in GDP?
Thanks