A Survey of Theories and Empirical Evidence
Chapter 5: Profits, Productivity and Firm Growth
Theoretical work has long been interested in the relationship between a firm’s relative performance (measured either in terms of profits or productivity) and its growth rate. In fact, a number of theoretical authors tend to take it for granted that firms with higher performance will reinvest their profits into growth, such that the more efficient firms will have higher growth rates. Empirical work into the matter, however, suggests that the expected positive relationship between performance and growth is generally lower than expected, or even non-existent. We begin this chapter by looking at the relationship between profits and growth (section 5.1). There remains a controversy, however, over how the relationship between financial performance and growth should be interpreted. Neoclassical economists, for example, think that in a perfect world, current financial performance should not be related to investment. If investment is related to financial performance, then financial constraints are preventing firms from undertaking their optimal expansion plans. Evolutionary economists take an opposite view – ideally, firm expansion should be related to current profits. This is because progressive industrial development requires the reallocation of scarce resources towards the more efficient producers. In addition to profits, many theorists have focused on the relationship between productivity and firm growth. In fact, profits and productivity are quite closely correlated and they can be considered as alternative indicators of relative performance. The relationship between productivity and growth is addressed in section 5.2. In section 5.3 we look at models that look at the coevolution of both profits, productivity,...
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