TRANSITION REPORT 2014 Innovation in Transition

Productivity: a firm-level perspective

Changes in the aggregate productivity of an economy can be described as the sum of five distinct components:2

  1. The “within effect” comprises changes in the productivity of individual firms.
  2. The “between effect” concerns the relative market shares of high and low-productivity firms. For example, if the former expand and the latter shrink, the aggregate productivity of the economy will increase.
  3. The “cross effect” concerns productivity gains which are driven by increases in the market shares of firms whose productivity is increasing fast. (Thus, the between effect reflects the growth of firms with high levels of productivity, while the cross effect reflects the growth of firms which are rapidly improving their productivity).
  4. The “entry effect” reflects the contribution made by new firms. A new entrant contributes positively to the overall productivity of an economy if it is more productive than the average firm.
  5. The “exit effect” captures the impact that exiting firms make to aggregate productivity. That effect is positive if the exiting firm is less productive than the average firm and its exit frees up valuable economic resources.
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Studies show that the first effect – productivity growth within firms – accounts for an average of 60 to 80 per cent of overall productivity growth.3 Until the mid-2000s, however, aggregate productivity growth in transition countries was driven largely by the reallocation of resources from less productive sectors and firms to more productive ones (that is to say, between and cross effects), as well as significant entry and exit effects.4

Significant barriers to the entry and exit of firms remain. Dismantling these barriers through liberalisation reforms has the potential to give a much-needed boost to the overall productivity of the region’s economies (see Box 1.2 on service-sector liberalisation in Ukraine). The same is true of barriers to the expansion of more productive firms, such as the political connections that low-productivity firms exploit to defend their positions (see Box 1.3).

At the same time, now that most of the easy options have been exhausted (in the form of the correction of distortions stemming from the legacy of central planning), productivity gains from firms’ entry and exit will be reliant on simultaneous changes in countries’ economic structures and supporting economic institutions, and change within firms will have to make a larger contribution to productivity growth.

Firms’ managers can increase productivity in many ways. They can make better use of excess capacity (if they have any), they can cut costs (shedding labour where necessary), and they can improve the way they manage their businesses. However, the most common and the most important driver of change within firms (particularly in advanced industrialised countries) is the introduction of new products and new ways of conducting business – in other words, innovation.5 Innovation and its contribution to productivity growth and the transition process will be the focus of this Transition Report.