Firm dynamics and job creation: revisiting the perpetual motion machine

Firms are constantly being born, growing and dying. Meehan and Zheng (2015) refer to these dynamics as a “perpetual motion machine”. When firms shrink and die, jobs are destroyed but they also give way to new firms and new jobs.

In normal circumstances there is a considerable amount of churn in the economy and, on balance, additions outweigh subtractions. This is summarised in Figure 1 which shows a steady decline in the number of ageing firms and replacement with new firms (in the top panel) and new firms contributing the lion’s share of job creation (in the bottom panel).

Studying the dynamics underlying these macro-trends can provide insights into the functioning of the economy and causes of, or barriers to, productivity growth. If firms ‘refuse’ to die, but stagnate instead, this may reflect insufficient competitive pressure that should cause these firms to fail. When firms stagnate, but do not die, they can also impede reallocation of resources and workers to higher valued uses – and as such they can impede productivity growth.

Empirical analyses show that reallocation from low productivity to high productivity industries is an important aspect of economic development (Rodrik and McMillan, 2011). Meehan (2016) found that productivity growth would have been higher in New Zealand in the 2000s if resources had been allocated to higher productivity firms or industries. Resources have been allocated most inefficiently within, rather than between, industries.

One implication of this is that firms are larger than they ought to be, given their productivity. These findings are consistent with findings overseas (Hsieh & Klenow, 2009; Bartlesman et al 2013).

Firm dynamics have also attracted attention of policy makers seeking to support productivity growth by investigating policies that can support firms exhibiting rapid employment growth – so-called “high-growth firms”.[1] The pursuit of policies to support “high-growth firms” is based on presumptions that high-growth firms are more likely to be high productivity firms, innovative, and disruptive in terms of the increasing competitive pressure when they enter new markets (MBIE, 2013).

Firm birth and growth rates also affect adjustments to economic shocks or structural changes in the economy. If employment growth begins to decline or firms begin to shrink, employees can only find work elsewhere if the perpetual motion machine is working well – with new firms being born and new jobs being created. If new job opportunities are not being created, such as often occurs following a negative economy-wide external demand shock, then the effects on workers can be significant and long-lived (see e.g. Farber, 2017).

Figure 1   Firm and employee counts by cohort

A. Firm count

B. Employee count 

[1] One commonly-used definition of high-growth firms is firms with at least 10 employees in the start year and annualised employment growth exceeding 20% during a three-year period (Eurostat-OECD, 2007).