Rates of both firm and job turnover are similar across most OECD countries even with the very different regulation of their labour and product markets. According to new research by Winfried Koeniger and Julien Prat, this arises from joint regulation of labour and product markets, in which, for example, countries with strict employment protection legislation also have much more regulated product markets.
The study, which is published in the June 2007 issue of the Economic Journal, notes that labour and product market regulations are generally less stringent in Anglo-Saxon countries than in continental Europe. In spite of this, firm and job turnover rates are rather similar across these two sets of countries.
This is puzzling, since one would expect that regulations hinder the reallocation of workers and businesses. Intuition suggests that in countries where entry barriers in product markets make it hard to set-up a business – as in Germany or France – firm turnover should be lower than in Anglo-Saxon countries where entry barriers are low. Similarly, labour market legislation that makes it harder to hire and fire workers should reduce job turnover rates.
Koeniger and Prat argue that the joint regulation of labour and product markets may explain this puzzle since both regulations have countervailing effects on job and firm turnover. The analysis focuses on set-up and administrative fixed costs in the product market and on employment protection legislation in the labour market.
How do labour and product market regulations affect firm entry and exit? Employment protection legislation reduces the value of new firms as they anticipate that they will have to pay firing costs with some probability in the future. This lowers the rate at which firms enter the market. Employment protection also increases firm exit since firms look forward to a lower surplus when they have to decide whether to stay or leave the market.
These opposite effects imply that, overall, firing costs have a small effect on firm turnover unless firms can default on firing costs on exit, which is the case in some OECD countries. The research finds instead that bureaucratic costs, which have to be paid in every period to operate the firm, increase firm turnover as exit becomes more attractive in bad times.
On the other hand, entry costs decrease firm turnover due to a selection effect: firms that would otherwise exit no longer enter the market in the first place. The researchers show how these countervailing effects of regulation on firm turnover can offset each other in a quantitative example.
Regulation in the labour and product markets also affects job turnover in opposite ways. Both bureaucratic burden and set-up costs in the product market increase job turnover in a firm by reducing competition for workers. As fewer firms operate in a regulated product market, they find it easier to fill vacancies and recruit more workers in good times. Furthermore, firms also hoard less labour in bad times since they anticipate that it will be easier to recruit workers in the future.
This positive impact of product market regulation on job turnover in each firm is opposite to the standard negative effect of firing costs. It illustrates how regulations in labour and product markets interact: more regulation in the product market implies that operating firms are larger and thus modifies the impact of firing costs on labour hoarding since different firms operate in the economy.
The researchers argue that it is important to account for this selection effect. Accordingly, before attempting to reform either the labour or product markets, policy-makers should take into consideration the interactions between both types of
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Selection’ by Winfried Koeniger and Julien Prat is published in the June 2007 issuthe Economic Journal.
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Julien Prat is at the University of Vienna.
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koeniger@iza.org); or Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com).