Demand-driven growth

Marek Ignaszak, Petr Sedláček 02 July 2021

a

A

Productivity growth in developed economies has declined noticeably in the last two decades. For instance, US productivity growth since 2000 has been about half of its 1950-2000 average. This trend has occurred against a backdrop of lower worker, job, and firm turnover – business dynamism – which is often linked to productivity-enhancing reallocation (e.g. Haltiwanger 2012, Decker et al. 2016, De Ridder 2019, Sterk et al. 2021). 

Schumpeterian theory of economic growth (Aghion and Howitt 1992) has proven to be the perfect laboratory to study the effectiveness of various policies aimed at reviving the seemingly lost growth potential of advanced economies. According to this theory, business dynamism and creative destruction are the key drivers of economic growth, whereby relatively less productive firms shrink and shut down to give way to more productive competitors (e.g. Acemoglu et al. 2018, Akcigit et al. 2018, Aghion et al. 2019). 

However, this tight link between productivity and survival has been challenged recently. In particular, the increased availability of detailed microdata on not only revenue, but also separately on quantities and prices, allows researchers to disentangle the impact of demand shifts or market power from quantity and efficiency changes. A growing body of evidence suggests that demand factors, rather than productivity alone, are crucial for the decisions of individual firms. For instance, Foster et al. (2008) use microdata on establishments producing physically homogeneous products (e.g. ready-mixed concrete or block ice) to show that demand variation across producers is the dominant factor in determining survival. Using a similar strategy, Foster et al. (2016) show that the gradual accumulation of demand is the key driver of life-cycle growth of establishments. Hottman et al. (2016) make use of detailed scanner data to estimate that observed differences in firm performance are largely attributable to demand-side factors. Similar findings are found in different countries, using different datasets and methodologies, suggesting that demand-driven firm performance is a robust empirical finding (e.g. Bernard et al. forthcoming, Eslava and Haltiwanger 2020, Kehrig and Vincent 2021). 

To account for these salient features of firm-level data, in a new paper (Ignaszak and Sedlacek 2021) we develop a new model of economic growth in which we break the tight link between productivity and profitability present in existing Schumpeterian models of growth. We use the model to analyse – theoretically and quantitatively – the extent to which aggregate economic growth is affected by firm-level demand variation.

As in existing modern growth models, also in our framework, individual firms invest into R&D to improve their production efficiency. We add to such models the possibility that individual firms also face variation in demand for their products, which is unrelated to their production efficiency. While economic growth is generated by advances in production efficiency alone, changes in firm-level demand can nevertheless have an indirect impact on aggregate growth through their effect on incentives to conduct R&D. The reason is simple: if firms expect their customer base to grow in the future, they have greater incentives to produce more efficiently and, in turn, reap greater benefits from future sales. This demand-driven firm-level ‘market size effect’ increases incentives to conduct R&D and, in turn, drives aggregate productivity and economic growth. 

Firm-level demand and aggregate economic growth

Having shown theoretically that demand-side factors can indirectly impact aggregate economic growth, we quantify our model to gauge how important this mechanism is in the US economy. We estimate our model using US Census firm data and infer that about 20% of aggregate economic growth in the US is in fact demand-driven. The fact that economic growth is not a purely supply-side phenomenon opens the door to the rigorous analysis of under-explored pro-growth policies, such as public procurement or product market regulation.            

In addition, our framework allows us to reassess the impact of existing growth policies, such as R&D subsidies. Using this example, we show that accounting for changes in firm-level demand is crucial for the quantitative analysis of growth policies.

The key reason why demand matters for the efficacy of growth policies is the influence it has on the firm selection process. In existing models of growth, firms which shrink or shut down are those that are less productive than their competitors. As documented in Foster et al. (2008), and as is the case in our framework, this is not necessarily true in the data. Specifically, firm selection is based on profitability, not productivity alone. Even relatively productive firms may shut down because of unfavourable demand changes and vice versa. This negative relationship between productivity and demand at the firm-level is particularly strong among young businesses which are typically relatively more productive but at the same time are fragile because of less developed customer bases.

Consequently, firms’ net present value calculations – such as those involved in decisions to conduct R&D – are significantly altered when variation in firm-level demand is taken into account. Quantitatively, we find that in our framework R&D subsidies are about twice as effective at stimulating growth compared to a model which ignores firm-level demand variation.  

Are these links observed in the data?

The link between changes in firm-level demand and R&D incentives – a market size effect – has been documented in existing studies. For instance, Acemoglu and Linn (2004) find that changes in market size (for instance, due to demographic shifts) lead to the entry of new drug producers in the pharmaceutical industry. Furthermore, Lileeva and Trefler (2010) show that in response to the Canada-US Free Trade Agreement, affected Canadian plants increased their labour productivity, engaged more in R&D and adopted novel technology at a higher rate. Similarly, Aghion et al. (2019) use firm-level data on French exporters to show that expansions of firms’ export markets result in a rise in patenting. 

