Is Entrepreneurship the Most Productive Part of our Economy?

This post is a part of a series by the Growthology team, where we take a look at some of the topics discussed in State of the Field, a compilation of knowledge on entrepreneurship research written by the leading experts in the field.

Productivity growth is a hot topic in the United States right now. More specifically, the absence of productivity growth is creating headaches for the Federal Reserve and other policymakers, and prompting lower forecasts of American economic growth.

In August, the Bureau of Labor Statistics reported that U.S. productivity growth had fallen for a third consecutive quarter, the longest such streak since 1979. This means that, since 2007, annual productivity growth, at 1.3 percent per year, has been half of what it was from 2000 to 2007. From a historical perspective, 1.3 percent doesn’t sound too bad—over the last 50 years, U.S. productivity grew 1.8 percent per year on average. But the thing about productivity is that seemingly small differences can have major macroeconomic consequences.

Productivity is a proxy measurement for quality of life

According to the McKinsey Global Institute, if U.S. productivity growth over the next 50 years averages 1.3 percent per year, per capita GDP growth will be 28 percent slower than in the past. In other words, our standard of living will improve sluggishly. It would be an economic half-century like the past 5 years, rather than one like the 1990s—stagnant wages, sluggish mobility, and all the social and political fights that come along with all that.

Productivity, it turns out, is quite important. It matters for economic indicators, and it is essential for everything else we enjoy about a high standard of living: education, entertainment, comfort, and so on. As most economists will tell you, productivity might be the only thing that matters.

So what is it? In Kauffman’s State of the Field overview of productivity, researchers Sarada (the University of Wisconsin-Madison) and Javier Miranda (U.S. Census Bureau) cite the standard economic definition of productivity as “the efficiency with which firms convert inputs such as labor, capital, and materials into outputs.” Even though we rely on aggregate productivity statistics to gauge the health of the economy (as above), productivity is really a firm-level concept. Productive firms expand and survive, and unproductive firms (theoretically) shrink and close.

When we say that U.S. productivity growth is strong, we’re really saying that the input-output conversion process at American companies is working well, that more firms are productive than not.

How do we increase productivity growth?

But what is a “productive firm,” and what determines productivity in an individual company? In their State of the Field summary, Sarada and Miranda cite recent research on “high quality management practices [that] relate systematically to productivity.” These include

  • incentive structures,
  • collecting and analyzing performance information,
  • linking it to compensation, and
  • setting targets and milestones for employees.

Not surprisingly, “having better quality labor and capital can also increase productivity.” And, third, “the adoption of information technologies and the R&D intensity also relate positively to productivity.” Exposure to higher levels of competition and international markets also seem to be associated with more productive firms.

Thus, according to the research literature, productivity growth in an economy comes from having productive firms. Productive firms are those that utilize good management practices, employ higher quality workers and equipment, and adopt technology faster than other companies. If they face competitive markets and sell overseas, that’s a bonus.

Connecting entrepreneurship and productivity

How does this relate to entrepreneurs and entrepreneurial firms? For the most part, it doesn’t. The State of the Field authors write candidly that “the discussion of productivity in entrepreneurship has largely been sidestepped” in their research overview. Instead, they opt for a deductive approach: if we can understand, at a general level, what affects productivity within and across firms, then we can gain “a better sense of what makes highly entrepreneurial, innovative and presumably productive firms.”

I’m not completely convinced by this deductive approach, however. For one thing, when we talk about productive firms, we usually are talking about entrepreneurial firms. A newly updated paper by John Haltiwanger, Ron Jarmin, Robert Kulick, and Miranda finds high-growth firms make disproportionate contributions to employment and output and productivity—and these high-growth firms are mostly young, viz. entrepreneurial.

But, are high-growth young firms more productive because of better management practices, higher quality labor and capital, technology adoption, and international market exposure? Perhaps, although for the most part the studies of management practices across firms and countries have looked at relatively larger manufacturing, retail, health care, and educational institutions.

Some in the world of startups and entrepreneurship would say that little of this research describes what actual entrepreneurial productivity looks like. In his introduction to Founders at Work (which has to be one of the best books ever written about entrepreneurship), Paul Graham observed that early-stage startups are “probably the most productive part of the whole economy.” But this type of productivity—developing big ideas, testing them—doesn’t really look like the productivity discussed in the research. In startups, it’s bathrobes and “offices strewn with junk at 2 in the morning... This is what real productivity looks like.”

High-growth firms—which are disproportionately young startups—are more productive because they are engaged in Steve Blank’s search for a business model. As the Haltiwanger et al paper points out, “high growth young firms are those that innovate and learn successfully.” There is, then, something about being a young company—a startup searching for a business model, a founding team learning its own capabilities—that lends itself to productivity more than being an established incumbent.

The final observation to make about productivity growth is that it is extremely uneven across time, sector, and company. During any given time period, only a handful of sectors accounts for the lion’s share of aggregate productivity growth in the economy. This has been true for nearly a century—Arnold Harberger called it the “yeast versus mushrooms” approach. Over time, too, the most productive sectors change. In the 1990s, for example, only about six sectors accounted for the productivity resurgence; in the first half of the 2000s, productivity growth was similarly concentrated, but in different sectors. Within those sectors in which productivity is concentrated, moreover, it’s usually a handful of highly productive firms that are driving that overall growth.

For higher productivity growth at the macro level, then, we need a wider set of those highly productive, high-growth, entrepreneurial firms. How do we do that? We could want more firms (of any type) adopting the practices shown to be responsible for higher productivity: better management, higher quality human capital, faster technology adoption, competing in overseas markets, and engaging in R&D. Alternately, we could want more high-potential startups, those embodying Graham’s bathrobe productivity.

Are those compatible? Are high-growth young firms more productive because they’ve adopted high-quality management practices and because they hire high-quality people? Or are they are more productive because they don’t have the constraints of established companies? What are your thoughts? Tell us @KauffmanFdn and @danestangler.

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