Selection, Reallocation, and Spillovers:Identifying the Sources of Gains from Multinational Production

Laura Alfaro Maggie X. ChenHarvard Business School George Washington University

& NBER & World Bank

May 2012

Introduction

• Nations with greater multinational activity exhibit, on average, higher productivity. (Borensztein et al. 1998, Alfaro et al. 2004, Harrison and Rodriguez-Clare, 2010, Kose et al. 2010;).

Introduction

• This positive correlation, likely conditional on other factors, is often attributed to knowledge spillovers whereby foreign multinationals generate positive productivity externalities to domestic firms:

– Knowledge transfer through partnerships, interaction and movement in labor markets, etc.

• There is a less stressed, alternative explanation, centering on firm selection.– Selection of multinational firms: Countries with greater openness to

multinational activity to attract firms that are, by selection, more productive (Helpman et al., 2004).

– Selection of domestic firms: Greater multinational activity leads to tougher competition and market reallocation, only the most productive domestic firms to survive (Melitz, 2003).

Introduction

• These mechanisms all imply a positive relationship between multinational production and greater host-country productivity but different causalities.

– Selection of multinational firms: Higher host-country productivity reflect the productivity of self-selected multinational firms.

– Selection of domestic firms and knowledge spillovers imply multinational activity causes higher aggregate domestic productivity.

• Tougher selection means a contraction of domestic production,• Technology spillovers represent positive externalities.

Objective of the Paper

• Disentangle and quantify the relative magnitude and statistical significance of the firm selection and knowledge spillover effects:

– Crucial for identifying the sources of productivity gains and setting effective FDI and industrial policies.

» Ignoring sources can lead to significant bias in understanding the nature of welfare and productivity gains and an over-estimation of the importance of knowledge spillover.

– If increases in productivity are due to knowledge spillovers, special treatment to foreign multinationals may be justified;

– If increases in productivity are due to tougher selection on domestic firms, policies should aim at improving human capital, and financial market conditions, facilitating gains from competition and resource reallocation.

Methodology

• Distinguishing these mechanisms is difficult by simply examining the relationship between multinational activity and average productivity.

– We develop a model of monopolistic competition and heterogeneous firms, adapted from Melitz (2003) and Helpman et al. (2004), and a structural empirical framework exploring the distinct predictions for the distributions of domestic firms:

• Selection of multinationals: Firms with greater ex-ante productivity self-select into multinational production.

• Selection of domestic firms: Competition from multinationals leads to market reallocations and an increase in the cutoff productivity and revenue (greater left truncation of the distributions);

• Knowledge spillovers: rightward shift of the productivity distribution, while the revenue distribution sees a weaker, or even leftward, shift.

Data and Estimation

• Worldwide firm-level dataset: Orbis

– Comprehensive financial, operation, and ownership information for over one million public and private manufacturing firms, 2002-2007.• Identify multinational activity across countries and explore the

heterogeneous effect of foreign investments (manufacturing firms).

• Structural estimation consists of two steps:

– Estimate the selection of multinational firms as a function of their ex-ante productivity, host-country and bilateral factors.

– Evaluate the effect of multinational activity on various properties of domestic production and the productivity distribution.

Preliminary Findings: Selection, Reallocation, Knowledge Spillover Effects

• Tougher selection for the domestic firms. – Entry of multinationals raises the cutoff productivity of domestic firms;

least productive domestic firms more likely to exit.

• Increased competition and market reallocations.– Increase in the minimum revenue of continuing domestic firms (implying

increase in fixed production costs and financing constraints).• Domestic firms’ revenue distribution shifts leftward (25th and 50th). • Domestic firms’ productivity distribution shift rightward; distribution

becomes more left truncated due to selection.

• Knowledge Spillovers: – Surviving domestic firms productivity increases at different percentiles.

Preliminary Findings: Productivity Gains

• Aggregate productivity increases by 1.4 percent across countries when the probability of entry by new multinational firms increases by 100 percent.

• The productivity of domestic firms increases by 0.9 percent, – Knowledge spillover and domestic selection account for 69 and 31

percent, respectively.

• The relative importance of each source exhibits significant country heterogeneity. – Firm selection and market reallocation are, on average, more

important in developed nations.

Related Literature: Spillovers and Selection

• Studies assessing the productivity spillovers from multinationals to domestic firms:

– Aitken and Harrison (1999) find evidence of negative spillovers in Venezuelan manufacturing enterprises (market-stealing effect).

