Abstract: Market competition drives industrial dynamics. Theoretically, only productive firms can survive the fierce market competition. In the transitional China, protection oriented industrial policies implemented by local governments however may keep some less productive firms in the market. Industrial agglomeration further provides conditions to help firm survival. This study first explores the link between TFP and firm exit and then investigates the firm exit decision by highlighting the role of industrial policies and industrial agglomeration and specialization. Based on the Annual Survey of Industrial Firms in China during 1998—2007, this study found that exiting firms suffer from low efficiency while surviving firms are more productive. Statistical results indicate that firms located in industrial zones and granted with heavy subsidies are less likely to exit, showing the significant role of local protection policies. In cities with substantial concentration of industries, firms may compete with each other fiercely and only productive firms can survive. The dual roles of state power and market force can also shed light on the regional production efficiency dynamics in China