Firms dynamics, labour force growth, and productivity: The curious case of NZ

In this post I am going to discuss how a change in labour force growth can explain firms’ entry/ exit rates. Recent findings by Hopenhayn et al (2018) for the US motivated me to think about this relationship in a NZ context.

Furthermore, the authors linked these entry and exit rates to “dynamism” and therefore productivity growth – a link I wanted to think about a bit more carefully.

Hopenhayn et al (2018) found that declining business dynamism in the US over time has been due to the declining labour force growth. Marginal Revolution has a nice run down of it here.

The intuition behind this result is that, when labour force growth accelerates current firms cannot absorb the new workers. As a result, new firms (young and small) enter. Such a dynamic leads to additional competition, a reduction in concentration and the average size of firms, and the destruction of inefficient firms – helping to drive dynamism.

How does this logic apply to NZ economy?

This finding fits our business dynamism and labour force growth story very well. NZ firms have high entry/exit rates as shown by the Productivity Commission, earlier MED/MBIE work, Treasury, and the OECD. Furthermore, the labour force has grown considerably due to immigration and rising labour force participation rates.

As a result, there is a link between the high labour force participation level and high entry and exit rates – which seems consistent with the Hopenhayn et al (2018) study but with the opposite sign! [Note: We would want more information on how entry and exit rates had changed to say it was the same result]

However, if the NZ experience can be viewed this way it provides somewhat of a puzzle – if “business dynamism” is happening here why is our multi-factor productivity so low?

Often the assumption is that high rates of firm creation and destruction facilitate innovation and new technology adoption. This creative destruction then helps to boost productivity growth – and explains the positive relationship observed between entry and exit rates and productivity in the OECD.

However, it is important to dig deeper. The OECD’s “One size does not fit all” paper shows that two countries have very high entry rates but low average post-entry growth: New Zealand and Turkey.

Not all destruction and creation are creative

Imagine a world where it is very cheap and easy to set up a business, and moreso you are given support when you do that. But after a year or two the support dries up and everything becomes compliance heavy.

In that sort of situation firms will be destroyed and new firms created that are doing the same thing with the same technology. Another term for this is that there is excessive churn in the number of firms that is not due to changing economic fundamentals – such churn limits the incentives to invest, and reduces institutional capital that comes from operating for a protracted period of time.

As a result, understanding why firms are being destroyed and created – rather than simply viewing all creation and destruction as a product of “creative destruction” matters.