– Keller and Yeaple (2009) show strong evidence of positive spillovers from foreign multinational to domestic firms in the United States.

– Javorcik (2004) shows multinational activity leads to positive externalities via backward production linkage.

– Arnold and Javorcik (2009), and Guadalupe at al. (2001) find foreign multinationals to acquire best performing domestic firms, explaining some but not all of the performance differential.

Related Literature: Factor Markets/ Competition Effect

• Evidence on the domestic selection effect of multinational activity and the relative importance of spillovers and selection is scarce.– Ramondo (2009) finds foreign plants' entry to be negatively correlated

with the market shares of domestic firms and positively correlated with the productivity of domestic incumbents in Chile.

• A few studies have taken the step to evaluate MNCs’ factor market effects .

– Labor: Aitken, Harrison, and Lipsey (1996) and Feenstra and Hanson (1997) find foreign multinational activity to increase industry wages and share of non-production workers in wage.

– Capital: Harrison and McMillan (2003) find borrowing by foreign firms exacerbates the credit constraints of domestic firms. Harrison, Love and McMillan (2004) find FDI inflows to be associated with a reduction in financing constraints using a larger cross-country dataset.

Related Literature

• Recent studies evaluating the welfare effects of multinational production (Ramondo and Rodriguez-Clare , 2010; Irrarazabal, Moxnes, Opromolla, 2011), and focus on the productivity effect of resources allocation across establishments (see, Hsieh and Klenow, 2009; Alfaro et al, 2009).

• Our paper is an effort to distinguish and quantify the roles of selection, reallocation and knowledge spillovers in the aggregate productivity effect of multinational production.

– Micro theoretical foundation to develop an empirical strategy that is able to distinguish their relative importance;

– Structural framework to quantify the magnitude of productivity gains associated with each effect;

– Cross-country analysis to quantify and evaluate how the knowledge spillover and selection effects may vary systematically across nations.

Outline

• Introduction and Motivation

• Theoretical Framework

• Data

• Empirical Methodology

• Results

• Conclusions

Theoretical Framework: Setup

Standard model of monopolistic competition with heterogeneous firms (Melitz (2003) and Helpman et al. (2004)).

• Two identical countries, H and F; two sectors, homogeneous (numeraire) and differentiated.

• Continuum of firms in each country. Each firm produces a different variety of the differentiated product and has a distinct productivity level θ.

• Given a CES utility function, the demand function for each variety of the differentiated product:

– x(θ) = the quantity of demand; p(θ) = price of the product variety, – E = the aggregate expenditure; P = the aggregate price

( )pEx

P P

Theoretical Framework: Production,Domestic Firms

• If firm θ of country H chooses to produce and sell at home, it must employ one unit of labor for each unit of output and incur marginal cost w/θ, (w= common wage rate.).

• The firm must pay a per-period fixed cost cfD,

– c denotes unit capital price – fD denotes the units of capital required in the production.

• The profit-maximizing strategy is to set p(θ)= w/(αθ)

1

D

D D D D

r E Pcf cfw

Theoretical Framework: Production, Foreign Firms

• Firms of country F may invest and produce in country H to serve country H's consumers via multinational production.

• Foreign multinational firms must pay a fixed cost cfM in each period,

– fM > fD.

• The profit earned by the foreign firm in country H:

1

M

M M M M

r E Pcf cfw

Theoretical Framework: Production Decisions, Cutoff Productivity

• Domestic firms produce in the domestic market if πD(θ) ≥ 0, which gives the cutoff productivity level θD for domestic firms to survive:

• Foreign firms invest and produce in the domestic market if πM(θ) ≥ 0; which gives the cutoff productivity level for foreign firms:

• θM > θD, minimum productivity to survive is higher for foreign firms (fM>fD).

1

1

0 DD D D

cf wE P

1

1

0 MM M M

cf wE P

Theoretical Framework: Knowledge Spillovers

• Productivity of domestic firms is assumed to be a function of two components:

– Raw productivity θa drawn from a distribution function G(θa) – Slope parameter τθ (zM )

• zM: indicator variable that denotes the existence of foreign multinational production.

Mz

a

Model: The Impact of Multinational ProductionThe Selection of Domestic Firms

• Openness to FDI induces an increase in the domestic cutoff productivity level θD , the least productive firms no longer earn positive profits and exit.

– Domestic cutoff productivity, (A denotes ex-ante, before MNC entry)

– Exits for A<<D

• The effects operate through domestic factor markets: increased factor demand by multinational firms bids up the real wage and capital price.

