The inclusion of cell averages for relevant knowledge-intensive variables highlights an important additional positive spillover effect on TFP for 2003 for foreign ownership: in addition to the own effects remaining highly significant and similar in magnitude, there is a significant and substantially larger in magnitude effect from the presence of foreign peer firms on TFP, which in the case of the 2003 dataset, is roughly six times larger in magnitude than the own effect. Other own-effect variables that were not significant in the models that omitted cell averages and are now significant in the 2003 dataset include exporting and training workers.

Figure 8 reports Olley-Pakes decompositions of TFP comparing 2003 and 2010 at the aggregate level, for small and large cities, for the industries with the largest samples in both datasets, and for separate size classes. At the aggregate level (Figure 8.A), allocative efficiency has improved, increasing roughly four-fold between 2003 and 2010, and accounting for the overwhelming share of the aggregate TFP increase over this time period. Comparing changes over time in small and large cities (Figure 8.B), most of the improvement in allocative efficiency between 2003 and 2010 has occurred in large rather than small cities; there was also a larger increase in average technical efficiency in large cities, 21 percent versus 16 percent for smaller cities.<sup>17</sup> At the level of specific industry groupings (Figure 8.C), most of the improvement in allocative efficiency occurred in food & beverages and in nonmetals & plastics, with again a relatively modest increase in average technical efficiency; in textiles, on the other hand, resources have moved so far in the wrong direction that by 2010 there is a negative covariance between outputs shares and productivity reflecting an allocative inefficiency where higher shares of output by the less productive firms actually reduce industry productivity. And finally, at the level of separate size groupings, the largest increase in allocative efficiency has occurred among large firms, with resources moving from smaller to larger firms within this size group; large firms have also benefited from the largest increase in average technical efficiency, a 36 percent increase. In contrast, medium-sized firms are characterized by the smallest increase in both allocative and technical efficiency.

# **VII. Firm-level Innovation Analysis**

# **Data sources**

For the firm-level innovation analysis, we compare the full 2011 WBES, including both manufacturing and services firms, to the baseline of the Sri Lanka Longitudinal Survey of Enterprises (SLLSE) – a survey collected between January and May 2008 and used by de Mel et al. (2009). This survey was designed to obtain a representative sample of micro, small and medium-size manufacturing and services enterprises in urban Sri Lanka, irrespective of their registration status. We use the booster sample of 610 small and medium enterprises collected for this survey because it is more representative of the size distribution of establishments in Sri

> 17 Our large city sample comes from Colombo, Gampaha, Kurunegala, and Kandy.

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