Breunig&Wong.

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The Australian Economic Review, vol. 40, no. 1, pp. 1–7

Policy Forum: Industry Dynamics

The Role of Firm Dynamics in Australia’s Productivity Growth

Robert Breunig and Marn-Heong Wong*

School of Economics, The Australian National University; and
Productivity Commission, respectively

1. Introduction 2. Explanations of Firm Dynamics

One seldom-explored factor explaining indus- Explanations of firm dynamics have centred
try productivity growth in Australia is the role around three themes. The first is the Schumpe-
of firm entry and exit. The importance of firm terian notion of ‘creative destruction’, where
dynamics has been highlighted by a growing entrants armed with new technology compete
number of international studies on large-scale with incumbents. If the entrants’ innovations
longitudinal micro datasets; however, only one succeed, they replace the incumbents. If not,
such study has been undertaken on Australian they fail to survive. Thus, aggregate productiv-
firms (see Bland and Will 2001). ity evolves with successive waves of innova-
Firm dynamics which result in a reallocation tion through entry and exit and the resulting
of output shares and resources from low to high resource reallocation. The second explanation
productivity firms can substantially impact is based on the concept of experimentation
aggregate productivity growth. Accordingly, under uncertainty, where firms in an industry
policies aimed at enhancing aggregate produc- make different bets on technologies, goods and
tivity and economic growth should take into production facilities. These generate differ-
account the costs of entry (such as excessive ences in outcomes and firms make decisions to
administrative regulations) and exit (such as in- expand, contract or exit as they learn about the
solvency regimes).1 In this light, the role of environment and their capabilities. Approach-
firm dynamics in Australia’s productivity ing the issue from a slightly different angle, the
growth merits greater attention, and it is the third premise links firm dynamics with product
aim of this article to document its importance. life cycles. Entry is relatively easy and there
In this article we review patterns of firm are many players when a successful new prod-
movements and present estimates of the contri- uct appears. As the market matures, the growth
bution of firm dynamics to the productivity of demand decelerates and economies of scale
growth of Australian industries. Our estimates become more important. Consequently, the
are principally drawn from the Business Longi- number of firms declines sharply, and then lev-
tudinal Survey (BLS), which covered the pe- els off. For evidence, see the review by Ahn
riod 1994–95 to 1997–98.2 (2001).
Another common way of thinking about
firm-level and overall productivity changes is
to distinguish between movements of firms
from an inefficient point to an efficient point on
* The authors would like to thank the Australian Bureau of
the frontier and between movements of the en-
Statistics for providing access to the data and, in particular,
Shiji Zhao and Valentin Valdez for their support and assis- tire frontier. This is elaborated in, for example,
tance. The content of this article does not reflect the views Dawkins and Rogers (1998). ‘Level’ effects
of the Productivity Commission. involve reducing a firm’s inefficiency and
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2007 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research
Published by Blackwell Publishing Asia Pty Ltd
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2 The Australian Economic Review March 2007

