How NZ’s productivity growth might be fostered by finding what makes “frontier firms” tick

We suspect some readers – maybe many – faltered when Finance Minister Grant Robertson announced he has approved the terms of reference “for an inquiry into the economic contribution of New Zealand’s frontier firms”.

Frontier firms?  What are they and give us some examples?

Robertson explained that these are the most productive firms in the domestic economy within their own industry.

“These firms are important as they diffuse new technologies and business practices into the wider New Zealand economy.

“While we do have some world-leading firms, we need them to lift performance and productivity to create a pathway for more firms to succeed on the world stage,” Grant Robertson says.

He referred to work undertaken by the Productivity Commission in 2016 which suggested that New Zealand’s firms – on average – were about one-third less productive than international firms in the same industry.

In that report, frontier firms are defined as those with productivity levels in the top five percent of the distribution in each industry.

The commission will lead the inquiry to identify ways to maximise the performance of these firms and lift their contribution to the economy.

The terms of reference include identifying the factors that could be inhibiting the performance of these firms, factors that detract from the diffusing of technology and knowledge in the New Zealand economy

And no – Robertson wouldn’t dare forget the Treaty.  The economic contribution of Māori frontier firms will be investigated, too.

In its report in 2016,the commission said a few New Zealand firms operate at or close to the international productivity frontier.

“But firm-level data shows that the processes of diffusion and reallocation generally do not work as well as they could in New Zealand. Many domestic frontier firms are disconnected from the international frontier, laggard firms tend not to converge to the domestic frontier, and resources are stuck in a tail of small and unproductive firms.

“Even though there is significant potential for catch up in New Zealand – firms starting at a productivity disadvantage have greater scope for catch-up productivity growth – there is evidence that too few New Zealand firms are benefiting from new productivity-enhancing technologies and ideas developed at the global frontier.”

If you comfortably grasped all that, well done.

The commission went on to say there are some very successful New Zealand firms, but in most industries productivity growth in New Zealand’s frontier firms has generally been well below that of global frontier firms.

“This suggests weak technology diffusion into the New Zealand economy and a lack of scale opportunities for high-productivity New Zealand firms.

“In the domestic economy, there is some tendency for productivity spillovers from leading to lagging firms. However, these spill overs are less likely across firms in some service industries and the construction industry compared to firms in other parts of the economy. Many firms in these industries operate in small local markets insulated from competition and learning opportunities.”

In an article in World Finance in 2017, Rachel Connolly  asked if frontier firms could give some insight into how to crank up productivity growth in the developed world.

“It is hard to overstate the role productivity has played in the prosperity we enjoy in the developed world today, and harder still to exaggerate the dire ramifications we now face as the OECD’s productivity growth grinds to a halt. The patchwork of reasons offered to explain the slowdown in production has failed to pinpoint the true cause, but recent research into ‘frontier firms’ has suggested they may provide some clue as to the solution.

“Coined by Paul Krugman, the widely adopted assertion ‘productivity isn’t everything, but in the long run it is almost everything’ identifies two crucial points: first, the extent to which productivity shapes an economy, and second, the metric through which we discuss productivity’s impact on living standards.”

Productivity, by definition, is the fraction of GDP produced per hour worked, Connolly explained.

Productivity growth therefore plays a vital role in the wealth of a nation.

“Historically, high levels of productivity growth have afforded citizens of the developed world privileges so ubiquitous they have been construed as rights, but this may not be the case for coming generations. Until 2000, OECD area countries maintained a steady growth rate of around two percent year-on-year, while in emerging markets this was often zero, or even negative. This is why living conditions in richer countries improved colossally in the second half of the 20th century while developing economies witnessed little change.

“However, in the years prior to the global financial crisis, productivity growth in the OECD area began to falter, eventually coming to a dead halt in 2008. Despite a brief period of improvement in 2010, growth in the OECD area has never fully recovered, and now stands at around one percent.

“This sluggish productivity will likely create two distinct problems for younger generations: for the first time in living memory, children in the developed world won’t experience a better quality of life than their parents, and, perhaps more worryingly, with debt payments contingent on GDP rising, developed countries will struggle to pay off mounting levels of public and private debt.”

The problems resulting from a slowdown in productivity were clear, Connolly observed, but the reasons behind the slump are less so.

Some economists argue the problem is due to a lack of good innovation, rather than a lack of investment.

But recent research examining so-called “frontier firms” suggest otherwise, says Connolly.

She names Google and Amazon as examples of frontier firms operating at the top end of productivity in the tech industry.

BMW, L’Oréal and Nestlé are other examples in their separate industries.

“Firms like these are often quick to adopt new technologies and implement innovative management practices, meaning [if the fault lies with technology] these companies should have also suffered a slowdown in productivity – this has not been the case.

Speaking to World Finance, Daniel Andrews, a senior economist at the OECD and author of Frontier Firms, Technology Diffusion and Public Policy, said productivity performance among those firms “has continued to grow quite strongly… the problem was everyone else, or, rather, what we call laggard firms.”

Andrews believes the benefits of their innovation and productivity aren’t diffusing to everyone else.

This discrepancy between hyper-productive firms and laggards may lead to an upheaval in developed economies:

“What we had before was a growth model in which the most technologically advanced firms innovate and the benefits of these innovations spill over into other firms, that has essentially driven economic growth for the last 50 years or so – since the Second World War. There seems to be a number of indications that process has broken down in the early 2000s.”

The reason for this lack of “innovation diffusion”, as Andrews calls it, is still unclear.

The cost of implementing new technologies is one barrier. Bad management, and the fact laggard firms are “not doing the things that are complementary to technology adoption”, is another.

Andrews notes that wage growth across OECD countries has remained low since the recession.  Companies therefore haven’t been forced to invest in labour-saving innovations.

In other words, the cost of investing in new equipment isn’t worthwhile because labour is so cheap .

Lack of competition in the market is another issue.

“Zombie firms – that is really weak firms – are increasingly able to survive in the market because they’re kept alive by creditors and weak banks.”

A troubling side effect of the breakdown in innovation diffusion is the growing inequality between salaries at frontier firms and their laggard counterparts.

The role of “frontier firms” has been examined, too, in an article by Spence Purnell,  a policy analyst at the libertarian Reason Foundation in the US.

 

Illustrating his article with the table above, he references new research papers from the OECD and MIT which

” … are helping to explain lackluster post-recession economic growth by showing how ‘superstar’ or ‘frontier’ firms have captured a lion’s share of economic gains while ‘laggards’ have dragged down productivity metrics.

“Even in fading industries like manufacturing, the researchers find significant correlations between the application of emerging technology, acquisition of quality human capital, and productivity gains.  Laggard firms represent firms who have significant lower rates of technological adoption and lower quality human capital.”

 We must wait and see what tack Robertson and the government will take when they are better apprised of what makes frontier firms so much more successful than the others.  For now, he is saying only that …

“We want all our innovative and productive companies to do well and have that success flow through to other parts of the economy,” Grant Robertson says.

Final reports are due to be delivered to ministers early next year.

2 thoughts on “How NZ’s productivity growth might be fostered by finding what makes “frontier firms” tick

  1. “In other words, the cost of investing in new equipment isn’t worthwhile because labour is so cheap .” The principal reason why New Zealand lags behind in innovation and productivity diffusion is the continuing reliance on low-skilled immigration. The second reason is poor management. Without attending to these issues everything else is futile.

    Liked by 1 person

    1. A perfect summary of the issue why these so called economists are incapable of concluding and articulating the role of the low-skilled immigration is farcical, perhaps it just doesn’t suit the narrative of their political paymasters.

      Liked by 1 person

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