Growth From Within

Why does one firm grow, while another in the same industry stagnates? The major reason, I believe, is that there are differences in productivity between the two firms.

The Solow Growth Model, a neoclassical model used in macroeconomics, gives us some insight into what drives productivity differences. The Solow model is concerned with economic growth in macro economies, but I believe some of the insights the model generates are applicable to individual firms at the microeconomic level.

Solow’s model posits the concept of “effective labour” – that is, an economy whose labour force leverages knowledge to become more productive. Individual firms can be viewed through the lens of effective labour. A firm which has greater effective labour is a firm that is more productive. In such firms, there is improvement and advancement in the firm’s stock of technology – how it creates and delivers value for its customers.

What is technology? Essentially, technology is ideas, knowledge, and learning. In particular, technology is knowledge about how to put inputs together to make more output. Essentially, having better technology means being able to produce more output from a given quantity of inputs.

A firm’s stock of technology can encompass a variety of things, ranging from engineering knowledge to business innovations. Production methods such as Just-In-Time, service concepts like big box stores, or new product innovations such as DVD are all examples of technology.

We can divide technology into two types: that which augments labour, and that which augments capital.Labour-augmenting technology is that which helps labour to become more productive. New production methods are an example of a labour augmenting technology. Similarly, ideas and knowledge which enable a firm to make better use of its capital stock are examples of capital augmenting technology.

A third type of technology is that which augments a firm’s total factor productivity – how it makes more effective use of both its labour and capital stocks. Lean production, for example, might allow a firm to use both less labour and less capital in its daily productive operations.

The notion of greater productivity arising from within a firm is a critical one. Firms that can develop the capability to learn and develop, acquire, and apply new knowledge can increase their productivity. Developing this capability can help a firm to develop a competitive advantage and grow, particularly if the capability and the knowledge it produces are difficult or impossible for rivals to imitate.

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