The Divergence in Firm Productivity Within the Same Sector: McKinsey Weighs In

One might expect that certain sectors of the economy will have faster productivity growth than others: for example, productivity seems likely to grow faster for semiconductor manufacturers than for a gas station.

But one striking change both in the US economy and around the world in the last couple of decades is that looking at firms within the same sector–that is, within the same general line of business–the firms that are productivity leaders have been expanding their lead over the productivity-lagging firms in the same sector.

This shift is driving other economic changes. For example, it turns out that a main factor behind increases in income inequality is the widening gap between high- and low-productivity firms in the same sector. To put it another way, whether you do relatively better or worse as a result of widening inequality may not have much to do with you personally, or where you live, or your job; instead, it’s about whether you work for a high- or low-productivity firm. The McKinsey Global Institute offers some thoughts about this issue and other productivity-related topics in “Rekindling US productivity for a new era (February 16, 2023). The report argues:

The most productive firms in every sector have widened their lead on the rest. In fact, the gap between the most and least productive is wider within sectors than in any other dimension we studied. Manufacturing provides a particularly striking example; leading firms operate at 5.4 times the productivity of laggards. In some manufacturing subsectors, the differences are extraordinary. The leading semiconductor manufacturers are 38 times more productive than the least-productive companies. This mirrors other research showing similar patterns of divergence across other sectors such as wholesale trade and information.

The “frontier firms” in the productivity vanguard are accelerating away from their peers. These firms tend to be larger, more connected to global value chains, and focus on technology-intensive aspects of their sector. Research suggests these leading firms invest 2.6 times more in technology and other intangibles such as research and intellectual property, and attract and invest in more skilled talent.

As a result, the gap between frontier firms and laggards has grown over the past 30 years. In manufacturing, the gap was 25 percent wider in 2019 than it was in 1989, with most of that change happening before 2000. At the same time, industry dynamism has fallen, as seen in metrics such as new firm entry rate (which has declined 29 percent from 1989 to 2019 in the United States) and labor reallocation rates (which are down 31 percent across sectors).

Standard economic principles would suggest that less productive firms would be replaced or would improve their performance. Researchers have offered multiple hypotheses for why this has not happened. For example, there is evidence that firms within the same sector may coexist without fully competing, by serving different customers, attracting different workers, or operating in different geographic markets. Finally, some researchers have pointed to declining measures of competition as a source of the divergence, which remains a matter of active debate.

Whatever the explanation for growing divergence, productivity gains must ultimately come from firms. If laggards don’t catch up or get replaced by more productive firms, US productivity will continue to splutter. For business leaders, the message is clear: improving your firm’s performance matters much more than the productivity of the sectors in which you operate.

As the McKinsey report points out, gains in labor productivity are fundamental for national prosperity. The key issue to remember here is that productivity gains build on each other. Thus, if productivity could be raised 1% per year, each year builds on the previous one, and after a decade the US economy would be (roughly) 10% larger. (Actually a little more than 10%, because the growth rate compounds over time.) The US economy is about $23 trillion in size right now, so being 10% larger involves gains of over $2 trillion. As I sometimes say, no matter whether your goal is higher wages or expanded government spending or tax cuts, it’s easier to achieve that goal in an expanding economy–where we are in effect arguing over how a growing pie will be divided up–than it is to accomplish your goals in a low-growth economy or even zero-sum economy, where gains for any particular goal require losses for other goals.

The MGI report discusses a number of ways for the US (or any nation) to improve productivity: better education and workforce skills, support for research and development, a competitive and evolving marketplace, and others.

Here, I want to emphasize a different lesson: The growing divergence between high- and low-productivity firms suggests that the challenge is not just one of cutting-edge innovation. Again, the cutting-edge firms across different sectors of the economy are doing pretty well with raising productivity. The challenge is for supporting an economic environment where the productivity laggards keep pace or die off, but don’t just keep falling farther behind.