What may happen to firm-level productivity in the UK after Covid-19?

Many businesses have responded to the pandemic by adopting new technologies and working practices. These may lead to productivity improvements. But other factors are important too, including the impact that damage to supply chains could have on the most productive ‘frontier firms’.

A key policy question is how the economic crisis might affect long-term productivity in the UK. Might it usher in faster productivity growth or weaken the outlook?

In the past, productivity has tended to recover quite well after the initial onset of a recession in the UK. But the experience of the 2008/09 recession following the global financial crisis was quite different, with productivity growth struggling to recover ever since – leading to the so-called ‘productivity puzzle’.

In the long run, productivity will continue to have a crucial role in determining our living standards. Both labour productivity and, most importantly, what economists call ‘multi-factor productivity’ (the overall efficiency with which labour and capital inputs are used together in the production process) are important. For advanced economies, including the UK, improvements in productivity are widely recognised as a key driver of long-run economic growth (OECD, 2015).

Multi-factor productivity is crucial because it reflects both efficiency and technical progress. This determines output (growth) and wage growth, as workers are rewarded by firms sharing the outcome of greater production efficiency via higher wages.

There are several channels through which productivity in an economy can be improved over time, ranging from infrastructure investments to policies that boost skills and education. But the dynamism and structure of the business base matters too. Research (such as Haldane, 2018) shows that low aggregate multi-factor productivity in the business base can arise from limitations in:

Leadership: Frontier firms are not among the global leaders in their industry.
Diffusion: There is a lack of diffusion of technology from the (national) ‘best-practice’ frontier to non-frontier firms.
Reallocation: There is insufficient reallocation of resources from less efficient firms to more efficient firms through ‘churn’ (opening of more efficient firms and closure of less efficient firms) and through the reallocation of existing market shares from low to higher productivity firms. Together, ‘churn’ and external reallocation are commonly referred to as ‘creative destruction’.

What are the key channels through which firm-level productivity may be affected?

There are numerous channels through which the business response to Covid-19 could affect firm-level productivity (Harris, 2020a). Here we focus on three.

Frontier firms

The pandemic might have a disproportionately negative impact on ‘frontier firms’ – defined as the most productive firms in an industry (see Andrews et al, 2016). They are often part of a global innovation hub and many are large multinational companies involved in complex global value chains (see Bloom et al, 2012). These value chains can consist of routine trade in goods and services, but increasingly they involve more intangible assets such as transfers of information, knowledge and technology (see Antràs, 2020, and World Development Report, 2020).

Over the last 30 years or so, the rise of frontier firms, dependent on their global value chains, has been crucial for driving productivity growth across the economy. But they may be particularly vulnerable to the Covid-19 shocks (in output and productivity) due to their reliance on global value chains. Any decline in international trade or the movement of people during the current crisis will disproportionately harm them.

If there is a move by governments to encourage ‘reshoring’ activities (to make supply chains shorter and nearer to customers), over time this should lower productivity (growth and levels) even further – since costs will rise and firms will also need to meet the (new) sunk costs of ‘domesticating’ supply chains.

Countering this, it is possible that improvements in digital technologies, robotics and automation may increase the resilience of supply chains and lower barriers to reshoring (Antràs, 2020). As digital platforms facilitate matching between buyers and sellers, this increases the potential for small(er) firm participation, as well as enhancing ‘just-in-time’ systems (avoiding increases in inventories, which have a negative effect on multi-factor productivity).

Diffusion

A lack of diffusion of best-practice technology from the frontier (whether global or national) to non-frontier firms is thought to be one key reason why productivity catch-up might not take place (see Andrews et al, 2016; Harris, 2020b).

Research shows that a key reason for low diffusion tends to be low levels of absorptive capacity in firms – that is, the ability of firms to internalise the external knowledge that needs to be present for a firm to be able to assimilate better technologies (Harris and Yan, 2019). This includes management practices (Bloom et al, 2019). Improving absorptive capacity also requires investment in intangible assets, and this tends to be among the first target of cost-cutting during recessions.

So for laggard firms, how might the diffusion of best-practice technology be affected by Covid-19? Diffusion is dependent on firms being able to assimilate external knowledge, and this requires expensive investments (including time and commitment) in tacit knowledge and intangible assets. This is more likely to be curtailed unless governments share the cost of this kind of investment.

Creative destruction and market cleansing

There is an expectation that creative destruction plays a particularly important role during and after recessions – a ‘cleansing effect’ to clear the market of inefficient production units (Kilinç, 2018). But distortions that impede an efficient allocation of resources across firms, and the process of entry and exit, have the potential to reduce the capability of more productive units to grow, thus reducing aggregate productivity (Brown et al, 2018).

Trade liberalisation (as well as larger numbers of firms nearer the technological frontier where competition is often strongest) also encourages innovation – see Aghion et al, (2013) for full details – and therefore leads to more creative destruction, as it reallocates resources to R&D (research and development) and higher quality exporters. The reduction (or even reversal) of such liberalisation will result in negative productivity outcomes.

A cleansing effect seems to have evaporated during and after the global financial crisis of 2007-09 (Barnett et al 2014; Harris and Moffat, 2016). Possible explanations for this include stricter employment protection leading to higher costs of firm entry and exit (Haltiwanger et al, 2014) or greater firm survival rates perhaps because of low borrowing costs, weak wage growth and loan forbearance.

One concern is how long-term the current response of governments to the pandemic will be, and whether or not this will have implications for creative destruction. Clearly, these measures were designed to protect the economy and to avoid associated mass unemployment. But over time the effects could actually be damaging for long-term productivity – if they lead to so-called ‘zombie firms’ become ever more prevalent.

Government subsidies have the potential to reduce net new firm entry in the longer run, and/or lower ‘within-firm’ productivity improvements. In such instances, the outcome will be a reduction in the market’s ability to reallocate resources towards firms with higher productivity, which can rebuild the longer-run growth of the economy. There were early signs (BBC News, 2020) that government support to keep firms from becoming insolvent reduced the level of firm closures in April to June 2020.

While the long-term prospects are unclear, the three channels clarified above provide guidance to policy-makers on where to look for clues on the long-term impact of the pandemic.