– Revenue:

• Increase in the average productivity and in the number of firms serving the market: a decrease in the aggregate P and on revenues, while the spillover from foreign firms exerts a positive effect.

• In the absence of productivity spillovers, all firms incur a loss in domestic sales in the open economy.

11

DD A

cf wE P

1/ MZ

D Ar r

Data

• We employ a cross-country firm-level panel dataset, drawn from Orbis, that contains comprehensive financial, operation, and ownership information for over 1 million manufacturing firms in 60 countries.

• We estimate total factor productivity using the semiparametric estimator developed by Olley and Pakes (1996).

– The production function is estimated for each country and each NAICS 4-digit industry;

• We consider two sub-periods: 2002-2004 and 2005-2007 and investigate how changes in multinational activity between the two periods affect host-country domestic firms.

• A firm is considered foreign owned if its global ultimate owner is based in a different country. There are about 36,000 foreign owned manufacturing subsidiaries in the final sample.

Empirical Evidence: The Self-Selection of Multinational Firms

• Estimate the following equation:

– zM(θ) represents foreign multinationals' binary decision to enter a given host country in 2005-2007,

– θ is the ex-ante productivity of multinational firms (estimated based on headquarters activities in 2002-2004)

– FEM is a vector of host country-industry dummies, – D bilateral country factors including distance, common border, and common

language between headquarters and host countries.

• Ex-ante productivity of foreign firms are expected to have an effect on the decision to participate in multinational activity but, unlikely to be directly correlated with the future productivity of host-country firms, Helpman et al. (2004): Exclusion conditions in the second-stage estimations to identify multinational production effects.

1Pr 1| ln ln 0 ln ln 01D DM D M M

z FE d

• More productive firms exhibit a greater likelihood of entering foreign countries, consistent with Helpman et al. (2004).

• Multinational activity exerts, on average, a positive and significant effect on the average productivity of domestic firms.

• Traditionally, it has been assumed that this productivity effect is associated to knowledge spillovers.

• But is the gain due to knowledge spillovers, selections, or both?

Empirical Evidence: The Self-Selection ofDomestic Firms

• Survival of individual domestic firms by estimating

• zD(θ) whether the domestic firm continues production in 2005-2007,

• θA is the lagged productivity of the domestic firm, (βZ :cumulative effect of new multinational entry on the survival probability of domestic firms, including the positive knowledge spillover effect and the adverse effects on financing costs and aggregate price).

• zM is an indicator for new multinational entry.

• Country and industry dummies to control for country and industry factors and country-industry clustering to allow for correlations within each cluster.

• To account for the endogeneity of zM, we substitute ^γM obtained.

0 1Pr 1 ln

1ln ln ln1

D A Z M

AZ

A

z z

Pcc P

• Domestic firms are more likely to exit the market in the presence of new multinational entry.

Empirical EvidenceThe Selection of Domestic Firms: Cutoff Productivity

• Higher probability of multinational entry leads to a significant increase 16% of the cutoff.

1ln ln ln ln1

AD A D M M

A

Pcz zc P

Empirical Evidence: Labor Market Reallocation

• A higher likelihood of multinational entry leads to a significant decrease in the level of revenue for firms at both the 25th and 50th percentiles (the relatively smaller domestic firms see a bigger contraction in their revenue).

ln ln 1 ln ln 1AD A A A M P M

Pr q r q z zP

Empirical Evidence: Capital Market Reallocation

• A higher probability of multinational entry leads to a significant increase in the cutoff revenue of domestic firms.

1ln 0.06, ln ln 0.16, assuming =2, ln 0.1, 0.9.1

A A Ac D

A A

P P Pc cc c P P P

ln ln lnD D D A M C M

A

cr r z zc

Empirical Evidence:Knowledge Spillovers

0 0ln ln ln

A a A M Mq q z z

• A higher probability of new multinational firms leads to an increase in the productivity of domestic firms at the 25th and 50th percentiles (3-4, percent upward shift of the productivity in the lower range of the distribution).

Estimated Welfare and TFP Gains

• 100-percent increase in the probability of MNC entry

• Aggregate domestic productivity (0.87 %): 75% increase in aggregate productivity.

• Knowledge spilloverse (0.6%): 69% of domestic productivity gain.• Realloction (0.3%): 31% of domestic productivity gain.

Within and Between Industry Reallocations

FDI Promotion Policy

Country Heterogeneity

100-percent increase in the probability of MNC entry

Tougher domestic market selections and reallocation in developed nations and relatively less knowledge spillovers.

