# **Contestability Effects:  The Relationship Between the Pace of Creative Destruction and Productivity Growth**

The analysis above focuses on the direct contribution of the reallocation process for productivity growth (either with the dynamic or cross sectional decomposition). These decompositions lead one to think about the reallocation contributions and the within firm contributions as being alternative explanations of productivity growth. The reallocation contributions are often interpreted in the literature as reflecting the creative destruction processes while the within firm are interpreted as reflecting more traditional sources of productivity growth (the average firm becomes more productive with advancing technology. However, rather than being alternatives, these effects (within vs. reallocation) may be closely related. That is, the pace of the creative destruction process might be interpreted as a measure of the c _ontestability or competitive of markets._ As such, greater competitive pressures may induce incumbents to perform more efficiently.

A first look at such _contestability effects_ is provided in Figure 13. In this figure, we exploit not only the cross country variation but the variation across industries in order to be able to increase the number of observations (and since in principle the above arguments should apply across sectors as well as countries). In particular, we examine the relationship between the contribution of net entry in a country/sector (using time averages from the country/sector/year data) and the productivity growth from incumbents (the within term in the FHK decomposition). Interestingly, we find a strong positive and statistically significant correlation between the net entry contribution and the productivity growth of incumbents.

This finding is suggestive that there is a relationship between the creative destructive and within firm sources of productivity growth. If nothing else, this strong correlation suggests that these components are not orthogonal alternatives but rather closely related. It might be, however, that the correlation in Figure 13 is readily explained as reflecting the impact of technological advances for both continuing firms and for the creative destruction process. That is, it may be that with technological advances we observe incumbents who survive increase productivity and also observe entering businesses (who presumably adopt the latest advances) more productive that the exiting businesses.

To focus more on the contestability hypothesis directly, in Figure 14 we examine the relationship between the firm turnover rate and the productivity growth of incumbents. We again find a positive and statistically significant correlation. This latter finding provides more direct evidence of a connection between the competitiveness or contestability of markets and the productivity growth within incumbent firms.

A related question is whether the pace of creative destruction is also related to the productivity difference between entering and exiting businesses. Figure 15 shows the relationship between the firm turnover rate and the mean difference (unweighted) between the productivity of entering and exiting businesses. We find a strong and positive relationship here as well.<sup>27</sup>

> 27. Given the discussion in section 2, it is possible to justify either a positive or negative correlation. On the one hand, a higher firm turnover rate might imply greater dynamism and thus competitive forces playing a greater role in determining market selection.  From this perspective, the correlation should be positive and since we found this in the data this is the interpretation we are pushing.  Alternatively, greater dynamism might also be due to greater randomness in market selection and/or greater market experimentation (which adds a form of endogenous randomness). Such greater randomness in market selection would imply a negative correlation.

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