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The white heat of technology
May 23rd 2002
From The Economist print edition


Regulation, the dynamics of firms and lagging productivity growth in Europe

THE Organisation for Economic Co-operation and Development, based in Paris, has for years preached about the urgent need for Europe to pursue labour- and product-market reforms, so as to lift productivity growth and create jobs. So yet another study on the subject is likely to be greeted with a yawn; but that would be a pity. For this time the OECD has used new data on individual companies in different countries to shed more light on its earlier, macroeconomic studies of what drives growth.

The OECD has compiled a database of companies' activities in ten rich countries. Using this data, its new study* examines the impact that regulation of product and labour markets has on productivity, and particularly the ways in which regulation might deter entrepreneurs from setting up new firms.

An economy's productivity can increase in three main ways. The productivity of existing companies might rise. The share of high-productivity producers might grow at the expense of low-productivity ones. Or new firms might enter the market and old ones might exit—assuming that the new are more productive than the dying.

The OECD study compares labour-productivity growth in 1987-92 and 1992-97. It finds that 50-85% of total productivity growth in each country is driven by what happens within existing companies. Shifts in market share play only a small role. On the other hand, the entry and exit of firms can account for 20-40% of total productivity growth. In high-tech industries, new firms are found to make a far bigger contribution to productivity growth. In more mature industries, productivity growth within existing companies, or the exit of old ones, counts for more.

How might the entry of new firms be influenced by labour- and product-market regulations? The study looks across several countries at the rates at which new firms are born and others die. In any given year, on average, about one-fifth of all firms are either new entrants or will close down. As many as 30-40% of new firms do not survive beyond their first two years.

It is often argued that one reason for low productivity growth in Europe is that high barriers to entry deter the creation of new firms. Not only are the administrative costs of start-ups high; it can also take ages to get a permit. Setting up a new firm takes, on average, seven business days in America, but 66 days in France and 90 days in Germany—reason to expect the rate at which new firms are created to be much lower in Europe than in America. Yet as the top chart shows, the entry and exit rate for firms is broadly the same in Europe as it is in America. The main exception is Germany, where the rate of corporate churning is quite a bit lower.

Still, the dynamics of new firms in America differ from those in Europe: start-ups tend to be relatively small in America, but they grow much more rapidly. American firms that survive double their employment over the first two years, on average; employment gains among new firms in Europe are only 10-20% (see bottom chart).

How might this reflect differences in market regulation? The swifter expansion of new American firms could simply reflect the bigger size of their domestic market. However, economists at the OECD reckon that the smaller initial size of new American firms, and their faster growth, chiefly reflects America's more liberal product-market regulation, as well as the lower cost of adjusting the workforce to changes in demand, thanks to less strict worker-protection laws.

Using various indicators to gauge the stringency of product-market regulation and the cost of hiring and firing workers, the study finds strong evidence that heavy-handed regulation reduces productivity. However, at an economy-wide level, this is not necessarily because product regulation and employment protection discourage the entry of new firms. Europe's problem is not so much barriers to entry as barriers to expansion: notably, job-protection laws that clearly discourage new hiring.

Further, it is in industries in which technology is rapidly changing that the impact of regulation on new start-ups, and hence on productivity growth, may be more significant than for the economy as a whole. There is good evidence that the more an industry or a country lags behind the global leader in a particular technology, the greater the impact of regulation on productivity. In such cases, stringent regulation might hinder the adoption of technology by existing firms, or restrict the entry of new high-tech firms. This helps to explain why Europe lags America in both the development of high-tech industries and the pace of investment in information technology.

Lower start-up costs and less strict worker protection make it easier for innovative entrepreneurs in America to experiment on a small scale (hence the smaller size of new firms), to test the markets and to expand. In Europe, the higher costs involved in changing the size of the workforce make all these harder. In a period of rapid technological change, greater experimentation allows new ideas to be tried out more swiftly. In such times, Europe's barriers to entry can become a barrier to growth.


The Role of Policy and Institutions for Productivity and Firm Dynamics: Evidence from Micro and Industry Data”, by Stefano Scarpetta, Philip Hemmings, Thierry Tressel and Jaejoon Woo. OECD working paper 329, 2002.




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