Discussion: Measures of Productivty, Correlations, Prices, Markups

• Firm productivity based on the output value produced by each firm given its inputs: (we do not observe firm-level physical output quantities and prices).

• No bias in cutoff revenue, and revenue distribution, and survival estimates. – Similar estimate of knowledge spillovers using shift in the productivity distribution

or exploring domestic survival and changes in revenues distribution moments.– Overestimation of spillovers if not considering both sources even with q, p data.

• Estimates of knowledge spillover could be biased downward if the distribution of productivity partly reflects the distribution of markups: More productive, higher markup firms survive, distributions shifts downward (Melitz and Ottaviano, 2008).

• Re-estimate spillover equations for industries with homogeneous products (shifts more likely to reflect changes in productivity) using country-industry-specific import demand elasticities > 75th percentile in each country ( Broda, et al., 2006)– Productivity distribution of domestic firms shifts rightward by 3% (25th, 50th

percentiles), no significant changes at 75th percentile; productivity distribution becomes more left truncated.

Conclusions

• The impact of multinational activity on host-country productivity has been a major topic of economic research.

• We develop a theoretical and structural empirical framework to distinguish knowledge spillovers and selection, less stressed in the literature:– Knowledge spillovers induce a rightward shift of the productivity

distribution; the selection effect, in contrast, causes a weaker, or even leftward, shift of the revenue distribution and an increase in the cutoff productivity and revenue.

• Using a large cross-country panel dataset of manufacturing firms, we find significant evidence of selections, market reallocations as well as knowledge spillovers.

• We also quantify the productivity gains associated with each effect and explore cross-country heterogeneity.

Theoretical Framework: Aggregate Outcomes

• ND : equilibrium mass of incumbent domestic firms in each country.

• Given the country symmetry assumption, the number of foreign owned firms in each country:

• The total mass of varieties available to consumers in each country and the total mass of firms competing in each country: N=ND +NM.

1 / 1M M D D

M M D

N G G N

N N

Theoretical Framework:Aggregate Outcomes

• The weighted average productivity levels of domestic and foreign firms, are respectivley given by.

• The productivity average summarizes the effects of the distribution of productivity levels on aggregate outcomes, (Melitz, 2003)

11

1

11

1

11

1 1

1Domestic: 1

1Foreign: 1

1Aggregate:

D

M

D

D

M

M

D D M M

g dG

g dG

N NN

1 11 1

11;

D

wP N p Np

EE Nr W N pL

Equilibrium Conditions

• Steady state equilibria: an entering firm with productivity θ would immediately exit if its profit level were negative or would produce and earn π(θ) in every period until it is hit with the bad shock and is forced to exit

• Zero cutoff profit conditions

r(D) = cfD ; r(M) = cfM

• Free entry condition (the expected value of future profits must, in equilibrium, equal the fixed entry cost.)

– where D 1-G(D) is the exante probablity of survival after entry

0 EE

D

cfv

Equilibrium Conditions: Factor Market Clearing Conditions

• Labor

– Total demand for labor in the domestic market equals the total supply of labor L:

– Which yields the number of domestic firms, ND, the number of foreign firms NF, and the total number of firms in the domestic market N.

• Capital.

– For simplicity, we assume firms finance a constant share of their fixed foreign investment cost in home countries and the rest abroad (empirical evidence).

– which yields the unit financing cost c.

1/D D M MN r r L

/D D M M E DN f f f K

Model: The Impact of Multinational ProductionAggregate Productivity and Welfare

• Producivity: Multinational entry leads to a decrease in the number of domestic firms ND, and an increase in the aggregate productivity.– Reallocations in factor markets and tougher selection of domestic firms.– Surviving domestic firms benefit from the positive externalities from

foreign firms and witness an increase in their productivity levels.

• Welfare: when there is an increase in the total product variety, N, this effect, together with the increase in aggregate productivity, leads to an increase in welfare

11

1

11

1

11

1 1

1Domestic: 1

1Foreign: 1

1Aggregate:

D

M

D A

D

M A

M

D D M M A

g dG

g dG

N NN

1 1 1

1 1 11 ; EP N p N W N pp L

Model

• Productivity Distribution before and After Multinational Entry

Model

• The Revenue Distribution before and After Multinational Entry

Data

• We employ a cross-country firm-level panel dataset, drawn from Orbis, that contains comprehensive financial, operation, and ownership information for over 1 million manufacturing firms in 60 countries.

