Our analysis begins by examining the proximate causes of economic success. We decompose differences in output per worker across countries into differences in inputs and differences in productivity.

There are three approaches to the decomposition of output per worker into inputs and productivity. One was developed by Christensen, Cummings and Jorgenson (1981) and involves the comparison of each country to a reference point. A country’s productivity residual is formed by weighting the log-differences of each factor input from the reference point by the arithmetic average of the country’s factor share and the reference factor share. The second is similar, except that the factor shares are assumed to be the same for all countries; this amounts to calculating the residual from a Cobb-Douglas technology. Finally, there is a method based directly on Solow (1957), discussed in a predecessor to this paper, Hall and Jones (1996), and summarized below. Because the Solow method gives results quite similar to those based on Christensen et al. (1981) or on Cobb-Douglas with standard elasticities, we will not dwell on this aspect of the work. We present results based on the simplest Cobb-Douglas approach.

Assume output Yi in country i is produced according to where Ki denotes the stock of physical capital, Hi is the amount of human capital-augmented labor used in production, and Ai is a labor-augmenting
measure of productivity. We assume labor Li is homogeneous within a country and that each unit of labor has been trained with Ei years of schooling (education). Human capital-augmented labor is given by

In this specification, the function ф(Е) reflects the efficiency of a unit of labor with E years of schooling relative to one with no schooling (ф(0) = 0). The derivative ф'(Е) is the return to schooling estimated in a Mincerian wage regression (Mincer 1974): an additional year of schooling raises a worker’s efficiency proportionally by ф'(Е)? Note that if ф(Е) = 0 for all E this is a standard production function with undifferentiated labor.