Productivity is key to economic growth: Why is it slowing down in advanced economies?

A few months before leaving office President Barack Obama wrote about the challenges that his successor would have to tackle. Recent innovations, he claimed, “have not yet substantially boosted measured productivity growth.” In fact, since 2004, productivity growth slowed across nearly all advanced economies. Productivity being the most important determinant of economic growth, Obama concluded, “Without a faster-growing economy, we will not be able to generate the wage gains people want, regardless of how we divide up the pie.” President Obama was right: Productivity is the key to economic growth. In fact, over 60 percent of cross-country differences in income can be explained by productivity. 

There are several explanations addressing the productivity slowdown that go from mismeasurement to the “drying out” of productivity-enhancing innovations, but consensus hasn’t been reached. What is clear is that in order to understand productivity it is important to look at the behavior of the smallest possible economic unit driving changes in aggregate productivity: the firm (individual businesses and corporations).

In my most recent working paper, I look at millions of firms concentrated in more than 40 countries trying to answer a simple question: Is there convergence? Convergence, originally, is the name given by economists to the process through which poor countries grow at faster rates than rich countries, generating catching-up (a process for which there is little to no evidence of actually occurring without certain conditions). So, taking this question to the firm level and with a focus on productivity, I ask: Are the very low-productivity firms improving their productivity at a faster rate than the high-productivity firms?

Intuition would say the answer is yes. Why? Imagine the life of a newly established small firm producing footballs. In its beginning, it is likely that the firm is very “unproductive,” with each football produced requiring more worker-hours than an already established, large football firm. But the small firm can improve relatively quickly by simply copying some best practices from the larger firms, by, for example, hiring one manager that used to work at a larger firm or by buying a football making machine that was invented and developed by others. Therefore, these small firms can be expected to improve their productivity quite fast. However, for the already highly productive firms to improve their productivity requires more effort than simply copying best practices. Instead, it requires innovating, which in itself is very risky and costly. Yet, if they want to stay at the top, the large firms must keep innovating, even while knowing it is likely that the smaller firms will eventually benefit from those innovations.

My paper finds evidence of convergence, but also of divergence. That is, fast productivity growth is concentrated at the bottom and at the top of the productivity distribution. The very small, low-productivity firms grow fast, but so do the large high-productivity ones. This result is consistent with what the Organization for Economic Cooperation and Development documents in their report The Future of Productivity.

But the result is salient because it implies that there is a “middle productivity trap,” where firms, once they reach average levels of productivity, will lag behind those at the very top. This trap could point to existing market frictions that hinder the spread of innovations from the top to the bottom. Moreover, it is consistent with two important facts: First, the widening productivity dispersion—a phenomenon that has been happening in the U.S. since the mid-1990s—and, second, the increasing market share of “superstar” firms. These both could very well be related to the slowdown in total productivity.

Productivity is the most important determinant of economic growth, and in turn, of living standards more generally. As Paul Krugman—Nobel Laureate in economics—once put it, “Productivity isn’t everything, but, in the long run, it is almost everything.” The challenge for policymakers is to focus on the long run and to identify the market frictions that are causing most firms to lag behind.

Download the working paper.