_4. Churning:_ There is a high pace of the reallocation of outputs and inputs across businesses that (i) is largely within narrowly defined sectors; (ii) differs substantially across sectors and firm characteristics (e.g., much more churning amongst young and small businesses);and (iii) where entry and exit of businesses account for a substantial fraction of the variation and the positive correlation between gross entry rates and gross exit rates across industries helps account for the differences in churning rates across sectors (e.g. Geroski, 1995, Ahn, 2000 and Davis and Haltiwanger, 1999 for surveys of the literature).

_5. Reallocation and Productivity:_ The pattern of reallocation is far from random. In well-developed market economies, the evidence is overwhelming that the pattern of reallocation is productivity enhancing. Accounting exercises show that a large fraction of total factor productivity and labor productivity growth at the industry level is accounted for by the reallocation of outputs and inputs from less productive to more productive businesses (see e.g. Olley and Pakes, 1996, Griliches and Regev, 1995, and Foster, Haltiwanger and Krizan, 2001, 2002) _._ .

# **_Why are firms so heterogeneous?_**

These statistical regularities depict a story whereby entrant firms start business with a different initial size reflecting differences in their own perceived ability. Because of the inherent uncertainty in their potentials, even an entrant who is very successful, _ex post_ , tends to begin with a smaller size at the initial stage of his life. This provides an explanation why small and young survivors show rapid growth. Competition continuously separates winners and losers with unsuccessful firms exiting the market relatively rapidly, and successful survivors growing and adapting. The accumulation of experience and assets, in turn, strengthens survivors and lowers the likelihood of failure.

Several theories have been developed to explain these observed patterns of firm dynamics survival and growth. They generally relate to the process of ‘creative destruction’ (usually ascribed to Joseph Schumpeter). The distinguishing element of Schumpeter’s theory from ‘standard’ theories of firm behavior is that it recognizes heterogeneity amongst producers and that the continual shift in the composition of the population of firms through entry, exit, expansion and contraction is essential in developing and creating new processes, products and markets.

The first two regularities are consistent with one class of models of firm learning process, the _passive learning model_ of Jovanovic (1982). In his model, a sequence of firms that do not know their own potential profitability enters the market. Only after entry does the firm start to learn about the distribution of its own profitability based on noisy information from realized profits. By continually updating such learning, the firm decides to expand, contract, or to exit. One of the main implications of this model is that smaller and younger firms should have higher and more variable growth rates.

Cabral (1995 and 2003) offers an alternative theoretical explanation for the observed negative relation between firm size and growth (the so called _Gibrat’s law_ ). His model assumes that firms must incur a sunk cost in building production capacity. Since small entrants have a higher probability of exit than large firms, it is optimal for them to invest more gradually, and thus experience higher growth rates if successful, than larger entrants. Cabral also suggests that financial constraints are an alternative for _sunkness_ of capacity and technology investment. Since cash constraints are expected to be less binding after start up, cash constrained start-ups should expect higher-than-average growth rates.

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