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One might assume lack of profitability is the main reason new businesses fail. But profitability plays a minor role compared to productivity in a firm’s ability to survive. That’s because new firms tend to be less productive than incumbent firms. If a new firm is unable to raise its productivity fast enough to either catch up or exceed incumbent firms, it will remain in a less competitive position.
A working paper from the Institute of Economics at Sant’Anna University in Pisa, Italy measures how productivity and profitability affect new firms’ survival. Three Italian economists used data on more than 3,000 new U.S. firms across a diverse range of industry sectors from 2004 to 2011. They find that productivity has 14 times greater impact than profitability in determining firms’ survival and growth rates.