• Orbis provides several distinct advantages:

– Ownership information (over 30 million shareholder/subsidiary links); time-series financial information; broad country coverage.

• Four categories of information:– Industry information including the 4-digit NAICS (primary industry);– Ownership information including domestic and global parents and domestic

and foreign subsidiaries;– Location information;– Financial information including revenue, employment, asset, and

investment.

Data

• We estimate total factor productivity using the semiparametric estimator developed by Olley and Pakes (1996).

– The production function is estimated for each country and each NAICS 4-digit industry;

• We consider two sub-periods: 2002-2004 and 2005-2007 and investigate how changes in multinational activity between the two periods affect host-country domestic firms.

• A firm is considered foreign owned if its global ultimate owner is based in a different country. There are about 36,000 foreign owned manufacturing subsidiaries in the final sample.

List of Countries

Data: Distribution of Domestic Firms

• Productivity distribution of domestic firms remained largely similar in the two periods for countries and industries where there was no multinational entry. Only the top range firms experienced a slight rightward shift in their productivity levels in 2005-2007.

• For countries and industries with positive multinational entry, the productivity distribution of domestic firms shifted slightly to the right, even for the small- and medium-productivity firms, while the distribution became more left truncated.

Estimating EquationsThe Selection of Multinational Firms

A foreign firm invests in a host country if M(), >M.

• We consider the following estimation:

• Estimate the probability of investing abroad, conditional on being active in the home country market zM()=1, as a function of firm productivity θ, host country demand conditions E and P, and fixed investment cost cfM.

– Host-country factors: country-industry fixed effect FEM.

– Bilateral factors: distance between host and headquarters countries, common land border and language.

• Based on estimates, we obtain:– Predicted probability of entry for each multinational, expected productivity of

multinationals in each host country, expected probability of new multinational activity in each host country,

1

1 1Pr 1| ln ln ln 0 .1DM D M

E Pz cfw

ˆ ˆˆ[ > | ], P , r .M D M M

Estimating EquationsThe Selection of DomesticFirms

A domestic firms survives D(), >D.

• We consider the following empirical especification

Pr[zD () = 1]= Pr[ > D]

• Dependent variable zD (θ): whether the domestic firm survives.

• Based on the estimates, we obtain: – Predicted probability of survival for each domestic firm, expected productivity

of surviving domestic firms, expected survival rate,

• Cutoff productivity of domestic firms (θA), capital price (cA), aggregate price (PA) to multinational entry.

1n n ln ln .1

AD A

A

Pcl lc P

ˆ[ ], ˆ ˆ Pr , . D D D

Estimating Equations Market Reallocations: Labor and Capital

• Larbor Market Reallocation

– Foreign multinational activity shifts the revenue distribution of domestic firms either rightward or leftward depending on whether Pτθ zM > PA,

– qA: qth (25th, 50th and 75th) percentile of the ex-ante revenue distribution.

• Capital Market Reallocation

– c/cA is expected to be greater than 1 and rD(θA) is the cutoff revenue prior to the openness to multinational activity.

ln ln 1 ln ln .D A A A A

A

Pr q r qP

ln n lnD D D A

A

cr l rc

Estimating EquationsKnowledge Spillovers

• When there is multinational production in an industry, the knowledge spillovers from foreign multinational firms would shift the productivity distribution of surviving domestic firms rightward by τθ .

• Let qA denote the qth quantile of θa;

– where qA represents the qth (e.g., 25th, 50th and 75th) percentile of the ex-ante productivity distribution.

– To address the selection of foreign multinationals, zM can be instrumented by from selection of MNCs.

ln n lnA A Aq l q

ˆM

Empirical Strategy

• The Selection of Domestic Firms: Cutoff Productivity

• Capital Market Reallocation

• Labor Market Reallocation

qA: qth (25th, 50th and 75th) percentile of the ex-ante revenue distribution.

• Knowledge Spillovers

1n ln ln ln1

AD A M

A

Pcl zc P

ln ln lnD D D A M

A

cr r zc

ln ln 1 ln lnAD A A A M

Pr q r q zP

ln ln lnA a A Mq q z

Empirical Evidence: Labor Market Reallocation

• To evaluate labor market reallocation effect, we asses changes in the revenue distribution f domestic firm revenue by examining the quantile estimation :

• where βP is expected to be negative and βθ is expected to be positive.

