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Economic Analysis (EA) Research Paper Series


Competition, Firm Turnover and Productivity Growth

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Competition, Firm Turnover and Productivity Growth

by J.R. Baldwin and W. Gu

Executive summary

This paper investigates the extent to which productivity growth is the result of firm turnover as output is shifted from one firm to another, driven by the competitive process. One part of turnover is due to entry and exit. The other part arises from growth and decline in incumbent continuing producers. Previously, we examined the impact of reallocation across establishments on aggregate productivity growth. In this paper, we measure the contribution of firm turnover and reallocation among firms to aggregate productivity growth. We ask how the shifts in market share from declining firms to growing firms enhances productivity growth.

Several studies have examined the contribution that this reallocation of outputs and inputs across individual producers makes to aggregate productivity growth. Many of these studies argue that reallocation often accounts for very little of aggregate labour productivity growth and that the main source of labour productivity growth comes from labour productivity growth within plants (see Organisation for Economic Co-operation and Development, 2001, and Scarpetta et al., 2002). The inference that is often drawn is that the competitive process is relatively unimportant when it comes to productivity growth. This paper argues that these other studies are misleading and based on imperfect analytical models.

In this paper, we argue that most previous studies underestimate the contribution of competition to labour productivity growth. To account for the contribution of output reallocation to labour productivity growth, we develop a decomposition method that measures the ‘between-firm’ component capturing output reallocation and the ‘within-firm’ component that consists of organic productivity growth that is unrelated to shifts in the relative importance of firms. We make use of a counterfactual calculation for this decomposition. In the counterfactual calculation, we ask what would have happened if we assume that there are no changes in the output shares of firms during the period. This produces an estimate of labour productivity change that would have occurred if there had been no change in market share — the within-firm component — and is different from the value of labour productivity change that was actually observed. The difference between what was actually observed and this counterfactual estimate is the between-firm component measuring the effect of output reallocation across firms that come from the competitive process of shifting output from one firm to another.

Most previous studies on firm turnover and labour productivity growth measure the contribution of the within-firm component to labour productivity growth, holding labour shares constant. This assumption is not neutral with respect to output shares. While there is no reallocation of employment across individual firms, there is an implicit reallocation of output taking place that is included in the within-firm component of this approach. It is just not recognized to be there. In particular, with constant labour shares and changing relative labour productivity, output and market share is shifted towards those firms with faster labour productivity growth. We show that this approach implicitly assigns most output share change to the within-firm component and therefore underestimates the between-firm component. In contrast, our decomposition focuses on output reallocation.

The results from using our decomposition method show that output reallocation and competition are an important source of labour productivity growth accounting for most of the overall labour productivity growth in Canadian manufacturing over a 10-year period. For the Canadian manufacturing industries, about 70% of overall labour productivity growth is due to changes in market share across firms in the periods from 1979 to 1989, and from 1989 to 1999. In contrast, the alternative method produces results suggesting that competition made little contribution to productivity growth.

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