Turnover-Based Productivity Growth October 31, 2005 James Tybout Pennsylvania State University and NBER

Productivity decompositions In standard productivity decompositions, turnover-based productivity growth (TBPG) occurs when: –Unproductive firms exit and more productive firms enter. –Market shares are reallocated from low productivity firms to high productivity firms. The other source of productivity growth is intra-firm productivity growth (IFPG). –Vintage effects –Endogenous innovation –Learning spillovers –Random shocks

TBPG and IFPG are jointly endogenous processes Because of vintage effects and endogenous innovation, IFPG reacts to turnover. TBPG, in turn, reflects the patterns of decay in relative productivity among incumbent firms. Transition dynamics can be subtle, and time horizons can be lengthy.

Descriptive analysis of TBPG has its limits Sometimes major policy shocks make it possible to draw inferences from descriptive statistics (e.g., Bartelsman et al, 2004, concerning the transition economies). But often, it is difficult to assess an industrial sectors performance and its relation to policy using productivity decompositions and reduced-form regressions. The alternative: structural models of industrial evolution.

Structural models with TBPG Because they are forward-looking models with uncertainty and multi-agent optimization, industrial evolution models are computationally cumbersome. The scope for variation in model specification is extensive: –Endogenous versus exogenous innovation –Competitive versus imperfectly competitive market structures –Vintage effects versus homogeneous capital –Perfect versus imperfect capital markets –Partial versus general equilibrium –Open versus closed economy But progress is being made, so specific stories about TBPG in specific contexts are starting to emerge. A (non-representative) sampling of developing country studies follows.

Macro shocks and subsidies for incumbent firms Bergoeing, Loayza and Repetto (2004) assume: –Firm-specific vintage capital and exogenous productivity shocks –endogenous turnover They explore the effects of production subsidies on the speed of recovery from a negative aggregate shock. The subsidy keeps low-productivity firms active. So: –subsidizing incumbents in the aftermath of a shock reduces volatility and firm destruction at the cost of a long period of stagnation. –The loss in present value of GDP is a factor of 1.5 to 2.5, depending upon the magnitude of the subsidy (3% or 6%). –Qualitatively, the simulations are consistent with cross-country correlations of regulatory indices with indices of the severity of recessions.

Exchange rate volatility and selection Pratap and Urrutia (2004) study industrial evolution in a context with: –foreign currency financed investment, –exports, –potential bankruptcy –exogenous, idiosyncratic productivity shocks Main findings: –Depreciation discourages investment by reducing the net worth of firms with dollar-denominated debt, and thereby raising borrowing costs. –This effect can dominate the demand-side effect of depreciation

Exchange rate volatility, interest volatility and TBPG Bond, Tybout and Utar (2005) assume: –Firms are closely held by risk-averse households with heterogeneous wealth. –Firms profits are determined by their capital stocks, productivity shocks, and the exchange rate. –Households choose whether to create (or shut down) proprietorships. Those that operate proprietorships choose how much to invest in them, subject to collateral constraints.

Exchange rate volatility, interest volatility and TBPG BTU (2005) estimate profit function and macro processes using Colombian data. They explore the effects of crisis-prone macro environments on TBPG and investment behavior. Key effects: –Households with modest wealth less likely to operate proprietorships during volatile periods. –Incumbents with big, poorly performing firms that would have exited in a stable environment are more inclined to hang on.

Simulated Transition to High Volatility Initially, volatility increases number of firms, relative to the base case

Simulated Transition to High Volatility The association between size and profitability is initially weakened by volatilitybig, poorly performing firms are induced to hang around

Simulated Transition to High Volatility The poorly performing firms that hang on reduce size-weighted productivity significantly.

Import competition and TBPG Erdem and Tybout (2004) examine the effects of import competition using an open economy version of the Pakes and McGuire (1994) model: –Oligopolistic market structure –Endogenous investments in innovation –Vintage capital effects – Imports are imperfect substitutes for domestic varieties –Quality of imports increases stochastically ET (2004) study the effects on TBPG (and welfare) of a reduction in the price of imported goods; accelerated innovation abroad.

Reduced Import Prices and efficiency Average quality of the domestic goods initially improves relative to imports. Why? The worst firms/product lines immediately shut down, and the deterioration due to reduced investment is gradual.

Reduced import prices and innovation But incentives to innovate are less because profits are lower (Schumpeter). So firms have shorter average life expectancies (not shown), and entry/exit go up.

Reduced import prices and producer surplus Producers earn less surplus in the new regime : –smaller mark-ups, –smaller market shares, –shorter life spans.

Accelerated improvement in imported goods Domestic goods quality improves rapidly because new firms/product lines embody best practice. Turnover is more rapid because firms have more incentive to be new.

Accelerated improvement in imported goods But heightened import competition reduces producers incentives to invest in innovation (Schumpeter wins again).

Concluding remarks Theoretical models provide some interpretations for TBPG and IFPG, and their relation to policy. But the relationships are subtle, dynamic and very dependent upon specific modeling assumptions. Some findings particular to special contexts have begun to emerge, but much remains to be done.

Concluding remarks Some directions to push in: –Move toward econometric estimation –Allow for endogenous innovation. –Model entrants in a more realistic way –Do a better job of characterizing performance –Study entry costs more closelywhen are they excessive?