moving it towards the production frontier. By such as office, accounting and computing ma-
definition, any productivity growth from such chinery had relatively high entry rates in most
changes will be short-lived. ‘Growth’ effects countries.
impact on the long term and relate to moving The initial years for entrants were tough.
the frontier outwards through, for example, in- Only 60 to 80 per cent of new firms survived
novation and human capital investment. Some the first two years of life and 40 to 50 per cent
factors may affect both level and growth, such of firms survived beyond the seventh year.
as the degree of competition in an industry,
which is likely to shape both the level of effi- 3.2 Australian Evidence
ciency and nature of innovation. Using Dawk-
ins and Rogers’ (1998) differentiation, firm In Australia, entry rates across 25 2-digit indus-
dynamics and resource shifts are likely to have tries ranged from 4.1 to 22.7 per cent and the
both level and growth effects on productivity at exit rate varied between 6.9 and 22.8 per cent
any time, depending on the composition of the over the period 1994–95 to 1997–98. The over-
factors driving firm dynamics. all annual entry rate was 4.7 per cent, and the
average exit rate was 4.6 per cent, which gave
3. Patterns of Firm Dynamics a turnover rate of 9.3 per cent.3 This is near the
lower end of the range of turnover rates in other
3.1 International Evidence countries for the same time period.
Entrants were on average 13 per cent of the
Extensive surveys on firm churning may be size of incumbents across all industries. This
found in Caves (1998), Tybout (2000) and Ahn was below the differential in most countries,
(2001). While these surveys cover a variety of but similar to the entrant–incumbent size gap
countries, industries and time periods, there is in the United States and Canada, which was
general agreement on the empirical regulari- between 10 and 20 per cent in the 1990s (Bar-
ties. To begin with, many firms enter and exit telsman, Haltiwanger and Scarpetta 2004). Ex-
most markets every year, and large changes in iting firms also tended to be smaller and
market shares across continuing firms are com- younger compared with incumbents, and this is
mon. Entrants are typically small and initial consistent with international findings. How-
failure rates are high, but successful entrants ever, the mean (median) age of an exiting firm
grow quickly. One implication is that new in the BLS of 9.8 (7.4) years implies that the
firms are on average less productive than in- majority of firms that eventually exit survived
cumbents. New firms, at start-up, may even be beyond the initial few years. This supports the
less productive than exiting firms. However, observation in Bickerdyke, Lattimore and
over a longer time horizon of five to ten years, Madge (2000) that Australian firms appear to
most surviving entrants catch up with incum- survive longer than their overseas counter-
bents. parts. Consistent with the evidence from other
In a recent study of 24 industrial and devel- countries, service industries experience greater
oping economies in Europe, North America, flux, with large turnover rates in sub-sectors
Latin America and East Asia by Bartelsman, such as retail trade, accommodation, cafes and
Haltiwanger and Scarpetta (2004), it was found restaurants, sport and recreation, and personal
that annual gross entry and exit rates varied be- services.
tween 10 and 25 per cent. Both entering and ex- We also compared the entry and exit picture
iting firms were, on average, smaller than yielded by summary statistics from the BLS
continuing incumbents. New firms were gener- with summary statistics compiled from the
ally only 20 to 60 per cent of the average size Australian Tax Office’s (ATO) unpublished
of incumbents. Turnover rates were higher in business income tax data. We found that ATO
the services sector (particularly in wholesale entry rates were much higher than those for the
and retail trade) compared with manufacturing. BLS. The ATO figures include ‘illegitimate’
However, some high technology industries entrants—for example, when companies that
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2007 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research
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Breunig and Wong: Role of Firm Dynamics in Australia’s Productivity Growth 3

have undergone restructuring form new sub- The decomposition method used is an exten-
sidiaries, or break up into several new firms, sion to a method proposed by Fox (2004)
and identify themselves as ‘commencing busi- (which we call the ‘extended-Fox decomposi-
ness’. However, the higher entry rates may also tion’6), as follows:
indicate an understatement of entry in the
∑ θi0ΔPi1 + ∑ ⎛⎝ --2-⎞⎠Δθi1ΔPi1 –
BLS.4 ΔP 0, 1 =
1
The ATO exit rates over a three-year interval i∈C i∈C
in the 1990s were moderately lower than the
∑ ⎛⎝ --2-⎞⎠Δθi1(a) + ∑ ⎛⎝ --2-⎞⎠ θi1(Pi1 – a) –
1 1
BLS exit rates. The evidence from both ATO
i∈C i∈N
and BLS statistics, then, seems to point to a
modest pace of firm exits in Australia. Similar ⎛ 1---⎞θ (P – a)
to the BLS, the ATO data showed that service
∑ ⎝ 2⎠ i0 i0
(1)
i∈X
industries had greater turnover compared with
manufacturing industries. Food retailing and where ΔP0, 1 is the growth of industry MFP be-
accommodation, cafes and restaurants re- tween periods 0 and 1; θi is the output share of
corded the highest volatility. firm i; Pi is each firm’s productivity level; and
The pattern of a high entry rate alongside a a is a scaling factor, which is the average ag-
relatively low exit rate across industries in gregate productivity level between the two pe-
Australia is different from most other coun- riods in our formulation. i indexes individual
tries. One possible reason is that Australia has firms in C, N and X, which are the sets of con-
been experiencing a sustained period of eco- tinuing, entering and exiting firms, respec-
nomic growth. The annual average turnover tively. The five terms on the right-hand side
rate from ATO data of 12.1 per cent appears to represent, in order, the fractions of industry
support the finding from BLS figures that Aus- productivity change attributable to ‘within-
tralia is among the developed countries with firm’ changes, ‘between-firm’ output share re-
the lowest firm turnover rates. allocation effects, ‘pure share’ changes, entry
More recent aggregate figures compiled by and exit. Table 1 presents the results from our
the Australian Bureau of Statistics (2005) from decomposition.7
ATO data show that the pattern of high entry Our detailed findings provide evidence that
rate and low exit rate has continued. Between firm dynamics was a key factor behind changes
2002–03 and 2003–04, the average annual in Australian industries’ MFP performance in
entry rate was 11.2 and the exit rate was 4.2 for the mid-1990s. The last column of Table 1
all industries. shows that the net effect of entry and exit is
positive for 20 of the 25 industries considered.
4. Productivity Decomposition Analysis This arises more from the positive impact of
firms with below average industry productivity
We have estimated the contribution of firm dy- exiting the market, as entrants are more likely
namics to aggregate productivity growth to contribute negatively to MFP change in the
through decomposing productivity change into first few years following entry.
two components: intra-firm productivity Looking at the other results in the table, the
change and inter-firm market share realloca- contribution from within-firm productivity
tion. A measure of multifactor productivity change is negative in over half of the industries.
(MFP) has been constructed from production In several industries such as personal and
function estimates, following Olley and Pakes household goods retailing and services to trans-
(1996), that incorporates firm-specific produc- port, the overall MFP increase is due entirely to
tivity differences and endogenises firms’ exit firm dynamics, as the within-firm component
decisions.5 Aggregate productivity for each of is negative. By contrast, the between-firm real-
25 industries is then obtained as the sum of location effect is positive in nearly all indus-
firm-level MFP weighted by each firm’s share tries; that is, activities have shifted rationally
of industry output (market share). from the less to more productive incumbents.
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4 The Australian Economic Review March 2007

