Firm productivity dynamism in the euro area

Prepared by Rodrigo Barrela, Vasco Botelho and Paloma Lopez-Garcia

Published as part of the ECB Economic Bulletin, Issue 1/2022.

This box discusses how movements of firms along the productivity distribution over time affect aggregate productivity growth.^[1] The analysis is based on firm-level data for six euro area countries; the data have been treated to represent the set of non-financial corporations with employees. Firms move along the productivity distribution in accordance with their capacity to react to shocks and to structural factors that incentivise innovative investment. This applies both to low-productivity firms that are striving to survive in the market and high-productivity firms that are facing the risk of falling behind the times. Firm productivity is very dynamic across all countries, sectors and years: Chart A shows that firms fighting for survival at the bottom of the distribution (at the 5th percentile) were, on average, able to increase their productivity ranking by 30 percentiles over a 12-year period. At the same time, firms initially at the top of the distribution (at the 90th percentile) saw their productivity ranking decrease by 20 percentiles. This is significant as changes in firm productivity account, on average, for more than 60% of annual aggregate productivity growth.^[2]

Firm productivity is particularly dynamic among young firms. The mean annual productivity growth of firms that have been active for fewer than six years is 8%, compared with 2.5% for firms that have been active for more than 20 years (Chart B, panel a, yellow bar). The contribution of young firms to aggregate productivity growth is the result of selection and learning, as firms learn to adapt and implement new ideas while re-optimising their business models and processes. At the same time, the average productivity developments of young surviving firms are driven by a few young “superstar” firms, which are defined as the top 10% of firms in terms of productivity growth among all firms that have been active for fewer than six years.^[3] While the median young firm (in terms of productivity growth) experiences annual average productivity increases of around 4% (Chart B, panel a, orange bar) over its first six years of activity, young superstar firms increase their productivity by around 100% per year, on average (Chart B, panel a, blue bar).^[4]

Young superstar firms stand out from the rest in several ways. These firms invest more, on average, than their young competitors, particularly in intangible assets, while using fewer and more specialised workers (Chart B, panel b). They also pay higher wages and benefit from higher labour productivity. This, in turn, could reflect either these firms’ higher investment in human capital or a more capital-intensive production process hinging on a strong complementary relationship between labour and capital.^[5]

Firm productivity has become less dynamic over time. This is the result of a loss of dynamism at both ends of the productivity distribution. First, there has been a significant decline in the share of low-productivity incumbents that register improvements in their productivity level over time (Chart C, panel a). Second, high-productivity firms were able to stay longer at the frontier in 2016 compared with 2006, although with some heterogeneity across countries (Chart C, panel b). The decline in firm dynamism alongside the productivity distribution is prevalent across low and high-tech sectors. These findings are consistent with an increase in the average age of frontier firms and with declining entry rates.^[6]

The causes of the slowdown in firm productivity dynamism deserve further research. Lower dynamism could be linked to the winner-takes-all dynamics triggered by the particular characteristics of new technologies, such as network effects or high fixed costs. These dynamics could result in higher market concentration and lower entry activity, as some studies that are particularly focused on the United States have shown.^[7] However, evidence for the euro area is not clear-cut and therefore deserves further research. As regards the lower firm dynamism in the euro area, recent evidence from the OECD suggests a link between the increases in market concentration, firm mark-ups and the incidence of mergers and acquisitions over the last decade.^[8] The slowdown in firm dynamism implies lower productivity growth, and therefore low potential output growth and a lower natural rate of interest. This highlights the important role of structural policies aimed at increasing the durability and resilience of economic growth stemming from firms’ investment in technological innovation, and of strengthening the market mechanism whereby highly productive firms thrive and less-productive firms shrink or exit the market entirely.