Reallocation Within an Industry: A Secret Strength for the US Economy

It would be nice if the processes of economic growth were well-mannered: for example, if it benefited all workers and industries and groups equally–or perhaps with some additional benefit for those with lower incomes.

But of course, growth isn’t a neat process. As technology and tastes evolve over time, some firms do better, some industries do better, some places do better. Even when growth is a net plus for the economy over time, some firms and industries and places end up worse off.

As it turns out, an ability to tolerate these disruptions of growth may be one of the secret weapons for the US economy. The IMF offers an argument that can be interpreted along these lines in Chapter 3 of the April 2024 World Economic Outlook, “Slowdown in Global Medium-term Growth: What Will it Take to Turn the Tide?”

The chapter discusses a variety of causes of slower growth around the world: a slowdown in productivity growth, lower rates of investment, a decline in the growth rate of the working-age population in many countries, and others. Here, I’ll focus on one particular cause of slower productivity, which is “misallocation of capital and labor across firms within sectors.” Or to put it more bluntly, it’s that part of the growth process, where successful firms in a given industry expand and unsuccessful firms in that industry either change their ways or else shrink and even disappear. The authors write (footnotes and references to boxes and figures omitted):

This section documents the contribution of rising misallocation of capital and labor to the decline in TFP [total factor productivity] growth and draws lessons for medium-term growth. So-called allocative efficiency measures the extent to which capital and labor are allocated to an economy’s most productive firms … A decline in allocative efficiency, whereby resources become more concentrated in relatively unproductive firms over a period of time, can reduce TFP growth; an improvement in allocative efficiency, as resources move toward more productive firms, will, however, boost TFP growth. …

The approach used here … finds that allocative efficiency declined during 2000–19 in most countries in a sample of 15 advanced and 5 emerging market economies. The median country in the sample experienced an average annual drag on TFP growth of about 0.9 percentage point from declining allocative efficiency. For the median advanced economy, this drag was 0.5 percentage point. Given that the median advanced economy saw TFP growth of only 0.5 percent during this period, this suggests that increased misallocation of capital and labor may have halved its TFP growth. A notable exception is the United States, where improvements in allocative efficiency helped boost annual TFP growth by 0.8 percentage point over the period.

This process of reallocation to more productive firms could, in theory, happen either within a given sector of the economy or between sectors. The IMF analysis suggests that the between-sector misallocation is important only for a few economies going through dramatic restructuring of growth, like China. For advanced economies, most of the misallocation is within sectors.

In turn, the greater misallocation traces back to a pattern I’ve been noting here for almost a decade now: within given sectors of the economy, the gap between the firms that are productivity leaders in a given industry and other firms in that industry has been widening, not just in the US, but around the world. The reasons for this shift are not altogether clear, but part of the reason seems to be that some firms have proven better than others at incorporating information technology throughout all of their processes. The IMF authors write:

A large part of the observed decline in allocative efficiency within sectors can be traced to uneven firm productivity growth during some of the 2000–19 period. … [T]he dispersion of firms’ real productivity in the 20 sample economies rose significantly leading up to the global financial crisis and, despite some subsequent reversion, remains elevated. This aligns with the decline in allocative efficiency, most of which also occurred in the first decade of the 2000s. … Ideally, firms with rapidly increasing real productivity should attract capital and labor from those growing more slowly, with marginal revenue products kept equalized. However, firm-level evidence points to frictions that slow this adjustment process. This leads to an initial decline in allocative efficiency, as faster-growing firms operate with less capital and labor than optimal. Consistently, sector-level evidence shows that a rise in a sector’s dispersion of real firm productivity is accompanied by a decline in its allocative efficiency.

What factors help the firms in some countries to adjust? The IMF points to factors like “market entry and competition, trade openness, financial access, and labor market flexibility.”