Where industries experiencing MFP growth cation terms are also important in offsetting
enjoy both positive within-firm and between- negative within-firm effects in industries regis-
firm contributions, the share of between-firm tering MFP decreases. This is the case, for ex-
reallocation is usually greater. Positive reallo- ample, in the textile, clothing, footwear and

Table 1 Contributions to Industry Productivity Growth

Share of components in normalised MFP changea (1995–1998)
Pure
Within- Between- share MFP Net entry
Industry ANZSIC firm firm change Entry Exit change effect b
Manufacturing C
Food, beverage and tobacco 21 0.821 0.295 –0.365 –0.010 0.259 1.000 0.248
Textiles, clothing, footwear and leather 22 –0.809 0.207 –0.532 0.002 0.132 –1.000 0.134
Wood and paper product 23 –1.657 1.174 –0.509 –0.019 0.012 –1.000 –0.007
Printing, publishing and recorded media 24 –0.344 –0.064 –0.345 0.019 –0.266 –1.000 –0.247
Petroleum, coal, chemical and associated
product 25 –0.891 0.155 –0.283 –0.007 0.027 –1.000 0.020
Non-metallic mineral product manufacturing 26 –0.378 0.201 –0.952 –0.005 0.134 –1.000 0.129
Metal product 27 –0.208 0.090 –1.402 0.014 0.506 –1.000 0.520
Machinery and equipment 28 –2.394 1.843 –0.639 –0.003 0.193 –1.000 0.190
Other 29 –2.627 4.177 –0.588 –0.036 0.074 1.000 0.038

Construction E
General construction 41 –0.750 0.397 –1.516 0.008 0.861 –1.000 0.868
Construction trade services 42 0.531 0.306 0.049 0.117 –0.003 1.000 0.114

Wholesale trade F
Basic material wholesaling 45 –1.311 0.318 –0.099 0.050 0.043 –1.000 0.093
Machinery and motor vehicle wholesaling 46 –2.976 2.354 –0.455 0.049 0.029 –1.000 0.078
Personal and household good wholesaling 47 0.431 0.537 –0.007 0.013 0.025 1.000 0.038

Retail trade G
Food retailing 51 0.446 0.668 –0.141 –0.003 0.029 1.000 0.027
Personal and household good retailing 52 –1.257 3.018 –0.611 –0.026 –0.124 1.000 –0.150
Motor vehicle retailing and services 53 0.515 0.677 –0.184 –0.025 0.018 1.000 –0.007

Accommodation, cafes and restaurants H/57 –0.470 0.734 –2.846 –0.013 1.595 –1.000 1.583

Transport and storage I

Road transport 61 0.930 0.479 –1.908 0.020 –0.521 –1.000 –0.501
Services to transport 66 –0.963 0.939 0.260 0.849 –0.084 1.000 0.765