We investigate the relationship between demand changes and productivity growth directly using firm-level data from Compustat. Specifically, following an established methodology for estimating (revenue-based) TFP and residual (demand variation) (e.g. Foster et al. 2008), we show that changes in expected demand have a positive impact on productivity growth. This holds true both in the data and in our model. 

Concluding remarks

In this column we put forward the notion that economic growth may not be a purely supply-side phenomenon. The new modelling framework that we propose is firmly grounded in existing empirical evidence on the role of demand for firm performance. We use our model to highlight that incorporating such demand-side features into state-of-the-art models of economic growth changes our understanding of the sources of aggregate growth and the quantitative efficacy of growth policies.

Therefore, to design effective pro-growth interventions, policymakers should pay attention not only to productivity and R&D dynamics at the firm level, but also to changes in demand. This also opens the door to a systematic study of new demand and product-market oriented policies for resurrecting the seemingly lost growth potential of developed economies. 

References

Acemoglu, D, U Akcigit, H Alp, N Bloom and W Kerr (2018), "Innovation, Reallocation, and Growth", American Economic Review 108(11): 3450-91. 

Acemoglu, D and J Linn (2004), “Market Size in Innovation: Theory and Evidence from the Pharmaceutical Industry”, Quarterly Journal of Economics 119(3): 1049–1090.

Aghion, P and P Howitt (1992), “A Model of Growth Through Creative Destruction”, Econometrica 60(2): 323-351

Aghion, P, U Akcigit and P Howitt (2014), “What do we learn from Schumpeterian growth theory?”, in Handbook of Economic Growth, Vol. 2, pp. 515-563, Elsevier.

Aghion, P, A Bergeaud, M Lequien and M J Melitz (2019), “The Heterogeneous Impact of Market Size on Innovation: Evidence from French Firm-Level Exports”, mimeo.

Aghion, P, S Guriev and K Jo (2019), "Chaebols and firm dynamics in Korea", CEPR Discussion Paper 13825. 

Akcigit, U, S Ates and G Impullitti (2018), “Innovation, trade policy, and globalisation”, VoxEU.org, 2 July. 

Bernard, A, E Dhyne, G Magerman, K Manova and A Moxnes (forthcoming), “The Origins of Firm Heterogeneity: A Production Network Approach”, Journal of Political Economy.

De Ridder, M (2019), “Untouchable firms: Market power, business dynamism, and productivity growth in the intangible economy”, VoxEU.org, 2 July. 

Decker, R A, J Haltiwanger, R S Jarmin and J Miranda (2016), “Where has all the skewness gone? The decline in high-growth (young) firms in the US”, European Economic Review 86: 4-23.

Eslava, M and J C Haltiwanger (2020), “The Life-Cycle Growth of Plants: The Role of Productivity, Demand and Wedges", NBER Working Paper 27184.

Foster, L, J Haltiwanger and C Syverson (2008), "Reallocation, Firm Turnover, and Efficiency: Selection on Productivity or Profitability?" American Economic Review 98(1): 394-425. 

Foster, L, J Haltiwanger and C Syverson (2016), “The slow growth of new plants: learning about demand?” Economica 83(329): 91-129.

Haltiwanger, J (2012), “Job Creation and Firm Dynamics in the United States”, Innovation Policy and the Economy 12: 17-38.

Hottman, C J, S J Redding and D E Weinstein (2016), “Quantifying the sources of firm heterogeneity”, Quarterly Journal of Economics 131(3): 1291-1364.

Ignaszak, M and P Sedlacek (2021), “Productivity, Profitability and Growth”, CEPR Discussion Paper 16205.

Kehrig, M and N Vincent (2021), “The Micro-Level Anatomy of the Labor Share Decline”, Quarterly Journal of Economics 136(2): 1031–1087.

Lileeva, A & D Trefler (2010), “Improved Access to Foreign Markets Raises Plant-level Productivity… For Some Plants,” Quarterly Journal of Economics 125: 1051–1099.

Sterk, V, P Sedláček and B Pugsley (2021), "The Nature of Firm Growth", American Economic Review 111(2): 547-79.

a

A

Topics:  Macroeconomic policy Productivity and Innovation

Tags:  economic growth, Schumpeterian growth theory, productivity, demand-side policies

Assistant Professor of Economics, Goethe University Frankfurt

Professor of Economics, University of Oxford; CEPR Research Affiliate

Events

CEPR Policy Research