May 24, 2002

Why Has the IT Revolution Come Slowly to Europe?

The Economist reports on an OECD working paper--“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 <$FILE/JT00125006.PDF>--that tries to account for why both unemployment and productivity growth have been unsatisfactory in most of continental Europe over the past decade. Scarpetta et al. may finally have found the smoking gun linking labor and product market overregulation to poor economic performance.

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.

They argue that it is in technologically-dynamic rapidly-growing industries that European job-protection laws (that discourage initial hiring) and red-tape barriers to firm start-up and expansion have the most powerful effects.

Stefano Scarpetta, Philip Hemmings, Thierry Tressel and Jaejoon Woo, "The Role of Policy and Institutions for Productivity and Firm Dynamics: Evidence from Micro and Industry Data," OECD working paper 329, 2002. Summary: From an accounting point of view, two main factors seem to have played an important role in explaining the growing disparities in growth paths across the OECD countries over the past decade: differences in productivity patterns of certain high-tech industries; and differences in the pace of adoption of the new information and communication technology (ICT) (see Scarpetta et al., 2000). These two facts, in turn, raise the question as to why OECD countries -- that have access to common technologies and strong trade and investment links -- differ in their ability to innovate and adopt new technologies. This paper looks at the possible role of regulations and institutional settings, in both product and labour markets, in explaining this phenomenon. Product market regulations may contribute to both innovation and adoption by creating different conditions for the birth and expansion of innovative firms as well as for the exit of obsolete ones. Likewise, policy and institutions in the labour market may affect the costs of adjustment associated with the shift to a new technology, as well as the returns to innovation activity.

The paper comprises two main sections. Section 1 presents a number of stylised facts from firm-level data. It starts by reporting evidence on productivity effects generated by the expansion and contraction of existing units, as well as by the entry and exit of firms. A decomposition of productivity growth is performed for different manufacturing industries, as well as for some service sectors. The Section then investigates further the process of firm dynamics -- entry, exit and post-entry growth -- in different industries and countries. Section 2 sheds some light on how policy and institutions influence firm and industry performance. First, it assesses whether policy settings in product and labour markets help to explain the observed differences in firm entry rates. Second, it presents industry-level productivity regressions that include policy variables for a wide set of OECD countries.

Summary of empirical results

The main results of the firm-level analysis, which is based on data from the late-1980s to the mid-1990s, can be summarised as follows:

  • A large fraction of aggregate labour productivity growth is driven by what happens in each individual firm, whilst shifts in market shares from low to high productivity firms seem to play only a modest role. Within-firm productivity growth also drives fluctuations in productivity growth over the business cycle, while reallocation tends to be a more stable component.
  • Labour productivity growth is also enhanced by the exit of low productivity units, especially in mature industries. In other industries -- in particular those experiencing rapid technological changes (e.g. information and communication technology industries) -- the entry of new units is also important in fostering overall labour productivity growth.
  • There is also tentative evidence which suggests that within-firm growth makes a smaller contribution to multifactor productivity growth -- a proxy for overall efficiency in the production process – compared with its effects on labour productivity growth. This suggests that incumbents often raise labour productivity by increasing capital intensity and/or shedding labour. In contrast, the entry of new firms provides a relatively large contribution to overall multifactor productivity growth, possibly because these firms enter the market with a more “efficient” mix of capital and labour and likely new technologies.
  • The analysis of firm dynamics reveals that a large number of firms enter and exit most markets every year. The early years are the most difficult for entrants: 30 to 40 per cent of entering firms do not survive the first two years. And, although failure rates decline with duration, only about 40 to 50 per cent of entering firms in a given year are still in business seven years later.
  • The likelihood of failure amongst young businesses is highly skewed towards small units, while surviving firms are not only larger, but also tend to grow rapidly. The combined effect of exits being concentrated amongst the smallest units and the growth of survivors makes the average firm size of a given cohort of entrants increase rapidly toward what appears to be the minimum efficient scale for the industry in question.
  • Overall, firm-level evidence suggests a similar degree of firm churning in Europe as in the United States. The distinguishing features of firms’ behaviour in the US markets, compared with their EU counterparts, are: i) a smaller (especially relative to industry average) size of entering firms; ii) a lower (albeit with greater variability) level of labour productivity of entrants relative to the average incumbent; and iii) a much stronger (employment) expansion of successful entrants in the initial years.

The econometric evidence suggests a number of ways in which policy and institutions may influence the patterns of productivity and firm dynamics. In particular:

  • Evidence suggests that stringent regulatory settings in the product market have a negative bearing on multifactor productivity, and (although results are more tentative) on market access by new firms. Likewise, high hiring or firing costs -- when not offset by lower wages or more internal training -- tend to weaken productivity performance. Moreover, these costs tend to discourage the entry of (especially small and medium-sized) firms into most markets.
  • The direct burden of strict product market regulations on multifactor productivity seems to be greater the further a given country/industry is from the technology leader. That is, strict regulation hinders the adoption of existing technologies in addition to its detrimental effects on innovation itself, possibly by reducing competitive pressures, technology spillovers, or the entry of new high-tech firms.
  • The empirical analysis of entry reveals that product market regulations and employment protection legislation (EPL) have a strong effect on market access of small- and medium-sized firms. The effect of EPL are not significant for the entry of very small units -- which are often exempted from these regulations. Likewise EPL, as well as product market regulations, do not influence significantly the entry of large units because they play a relatively minor role in the overall entry and post-entry adjustment costs.

Policy considerations

The empirical evidence presented in this paper suggests that aggregate productivity patterns depend on a combination of within-firm performance and firm dynamics: the specific contributions of these two factors vary across industries and countries, depending inter alia on the “maturity” of each industry and on market and regulatory framework conditions. As far as within-firm performance is concerned, the present results lend support to the idea that strict product market regulations -- as exist in many continental European countries -- may hinder multifactor productivity, especially if there is a significant technology gap with the technology leader.

There appears to be relatively straightforward evidence that strict regulations on entrepreneurial activity, and high costs of adjusting the workforce, negatively affect the entry of new (small) firms. However, the link with aggregate performance is less clear-cut in this case, insofar as greater firm dynamics is not univocally associated with stronger productivity performance. Nevertheless, these results offer a consistent interpretation for the observed cross-country differences in firm dynamics, which has some policy implications. In particular, they offer a rationale for the fact that new firms tend to be smaller and with lower-than-average productivity in the United States when compared with most European countries, but, if successful, they also tend to grow much more rapidly. The more market-based financial system may lead to a lower risk aversion to project financing in the United States, with greater financing possibilities for entrepreneurs with small or innovative projects, often characterised by limited cash flows and lack of collateral. Moreover, low administrative costs of start-ups and not unduly strict regulations on labour adjustments in the United States, are likely to stimulate potential entrepreneurs to start on a small scale, test the market and, if successful with their business plan, expand rapidly to reach the minimum efficient scale. In contrast, higher entry and adjustment costs in Europe may stimulate a pre-market selection of business plans with less market experimentation. There is no evidence in the available data that one model dominates the other in terms of aggregate performance. However, in a period (like the present) of rapid diffusion of a new technology (ICT), greater experimentation may allow new ideas and forms of production to emerge more rapidly, thereby leading to a faster process of innovation and technology adoption. This seems to be confirmed by the strong positive contribution made to overall productivity by new firms in ICT-related industries in the sample of OECD countries analysed in this paper.

Posted by DeLong at May 24, 2002 02:25 PM | TrackBack

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