analysis, we compare data from the 2011 WBES with the earlier 2004 WBES. For the firm-level innovation analysis, we compare findings from the latest WBES with a representative sample of enterprises collected as part of the Sri Lanka Longitudinal Survey of Enterprises by de Mel et al. (2009). These analyses provide complementary windows into key levers with which policymakers may improve the efficiency and novel use of resources already available in the economy.

<mark>Section II provides a context for the ensuing analyses by reviewing the importance of productivity and innovation as key drivers of sustainable high growth rates. Section III summarizes historic trends pertaining to reallocation of resources across broad sectors of the Sri Lankan economy. Section IV presents our main business environment-related hypotheses. Section V presents the data, methodology and analysis of cluster-level productivity. Section VI and VII then present the data, methodology and analyses of firm-level TFP and innovation. Section VIII concludes. Our empirical findings highlight the importance of connectivity to global knowledge (reflected by one or more of export participation, directly imported inputs, foreign ownership, and access to the internet), availability of skills, and access to finance as key correlates of cluster-level productivity and firm-level TFP and innovation. We also present evidence, under the assumption that the samples are statistically representative, that both allocative and average technical efficiency have improved, with allocative efficiency increasing roughly four-fold between 2003 and 2010, and accounting for the overwhelming share of the aggregate TFP increase over this time period. Most of the improvement in allocative efficiency has occurred among larger firms, and in large rather than small cities.</mark>

# **II. The Growth Benefits of Endogenous Productivity Improvements**

Compared to advanced economies, productivity in developing economies is low because the average firm is less productive and because there are much larger differences in productivity across firms, both across sectors and within sectors, with less efficient firms having disproportionately large market shares. There is a growing body of empirical work documenting large gaps in productivity across firms in developed and developing countries (Syverson 2011, Banerjee and Duflo 2005). Recent empirical work for Latin American countries (Pages et al. 2010), for the Brazilian manufacturing sector (Ferraz and Monteiro 2009), for India (Dutz 2007), and for China and India (Hsieh and Klenow 2009) indicate that within-country TFP differentials across firms are much greater in developing economies than in the United States and Europe: within disaggregated industries of the manufacturing sector, a plant at the 90th percentile of the productivity distribution makes on average 5 times as much output with the same measured inputs as the 10th percentile plant in China and India, while this dispersion in the U.S. has been estimated to be closer to 2:1 (Syverson 2004).

There is a twin policy challenge posed by such large within-country productivity heterogeneity. A first challenge, and important source of productivity increase, is improving the allocation of 4