The Australian Economic Review, vol. 40, no. 1, pp. 1–7  2007 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research Published by Blackwell Publishing Asia Pty Ltd 1. Introduction One seldom-explored factor explaining indus- try productivity growth in Australia is the role of firm entry and exit. The importance of firm dynamics has been highlighted by a growing number of international studies on large-scale longitudinal micro datasets; however, only one such study has been undertaken on Australian firms (see Bland and Will 2001). Firm dynamics which result in a reallocation of output shares and resources from low to high productivity firms can substantially impact aggregate productivity growth. Accordingly, policies aimed at enhancing aggregate produc- tivity and economic growth should take into account the costs of entry (such as excessive administrative regulations) and exit (such as in- solvency regimes). 1 In this light, the role of firm dynamics in Australia’s productivity growth merits greater attention, and it is the aim of this article to document its importance. In this article we review patterns of firm movements and present estimates of the contri- bution of firm dynamics to the productivity growth of Australian industries. Our estimates are principally drawn from the Business Longi- tudinal Survey (BLS), which covered the pe- riod 1994–95 to 1997–98. 2 2. Explanations of Firm Dynamics Explanations of firm dynamics have centred around three themes. The first is the Schumpe- terian notion of ‘creative destruction’, where entrants armed with new technology compete with incumbents. If the entrants’ innovations succeed, they replace the incumbents. If not, they fail to survive. Thus, aggregate productiv- ity evolves with successive waves of innova- tion through entry and exit and the resulting resource reallocation. The second explanation is based on the concept of experimentation under uncertainty, where firms in an industry make different bets on technologies, goods and production facilities. These generate differ- ences in outcomes and firms make decisions to expand, contract or exit as they learn about the environment and their capabilities. Approach- ing the issue from a slightly different angle, the third premise links firm dynamics with product life cycles. Entry is relatively easy and there are many players when a successful new prod- uct appears. As the market matures, the growth of demand decelerates and economies of scale become more important. Consequently, the number of firms declines sharply, and then lev- els off. For evidence, see the review by Ahn (2001). Another common way of thinking about firm-level and overall productivity changes is to distinguish between movements of firms from an inefficient point to an efficient point on the frontier and between movements of the en- tire frontier. This is elaborated in, for example, Dawkins and Rogers (1998). ‘Level’ effects involve reducing a firm’s inefficiency and Policy Forum: Industry Dynamics The Role of Firm Dynamics in Australia’s Productivity Growth Robert Breunig and Marn-Heong Wong* School of Economics, The Australian National University; and Productivity Commission, respectively * The authors would like to thank the Australian Bureau of Statistics for providing access to the data and, in particular, Shiji Zhao and Valentin Valdez for their support and assis- tance. The content of this article does not reflect the views of the Productivity Commission. Breunig&Wong.107 Page 1 Monday, January 1, 2007 6:16 PM