Regulation that makes it more difficult and costly for new firms to enter a market can substantially reduce an economy’s productivity. That is the central finding of research by Dr Markus Poschke, published in the December 2010 issue of the Economic Journal.
What happens is that the higher costs of entering a market due to regulation imply fewer active firms in that market and thus weakened competition. Such an environment not only protects weak incumbents and allows firms to charge higher prices, but also reduces incentives to adopt more advanced technologies.
According to Dr Poschke’s analysis, these factors imply that what seem to be small costs of entry – such as those observed in many continental European countries – can lead to large losses in terms of productivity and output. Up to a third of productivity differences between a country like Germany and the United States may be due to entry costs. Reducing these entry costs could thus have very large benefits.
According to the Lisbon Agenda, formulated in 2000, the European Union was to become ‘the most competitive and dynamic knowledge-based economy in the world’ by 2010. Around the time the agenda was adopted, output per hour in continental European economies lagged the US level by between 10% (for example, in Germany and the Netherlands) and 30% (for example, in Italy). This was despite higher capital intensity in several of these countries.
These countries also featured relatively high costs for newly entering firms of complying with entry regulation. These costs are minuscule, for example, in Canada, New Zealand and the United States, but also in Denmark, Norway and the UK. In contrast, they are much larger in Germany, France, Italy and the Netherlands, where they amount to almost $8,000 once the cost of the entrepreneur’s time is factored in.
Previous research using data across many countries has shown that countries with higher entry barriers tend to have lower levels of productivity (Barseghyan). This is not entirely surprising since it is known that the process of firm entry and exit contributes significantly to economic growth (Foster, Haltiwanger and Krizan).
The new study sheds further light on the channels through which entry costs affect productivity and quantifies their importance. In particular, it shows that what appear to be small entry barriers – $8,000 is not large compared to typical entry investments, in particular in the manufacturing sector – may have large effects.
These costs affect the economy in the following way: where entry regulation makes entry more costly, fewer firms will want to enter a market. As a result, fewer firms will be active in the market. This has three important implications for the productivity of the economy:
Quantitatively, the last channel is particularly important. Intuitively, it comes about because firms tend to have larger market shares when there are fewer active firms. In those circumstances, the potential gain in market share from improving productivity and charging lower prices is naturally more limited, thus reducing the incentive to invest in technology.
The research shows that in a model designed to reflect closely the process of entry, exit, growth and decline of firms observed in reality in a flexible economy such as the United States, introducing European-level moderate costs of entry induces reductions in productivity, output and consumption of about 2.5%. This is more than 10 times larger than the direct cost to firms of complying with the regulation.
These findings suggest that up to a third of productivity differences between a country like Germany and the United States may be due to entry costs. While the costs of entry have fallen slightly in continental European countries in the last few years, these results suggest that further reductions may have large benefits.
ENDS
Notes for editors: ‘The Regulation of Entry and Aggregate Productivity’ by Markus Poschke is published in the December 2010 issue of the Economic Journal.
Markus Poschke is an assistant professor in the department of economics at McGill University (homepage: http://people.mcgill.ca/markus.poschke).
Data on output per hour come from the Groningen Growth and Development Centre’s Productivity Level Database: http://www.ggdc.net
The costs of complying with entry regulation have been measured minutely in a paper by Djankov, La Porta, Lopez-de-Silanes and Shleifer – the measures are available on the World Bank website: http://doingbusiness.org
For further information: contact Markus Poschke via email: markus.poschke@mcgill.ca); or Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com).