Quality beans

Starbucks, Tim Hortons, Second Cup, Timothy’s World of Coffee, Bridgehead, McCafe. Canada’s coffee scene is dominated by half a dozen chains. Some are imported from the US, others are homegrown success stories. They each have a loyal customer base who dutifully line up for their preferred cup of mass-brewed medium, dark or coconut roast.

Each of these chains sells a similar product with subtle variations in quality. They’re all terrible, but some are more terrible than others.

In any market, firms, like cups of coffee, exist along a continuum. Under-performing and low quality firms are at one end, and high quality firms at the other. These differences can be explained by a number of factors, mostly though, it’s because running a business is hard and some are better at it than others.

In a new study (presented at a recent Institute for Research on Public Policy symposium but not yet available online), Dan Trefler looks at how the introduction of Chinese competition impacted Canadian firms, and the role that firm quality plays in determining their response.

Exposing Canadian firms to competition created both winners and losers. Interestingly, the biggest winners were not the firms at the frontier. Actually, high quality firms weren’t really affected at all. They were already at the top of their game, and as the new entrants didn’t pose a competitive threat, there was no response required.

The winners weren’t at the bottom either. Low quality firms were the biggest losers. Chinese firms were simply more competitive, and they forced low quality domestic firms out of the market.

It was the firms in the middle that gained the most. When exposed to Chinese competition, these firms found themselves in an awkward position. Previously they had been one of a few, but now they were one of many. Suddenly they were faced with a choice: they could either tread water and risk going the way of low quality firms; or they could innovate and “escape” the competition. Trefler’s results show that they chose the latter — choosing to invest in productivity enhancements and thereby moving up the quality scale.

The net effect on productivity is positive and significant. The loss of unproductive firms is akin to when your teacher says that your worst test doesn’t count towards your final grade. Previous studies estimate that the size of the trade-induced productivity gains among mid-quality firms are in the order of 4-5 per cent.

Closing the gap between laggards and leaders is a both a key opportunity for future productivity growth, and a challenge for policy makers. The OCED write: “it is remarkable how little is actually known about the characteristics of firms that operate at the global frontier… even less is known about the policies that might help laggard firms close their productivity growth gap with the frontier.” Along the quality spectrum, it’s the ones in the middle that are probably in need the most policy attention. The top performers seem to know what they’re doing (perhaps). And it’s probably best if the struggling laggards at the bottom drop out of the market altogether. The middle is where most of the economy lives, and where incremental improvements can have the biggest impact on the macro scene.

Post script: Trefler has written extensively on the firm performance pre and post exposure to trade, mostly on what happened to Canadian manufacturing firms after NAFTA.

I’m currently based with Innovation, Science and Economic Development Canada, where I’m working on a project contrasting the Australian and Canadian innovation systems. Consider this a test balloon for how I’m thinking about the issues. Feedback welcomed.