Property and business services L

Property services 77 0.281 0.659 0.044 –0.006 0.022 1.000 0.016
Business services 78 1.272 0.052 –0.406 –0.024 0.107 1.000 0.083

Cultural and recreational services P

Motion picture, radio and television services 91 0.398 0.892 –0.392 –0.002 0.105 1.000 0.102
Sport and recreation 93 1.637 –0.470 –0.316 0.000 0.149 1.000 0.149

Personal and other services Q

Personal services 95 0.848 0.116 0.011 0.041 –0.017 1.000 0.024
Notes: (a) The MFP change indicator is normalised to one for each industry. The within-firm, between-firm, pure share
change, entry and exit effects sum to one.
(b) The net entry effect sums the entry and exit components in the ‘Entry’ and ‘Exit’ columns.

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2007 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research
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Breunig and Wong: Role of Firm Dynamics in Australia’s Productivity Growth 5

leather industry, where positive reallocation ef- 5. Summary Remarks

fects compensated for 30 per cent of the nega-
tively contributing terms. In sum, our detailed Firm entry and exit is a regular feature of pro-
findings support firm dynamics and the reallo- duction around the world and Australia is no
cation of output to more productive firms as the exception. An examination of the pattern of
key factors behind the aggregate positive pro- firm dynamics based on BLS and ATO data in-
ductivity performance of Australian industry in dicates that Australian industries are charac-
the mid-1990s. terised by average (compared with other
developed countries) entry rates alongside rel-
4.1 Comparison with Other Studies atively low exit rates. Our analysis reveals that,
despite being amongst the countries with lower
Our study, along with many using longitudinal firm turnover, the exit of low productivity firms
firm-level data, has identified an important ef- from the market nevertheless has made a non-
fect of firm dynamics in contributing to aggre- negligible contribution to industry-level pro-
gate productivity growth. Firm dynamics are ductivity increases. Our analysis also shows
demonstrated to be an important factor in pro- that market share reallocation among continu-
ductivity growth in manufacturing industries ing firms accounts for a significant share of in-
by Baily et al. (1992) and Foster, Haltiwanger dustry MFP growth and/or compensates for
and Krizan (2001) for the United States, MFP declines. Studies, and policies, based
Levinsohn and Petrin (1999) for Chile, and upon a model of a representative firm which is
Hahn (2000) for Korea. increasing its productivity are flawed in a world
Our finding that exit contributes more than where firm dynamics, a growing role for more
entry is also found in Bartelsman, Haltiwanger productive firms, competition from entrants,
and Scarpetta (2004) for a wide range of devel- and failure of low productivity firms are impor-
oped and developing countries. We share the tant sources of aggregate productivity growth.
view of Scarpetta et al. (2002), who found that
service industries in the United Kingdom December 2006
showed more varied outcomes than manufac-
turing industries. We find that firm dynamics Endnotes
contribute equally to productivity growth
across manufacturing and services, unlike Fos- 1. New firms which start out with low produc-
ter, Haltiwanger and Krizan (2002) and van der tivity may have the potential to become high
Wiel (1999) who find that services are more af- productivity firms in the future, as pointed out
fected by market share reallocation, in particu- by Webster, Buddelmeyer and Jensen (2007) in
lar entry and exit. this Policy Forum. However, this would only
Bland and Will (2001), using only the small- be a basis for a policy of saving low productiv-
and medium-sized firms in the BLS, find, in ity entrants from failure if the government
contradiction to our study, that within-firm ef- could successfully pick which firms will fulfill
fects make the most important contribution to their potential or if the average expected pro-
labour productivity increases. Furthermore ductivity of these low productivity entrants is
they find small, mostly negative, net entry ef- higher than the average expected productivity
fects and, in accordance with our results, that of incumbents.
entering and exiting firms have lower than av-
erage (labour) productivity. These differences 2. See Breunig and Wong (2006a). Analysis re-
are driven by several factors: our study uses 2- ported in this article is based on the Main Unit
digit industries instead of 1-digit industries; we Record File (MURF) of the BLS, which in-
include the large firms which they exclude; we cludes large firms in addition to small- and
analyse MFP instead of labour productivity; medium-sized firms. MURF is available only
and we use a decomposition that we believe is on site at the Australian Bureau of Statistics for
theoretically superior.8 confidentiality reasons.
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6 The Australian Economic Review March 2007

3. This is lower than Webster, Buddelmeyer References

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