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The poverty of nations

Productivity at the firm level contributes significantly to income growth, helping to explain why some nations are far richer than others

March 2, 2021


Douglas Clement Managing Editor (former)
Poverty of nations key image
Cara Ewing/Minneapolis Fed

Article Highlights

  • Differences in productivity play an important role in global income inequality, but quantifying its contribution is difficult
  • By comparing market shares that multinational firms hold in different nations, recent research suggests that firm-embedded productivity explains about one-third of the variation in output per worker
  • Policies to reduce international gaps in firm-embedded productivity could reduce global inequality
The poverty of nations

Understanding disparities in global wealth has preoccupied economists since Adam Smith, whose Inquiry spurred the pursuit in 1776. Initially, scholars measured and debated the roles of labor and capital, trade and natural resources. All remain relevant, but for decades the spotlight has been on productivity—definition, quantification, trends, sources. Despite much effort, however, productivity remains enigmatic to economists. Particularly elusive: What causes productivity to increase or decline? As Stanford economist Moses Abramovitz famously wrote, it is a “measure of our ignorance.”

Recent debate has centered on two possibilities, not mutually exclusive. The first: country-level factors, such as infrastructure, regulation, amenities, and worker quality. These factors affect the productivity of every company that operates within national borders. Good infrastructure and amenities, looser regulations, and well-educated workers should all spur productivity. They can be hard to change, but policy intervention is clearly possible.

The second source: firm-embedded attributes, the characteristics that are unique to a given business, including its management practices, “blueprints” of replicable business formats (like franchises), and intangible capital such as patents, R&D, and intellectual capital. This firm-level productivity is the ineffable know-how that some firms have and others covet—the secret sauce of success.

Firm-level productivity is the ineffable know-how that some firms have, and others covet—the secret sauce of success—and it travels wherever the firm goes.

This type of productivity travels wherever the firm goes—a Starbucks franchise in London resembles its Athens counterpart. Amazon warehouses in Mumbai and Memphis function similarly. But by its very nature, firm-embedded productivity is hard to quantify. Intangible capital, algorithms, and corporate know-how are tightly held and difficult to measure.

In an Institute working paper, Institute visiting scholar Javier Cravino of the University of Michigan, with his colleagues Vanessa Alviarez and Natalia Ramondo, describe a novel method for gauging firm-embedded productivity and measuring its contribution to income variation. “Differences in firm-embedded productivity account for about one-third of cross-country variance in output per-worker,” they write.

The policy implication? Improve productivity at the firm level through tax incentives for R&D and research grants to stimulate firm innovation. “Policies that help to close the gap in firm-embedded productivity across countries,” the economists conclude, “can go a long way in reducing cross-country income differences.”

Little competition, large market shares

The scholars begin their research with a simple observation: The market share of any given multinational enterprise (MNE) is, on average, four times larger in a developing nation than in a high-income country. Why? Less competition in poor nations, suggesting lower overall firm-embedded productivity. In other words, domestic companies in developing nations tend to be less productive than MNEs operating in those nations. These foreign subsidiaries outperform domestic firms, taking large portions of the home market.

“Differences in firm-embedded productivity account for about one-third of cross-country variance in output per-worker.” The policy implication? Improve productivity at the firm level.

The economists use this insight to quantify firm-level productivity. Since MNEs have larger market shares in countries with relatively scarce overall firm-embedded productivity, the economists can measure aggregate firm-level productivity in one nation relative to another by comparing relative market shares of the same company in the two nations. “Differences in market shares of the same MNE in different countries pin down the difference in aggregate firm-embedded productivity between those countries.”

They pin it down with a detailed set of firms and nations, using France as a benchmark against which other national levels are gauged. With a sample of 27 countries and the local and multinational firms that operate within them, they first measure cross-country differences in MNE market shares, finding enormous variation. While multinationals in Germany and the United Kingdom have similar shares of the national market to the reference country of France, they represent 12 times that share in Estonia and Lithuania. MNE market shares in Greece and Portugal are closer to the sample average of about four times that of France. In brief, MNE firms dominate national markets in less-developed nations.

By then comparing firm market shares in various nations, they measure firm-embedded productivity and, again, find wide international variation. For this overall sample of high-income and developing countries, firm-embedded productivity is somewhat lower than in France. It’s about the same in Germany and South Korea, and a bit higher in Japan. In Estonia, Latvia, and Lithuania, aggregate firm-embedded productivity is much lower than in France.

Wide variations

It’s also notable that the relative importance of firm- and country-embedded productivity varies by country. Italy and Slovenia have similar levels of country-embedded productivity, according to their estimates, but Italy has higher firm-embedded productivity, generating significantly higher output per worker for Italy than Slovenia. (Italy’s per worker output is about the same as France’s; Slovenia’s is just half.)

Again, overall, cross-country variation in firm-embedded productivity accounts for about a third of differences in output per worker internationally (for this sample). The range varies from about one-fifth to half, depending on the country.

Not surprisingly, firm-embedded productivity varies widely across countries by sector. Japan, Korea, and Germany have relatively high firm productivity levels in manufacturing, but that isn’t the case for the services sector (all relative to France). In services, Germany, Hungary, and Mexico have higher firm-embedded than country-embedded productivity; all other countries are the opposite. For most nations, textiles, apparel, and wood have very low firm-embedded productivity but high country-embedded productivity. The opposite is the case for the basic metals sector, and for transport equipment and other manufacturing.

Domestic companies in developing nations tend to be less productive than multinational enterprises … [so the latter take] large portions of the home market. The economists use this insight to quantify firm-level productivity.

Further analysis uncovers two other important findings. The substantial contribution of firm-embedded productivity is due not to market scale—that is, it isn’t related to the size of a nation’s market—but rather to the variety of goods or services produced. Further, the wide variation in firm-embedded productivity across countries is accounted for mainly by variation across domestic firms, not the foreign affiliates of MNEs. That is to say, the dramatic productivity differences among local businesses, not international subsidiaries, is what explains the international range in firm productivity.

Minding the gap

That differences in national market shares of multinational enterprises reflect the relative competitive strength of local firms is a key intuition for Cravino and his co-authors. It allows them to measure the elusive firm-embedded productivity and to estimate its contribution to observed international differences in output per worker and, therefore, in income per capita. Strategies that shrink gaps in firm-embedded productivity are the clear policy implication. A further research step: broadening this exercise by expanding the sample of nations analyzed. The economists were limited to just over two dozen countries, relatively few of them identifiable as developing. A larger set will permit stronger conclusions.