Product Substitutability and Productivity Dispersion

There are tremendous across-plant differences in measured productivity levels, even within narrowly defined industries. Most of the literature attempting to explain this heterogeneity has focused on technological (supply-side) factors. However, an industry's demand structure may also influence the shape of its plant-level productivity distribution. This paper explores the role of one important element of demand, product substitutability. The connection between substitutability and the productivity distribution is intuitively straightforward. When industry consumers can easily switch between suppliers, it is more difficult for relatively inefficient (high-cost) producers to profitably operate. Increases in product substitutability truncate the productivity distribution from below, implying less productivity dispersion and higher average productivity levels in high-substitutability industries. I demonstrate this mechanism in a simple industry equilibrium model, and then test it empirically using plant-level data from U.S. manufacturing industries. I find that as predicted, product substitutability measured in several ways is negatively related to within-industry productivity dispersion and positively related to industries' median productivity levels.