Chief Economists Series: Dysfunctional Firm Dynamics and Productivity Stagnation in Mexico by Santiago Levy

On April 10, 2023, the Center on Global Economy and Governance (CGEG) and the MPA in Economic Policy Management organized the second lecture of the Chief Economists Series: “Dysfunctional Firm Dynamics and Productivity Stagnation in Mexico” delivered by Santiago Levy

April 10, 2023

Santiago Levy is a Nonresident Senior Fellow at the Brookings Institution and Senior Advisor with the UNDP. Jan Svejnar, Director of the CGEG, introduced and led the lecture.

As the Former Deputy Minister at Mexico’s Ministry of Finance and President of Mexico’s Federal Competition Commission, Levy knows well the economic status and development of Mexico and has participated in the series for many years. While Mexico has joined the North American Free Trade Agreement (NAFTA) for 30 years now, its GDP grows the slowest despite its higher investment than Canada and the U.S. This is the opposite from what people expected when Mexico first joined NAFTA, and Levy explained the reasons behind Mexico’s dysfunctional economic development.

To analyze why Mexico has grown slower than people expected, Levy focused on analyzing Mexico firms from 1998 to 2018. He uses census data in Mexico in 1998 and 2018, which captured all firms in a fixed location in localities of 2500 or more inhabitants, where approximately 95% of Mexico’s population lives. This research covers firms of all sizes, both formal and informal, yet it also captured over half of the labor force, as most of Mexico’s labor works on the street. The firms can be divided into manufacturing, services, and commerce sectors. They can be classified into formal (at least one peso of contributions to IMSS) and informal (which is then divided into legal and illegal firms). Most firms in Mexico are informal, and while firm informality is primarily legal, firm illegality is usually concentrated among very small and small firms. Between 1998 to 2018, firm formality fell while its illegality increased.

Then Levy looked into the firm's capital and market shares to further understand the performances of these firms. His analysis found that formal firms are more capital-intensive, while informal firms are more employment-driven. While formal firms are a minority in the market, it obtains a larger share of the market (75%). There are increases in market share in commercial and service sectors, and research allocation has moved in the direction opposite of what people expected. From 1998 to 2018, the informality of firms has increased, and firm structure has polarized.

What is also important in the analysis is the productivity of the firms. Levy calculated the aggregate total factor productivity (TFP) of the firms in the market and weighted it by the share of research that each individual firm captures. Levy also considered the sizes and sectors of these firms in his analysis. Through his calculations, he noticed that formal firms are substantially more productive than informal firms regardless of how one classifies firms by sector and size. The difference in the productivity mean between formal and informal firms increased from 125% in 1998 to 144% in 2018. The productivity distribution has become more polarized in the past 20 years.

Levy took a closer look at the polarized productivity distribution. He focused on the left- and right-tails of the productivity distribution. From the analysis of the left-tail, which is the least productive firm, he noticed that the mass of the left-tail distribution is higher in 2018 than in 1998, suggesting that the number of informality increased and the mean productivity fell. From the analysis of the right-tail, the most productive firms, Levy noticed that the average productivity increased a little and that most productive firms are larger firms. This suggests a dynamic productivity decomposition, which might be the leading cause of Mexico’s slow economic growth.

To figure out the cause of productivity distribution shifts, Levy pulled together a panel of firms in the 1998 and 2018 censuses, and he divided firms into entry firms (appeared in the 2018 census but not in 1998), survival firms (appeared in both 1998 and 2018 census), and exit firms (appeared in 1998 census but not in 2018). He matched these firms across sectors and sizes over 20 years. He noticed that more firms survived informalized than formalized, and the forces pulling resources to informal sectors is extremely strong. Between 1998 and 2018, TFP fell by 7.4%. Looking at the decomposition terms, exit companies contributed to productivity, and exiting formal firms have higher productivity than surviving informal firms. Levy concluded that through his analysis, between 1998 and 2018, Mexico’s firms' dynamics were dysfunctional, and “creative destruction” was dominated by Mexican “destructiveness.”

Levy then suggested that there are two reasons behind the stagnant productivity. First, Mexico's market is not doing its job. While many firms survive and new firms are created, they have low productivity. This led to a huge competition problem within Mexico, as competition is not sorting out firms the way it should now. Competition does not work because Mexico has many distortions that allow low-productivity firms to survive. If informalities had disappeared in Mexico, the TFPO would increase by 27% over 20 years, which might be less than some East Asian countries, but will be higher than both Canada and the U.S. Rather than divergence; there would have been convergence in Mexico’s TFP vis a vis its partners in NAFTA.

Following the presentation, Levy answered questions from Professor Svejnar and the students on the informality of Mexico’s firms. He also engaged with students on topics ranging from corruption in Mexico and the future development of Mexico's economy.

Written by Beverly (Yunan) Yang