Saturday, July 14, 2012

National productivity comes from firms' productivity

We've been debating what needs to be done to lift Australia's flagging productivity performance for a year, but only this week have we stopped using it in the unending political blame game and got down to some solid economic analysis.

The breakthrough came in a much-discussed speech Dr David Gruen, of Treasury, delivered to the annual Australian Conference of Economists in Melbourne.

Gruen made the apparently hugely controversial point that the primary responsibility for the productivity of the private sector - its output per unit of input - rests with the firms making up that sector and only secondarily with the government.

The government's role is in supporting the productive capability of the economy through investment in education and training, science and research, and infrastructure.

"Government involvement in these sectors is important," Gruen says. "Markets left to their own devices will tend to result in too little investment where there are social or spill-over benefits [in the jargon, 'positive externalities'] to the broader community beyond the returns available to a private investor.

"Governments influence the environment in which firms engage with each other and make investment and production decisions. They set the rules of the game, if you like, and affect the incentives that firms face, and their flexibility to respond."

But it's businesses that do the playing. So what do we know about the drivers of productivity improvement in the private sector? Well, a fair bit of empirical research has been done locally and overseas in recent years.

It shows that overall productivity improves in two different ways. One source is greater technical efficiency through innovation within the firm. Technical improvement comes about through research and development within the firm, or in partnership with the formal research sector.

But as a small country, most of the technology put into production in Australia is first developed overseas, Gruen says. A survey by the bureau of statistics shows only a small fraction of our innovative firms do things that are genuinely new to the world, or even new to Australia. Much more innovation is simply new to a particular industry.

"What usually distinguishes leading organisations is not so much their ability to create knowledge, but rather their ability to absorb technology developed elsewhere and apply it to their own circumstances," he says.

Why do firms innovate? According to the bureau's survey, three-quarters of innovative firms report undertaking innovation to improve profits. About 40 per cent also wanted to increase or maintain their market share and a quarter needed to develop products that were more competitively priced.

That's pretty much what you'd expect, but the second source of productivity gain is less obvious and less benign: it improves when production in an industry shifts from low-productivity firms to high-productivity firms.

A study of Australia firms in the 1990s found a remarkably wide range in their efficiency. The labour productivity of the most efficient firms was about four times that of the least efficient. Only about half this difference seems to be explained by differences in size.

So the productivity of an industry is improved when low-productivity firms are taken over or otherwise cease to exist, and also when new businesses with bright ideas start and grow.

Few people realise how much turnover there is of firms, even when the economy is growing strongly. According to figures from the bureau, about 8 per cent of firms close down each year. And about 40 per cent of new firms exit in less than four years.

Get this: overseas estimates suggest the net effect of the entry and exit of firms accounts for between a fifth and a half of the improvement in labour productivity over time. In high-technology industries, in particular, start-ups play an important role in promoting technological adoption and experimentation, Gruen says.

Hint to politicians: "Policies that act to slow the movement of resources will tend to limit this source of productivity improvement."

Another way to study productivity at the firm level is to look at management practices. Like productivity, management is about how well resources are used in production. So if you can rate particular management practices and give management teams a score, maybe this will help explain productivity differences across firms and even across countries.

One long-running study is doing this for 9000 medium and large manufacturing firms in 20 countries. It gives good ratings to firms that monitor what's going on in the firm and use this information for continuous improvement; set targets and track outcomes, and promote employees based on their performance.

The study shows management practices in Australia are mid-range: well below the United States, Germany, Sweden, Japan and Canada, but similar to France, Italy and Britain. And we have a larger tail of companies at the poor management end of the distribution compared with the US.

Looking at the performance of Australian firms, large manufacturers tend to be much better managed than small ones - a worry because our firms tend to be smaller than those in other countries. And it does seem clear better-managed firms are more innovative and have higher productivity.

Gruen argues periods of significant structural change - as at present - are often periods of growth and reform for the economy.

For a firm that's been doing the same thing for a long time, changes in business models are risky, difficult and may well require staff lay-offs. But when structural change means doing the same old thing is likely to be unprofitable, the opportunity cost of transforming work practices is substantially lowered. Structural change usually involves firms coming under greater competitive pressure. And tough competition and innovative activity seem to go together.

In Australia, firms that report having more competitors, that are in industries with low mark-ups, that export, or that experience downward pressure on profit margins are more likely to be innovators.

Case studies of Australian manufacturers hit by the reduction of import protection in the 1980s and '90s show the firms that succeeded did so by changing their practices. The number of plants diminished, plants became more specialised, model ranges were cut and world-best technology introduced.

Of course, some firms close down and leave the industry. But that's the harsh part of the lovely sounding productivity improvement: Competition boosts productivity partly by moving resources to more successful firms.

Get it? When politicians protect firms from closing, they risk stifling productivity improvement. For countries, comfortable and rich don't go together.