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An industry grows when so-called “reallocation effects” weed out less-productive firms and allow more-productive firms to flourish. When regulation encourages fair competition, more-productive firms progressively gain larger shares of the market at the expense of less-productive ones, because they use the same inputs more effectively. As less-productive firms leave the industry, they free up resources and market share for more-productive firms to compete over. This leads to a virtuous cycle of reallocation in which resources are put to better and better use.
A working paper commissioned by the Norwegian central bank estimates that about 45 percent of Norwegian non-oil manufacturing growth between 1997 and 2001 can be explained by reallocation effects. In other words, about half of manufacturing growth during this 5-year period came from more-productive firms making better use of resources that were freed up as less-productive firms left the market.
As an extension to the paper, the authors included an R&D reallocation effect, whereby more profitable firms invest more heavily in R&D with the expectation of earning higher returns in the future. In this innovation race, firms that invest more heavily in R&D tend to increase their productivity by leveraging their successful innovations. When factoring in firm-level R&D investment, the authors attribute 72 percent of non-oil manufacturing growth between 1997 and 2001 to reallocation effects. This highlights the huge role firms’ innovation decisions make in increasing their productivity and driving economic growth.