Productivity dynamics and the cleansing effect of two recessions: Evidence from the manufacturing sector in Korea

• Author: Chulwoo Baek,Hun Jun Lee,Jeong‐Dong Lee
• Date: 01 October 2017
• Published date: 01 October 2017
• DOI: http://doi.org/10.1111/1468-0106.12239

PRODUCTIVITY DYNAMICS AND THE CLEANSING

EFFECT OF TWO RECESSIONS: EVIDENCE FROM THE

MANUFACTURING SECTOR IN KOREA

HUN JUN LEE*Seoul National University

JEONG-DONG LEE Seoul National University

CHULWOO BAEK Duksung Women's University

Abstract. In general, recessions provoke the exit of a greater number of firms from the market. Less

productive firms are more likely to exit and release their former resources to the remaining, more

productive firms. The present study investigates two recessions in Korea: the Asian financial crisis

and the global financial crisis. The main objective of the present study is to analyse the process of

creative destruction in a recession, specifically the cleansing effect. We measured total factor

productivity using micro-level manufacturing plant data from 1993 to 2013. We decomposed the

source of the changes in total factor productivity to measure the cleansing effect in two large

recessions. During the first recession in the 1990s, there was no evidence to support a cleansing effect

hypothesis. In contrast, during the second recession in the 2000s, there was evidence of a cleansing

effect. In addition, we found differences in market selection criteria in the two recessions; by the

second crisis, the market selection criteria had changed to enable a more conducive environment

for the creative destruction process.

1. INTRODUCTION

Inevitably, pressure is placed on every firm to survive once it opens for business.

Afirm’s decision to exit a market is the last option and a fate that all

stakeholders of the firm want to avoid. However, from the perspective of either

the industry or the nation, a firm’s exit decision has a different meaning. In

general, less productive firms are replaced with more productive firms through

competition, and the resources in the market can then be used in more produc-

tive ways. The process of the entry into the market of more productive firms and

the exit of those less productive can be captured through Schumpeter’s (1934)

canonical model of creative destruction. Through the process of creative

destruction, a new equilibrium is formed. When the old equilibrium is moving

toward a new one, resource reallocation happens in a way that is more produc-

tive. Thus, to ensure a more productive use of resources, the exit of a less

productive firm gains significance at the industry or national level. This may

be one reason why researchers have focussed on which firms are exiting the

market. The well-known research, such as Jovanovic (1982), has found that

more productive firms have a survival and growth advantage and less productive

firms are more likely to falter and then exit the market. Hopenhayn (1992)

examined an equilibrium model of firm dynamics in terms of market entry and

exit. Propositions in the research showed that the productivity level of a firm

*Address for Correspondence: Hun Jun Lee, 1 Gwanak-ro, #37-312, Seoul National University,

Gwanak-gu, Seoul 08826, Korea.

E-mail: hunjunlee@snu.ac.kr

Pacific Economic Review, 22: 4 (2017) pp. 677–701

doi: 10.1111/1468-0106.12239

© 2017 John Wiley & Sons Australia, Ltd

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was related to its survival. He also noted the necessity of the resource realloca-

tion process in firm dynamics. Other research has pointed out that the market

selection mechanism works to filter out less productive firms from more produc-

tive ones (Baily et al., 1992; Ericson and Pakes, 1995; Disney et al., 2003).

The process of selection and productivity-enhancing resource reallocation can

be accelerated through the business cycle. Schumpeter (1954), a pioneer who

researched the relationship between creative destruction and the business cycle,

argued that the business cycle could influence the magnitude of creative destruc-

tion in recessions. In a period of economic downturn, less productive firms are

more likely to exit markets and their resources then flow to more productive

firms. Consequently, the productivity of the whole economy can increase with

the more productive use of such resources. The aim of this study is to confirm

the existence of productivity-enhancing reallocation, referred to as the cleansing

effect in the manufacturing sector, during two economic recessions in Korea.

The subsequent sections of this paper are organized as follows. Section 2

briefly reviews the literature on economic downturns and creative destruction.

Section 3 introduces the background of the two economic crises in Korea in

the 1990s and 2000s. Sections 4 and 5 describe the empirical methodology imple-

mented and the data analysed in this study, respectively. Section 6 demonstrates

the results. The final section, Section 7, summarizes and concludes the research.

2. LITERATURE REVIEW

Generally, the profitability of a firm is the final determinant in its exit from the

market in a period of economic downturn. Thus, the number of firms below the

exit threshold increases in recessions, as described in Figure 1. After a massive

market exit of firms, the resources of these firms will be released and flow to sur-

vivor firms that are more profitable and productive than the ones leaving the

market. Through the process of resource reallocation, the aggregated productiv-

ity will be increased and this is referred to as productivity-enhancing reallocation

or the cleansing effect.

Figure 1. The cleansing effect in a recession.

H. J. LEE ET AL.678

© 2017 John Wiley & Sons Australia, Ltd