Declining U.S. Dynamism?

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There’s a research report from Brookings that’s making it’s way around the inter-tubes. The title is “Declining Business Dynamism in the Untied States“, by Ian Hathaway and Robert Litan. The upshot is that business dynamism is declining. The firm entry rate (i.e. the number of firms less than one year old as a proportion of all firms) was about 15% in 1978, was about 11% in 2006, and is currently less than 8%. This trend is taken as a troubling sign of reduced dynamism. What dynamism exactly is supposed to mean isn’t clear, but on the assumption that it is synonymous with firm entry, then it is declining. There is some hand-waving about how this portends lower growth in the future.

But it isn’t immediately obvious that the declining rate of entry is a problem. I’m suspect that this is a measure that seems like it would be better if it went up, but that isn’t necessarily true. Imagine if the entry rate went to 100%; would it be good that literally every firm in the U.S. was less than 1 year old?

Their appendix figure A1 shows the actual number of firm entries per year. This held at roughly 500,000 new firms per year from 1978 to 2007, and then there is a deep plunge to 400,000 by 2010 before recovering slightly in 2011. So it is not that the U.S. is coming up with fewer new companies. Even in the midst of the worst economic downturn since the Great Depression (or 1981 depending on what rows your boat) the U.S. added 400,000 new companies. At the same time, the absolute number of exits has increased from about 300,000 a year in the early 1980’s to about 450,000 over the last few years. Because we have more firms now (remember all those entries?), this means the exit rate has held steady at about 9% of firms exiting each year.

So, does this imply some kind of loss of dynamism in the U.S. economy? As I said, it’s not obvious. One of the things I think is a pretty robust empirical fact is that productivity (labor productivity or total factor productivity) varies by a lot across firms in the U.S. and other countries (see Syverson, 2011). The stylized fact I have in my head is that the 90th percentile manufacturing firm in the U.S. is roughly 2 times more productive than the 10th percentile firm. A large portion of productivity growth comes from reallocation of inputs from low-productivity firms to high-productivity firms. Some of this reallocation takes place by having low-productivity firms exit and having high-productivity firms enter. But I don’t know that the research is conclusive that entry is the primary source of this reallocation – shifting inputs to existing high-productivity firms is a big part of productivity gains.

Foster, Haltiwanger, and Syverson (2008) is one of the best studies I know of these reallocation effects because they are able to distinguish physical productivity (number of widgets produced) from revenue productivity (number of dollars produced). What they find is that entry alone accounts for 14% of revenue productivity growth from 1977 to 1997. Entry accounts for 24% of physical productivity growth in the same period. A sizeable portion, but reallocation between existing firms and productivity growth within existing firms account for the remaining productivity growth observed.

However, FHS are looking only at very specific industries: coffee, boxes, bread, gasoline, sugar, plywood, and a few others. Basically, industries with very homogenous outputs that can be measured easily (e.g. gallons of gasoline). Their results may under- or over-state the true effect of entry on overall productivity growth in the U.S.. As they note, though, their study actually shows much higher effects of entry on productivity than prior work because of their separate data on revenue physical productivity. Their firms also have entry and exit rates (22% and 19%, respectively) well above the average for the U.S. as a whole, and if entry is very important for dynamism, then shouldn’t these industries show the strongest possible role of entry?

Even if entry does account for a sizeable portion of productivity growth, the Brookings report isn’t saying that entry has fallen to zero. If the entry and exit rate flatten out at, say, 9% each, then this means that every year 9% of all firms go out of business, and that number is exactly replaced by a entirely new group of firms. The total number of firms will remain constant, but each firm would have an average lifespan of about 11-12 years. Do we care if the total number of firms stays constant, so long as there is turnover?

There isn’t any reason to believe that a growing number of firms is necessarily good, especially as we move more and more to producing goods and services that scale easily. To be more clear, it makes sense to believe that the number of cement firms or bakeries increases proportionately with population, as these goods don’t transport well and so meeting demand requires new locations (and possibly new firms). But just because we have more people doesn’t mean we need another Microsoft (you could argue we don’t need the one we have already). So the fact that the growth rate of the number of firms is slowing down doesn’t necessarily bother me. It may just indicate a change in the nature of products we produce, or represent better screening by lenders/backers/VC firms.

I could of course be horribly wrong, and we’ll all be living in the woods in three years. I, at this point, am not planning on buying extra canned goods.