• Given the estimate of βθ , we can obtain an estimate of βP and P/PA.

ln ln 1 ln ln 1AD A A A M P M

Pr q r q z zP

Empirical Evidence: Capital Market Reallocation

• Effect of foreign multinational activity on domestic financial markets by examining

• where ln rD (θD)-ln rD (θa) is the change in the cutoff revenue of domestic firms

– Βc , expected to be positive, captures the effect of foreign multinational activity on financing costs.

– To address the selection of foreign multinationals, zM is instrumented by

ln ln lnD D D A M C M

A

cr r z zc

.M

Empirical Evidence:Knowledge Spillovers

• Productivity distribution of domestic firms

• βθ : magnitude of knowledge spillovers ; z M is instrumented by

0 0ln ln ln

A a A M Mq q z z

.M

• A higher probability of new multinational firms leads to an increase in the productivity of domestic firms at the 25th and 50th percentiles (3-4, percent upward shift of the productivity in the lower range of the distribution).

Summary of Estimated Effects

Quantifying Productivity Gains from Multinational Production

• Average productivity increases by 1.4 percent across countries when the probability of entry by new multinational firms increases by 100 percent: – (1) the greater productivity of entering multinational firms (the self-

selection of multinational firms); – (2) the higher average ex-ante productivity of surviving domestic firms

(the selection of domestic firms); – (3) knowledge spillovers.

1 1

1

111 1.

ˆ ˆ ˆ ˆwhere , , , and are used to proxy for , , / and respectively

D M M

M

A A

D M D M D M D A MN N

Decomposing the Productivity Gains

• The Selection of Multinationals

– Entering multinationals are, on average, 4.9 percent more productive than domestic incumbents.

– Given the weight of multinational firms in the aggregate economy, i.e., 14 percent (= γM/(1+γM)), this productivity advantage leads to 0.68 percent increase in aggregate productivity.

• The Selection of Domestic Firms

– Aggregate domestic productivity increases by 0.87 percent when the probability of multinational entry rises by 100 percent.

– Given the weight of domestic firms in the aggregate economy, i.e., 86 percent (=1/(1+ γM)), this is equivalent to 0.75 percent increase in aggregate productivity.

1MM

A

0 0| | 1DD

A

Decomposing the Productivity Gains

• Knowledge Spillovers

– Knowledge spillovers alone lead to about 0.6 percent increase in domestic productivity (or equivalently 69 percent of the domestic productivity gain).

• Selections

– The estimates suggest 0.3 percent increase in domestic firm productivity (or equivalently 31 percent of the total domestic productivity gain) when domestic selections and market reallocations are the only operative channel.

, 0 , 0| | 1c c

DD p p

A

0 0| | 1D

D

A

Country Heterogeneity

Country Heterogeneity

Discussion: Correlations Productivity, Prices, Markups

• Melitz and Ottaviano (2008): In a variable-markup setup, although only more productive firms survive (with higher markups, less productive exit), the distributions of markups and prices of surviving firms shifts downward. – Estimates of knowledge spillover could be biased downward if the

distribution of productivity partly reflects the distribution of markups.

• Re-estimate spillover equations for industries with homogeneous products (distribution shifts more likely to reflect changes in productivity).– Country-industry-specific import demand elasticities > 75th percentile

in each country ( Broda, et al., 2006)

• Productivity distribution of domestic firms shifts rightward by 3% at the 25th and the 50th percentiles, no significant changes at the 75th percentile and productivity distribution becomes more left truncated (increase in the cutoff productivity suggesting tougher selection).

Within and Between Industry Reallocations

• Knowledge spillovers across industries.

• Backward linkageij and Forward linkageij} to measure the extent of the input-output relationships between each pair of industries (Javorcik, 2004).

– Backward linkageij : measures the share of a downstream industry j's inputs that come from an upstream industry i and

– Forward linkageij} : measures the share of a downstream industry i's inputs that come from an upstream industry j.

Within and Between Industry Reallocations

Within and Between Industry Reallocations

• Reallocation channel: increased MP in one industry causes increased demand for capital and labor and subsequently higher factor prices.

• Labor similarityij: industry pair's similarity in occupational labor requirements – Industries with greater similarity in occupational labor structure are

expected to share greater externality in labor markets. – BLS National Industry-Occupation Employment Matrix: industry-level

employment across detailed occupations counts converted into occupational percentages and industry pair correlation in occupational percentages.

• Capital similarityij: measure of industries' similarity in capital-good demand,– Correlation of investment flows (capita flow data from BEA).

Within and Between Industry Reallocations