Air pollution induces aggregate productivity growth: evidence from Chinese firms through productivity decomposition analysis

Severe air pollution is known to affect firm-level productivity, yet its impact on firm dynamics (market share shifts, entry, and exit) has been previously overlooked. Based on extensive panel data of 212,263 firms across 294 Chinese cities, we construct a comprehensive theoretical model and apply 2SLS and IV-Probit methods to investigate the effects of air pollution on aggregate productivity growth. Employing change in mixing height as an instrumental variable, we uncover that air pollution primarily decreases aggregate productivity growth through two ways: a reduction in firm-level productivity (within-firm effect) and a redistribution of market shares in favor of higher-productivity firms (between-firm effect). These effects exhibit strong heterogeneity according to the industrial polluting level, geographical location, firm ownership, and firm size. Mechanism analysis indicates that air pollution raises a firm's welfare expenditures and inventory costs, crowding out funds for research and development; environmental regulation and industrial competitiveness will further amplify within- and between-firm effects. Utilizing a standard productivity decomposition analysis, we determine that air pollution is responsible for 9.369% of the decline in aggregate productivity growth from 1998 to 2015, and an even more significant 15.563% from 2011 to 2021, with the within-firm effect being the primary driver. This study offers valuable insights for objectively evaluating the economic losses induced by air pollution and provides significant implications for the development of environmental policies and firm strategies in China.