RDP 2007-04: Productivity Growth: The Effect of Market Regulations 1. Introduction

During the late 1990s some countries experienced a productivity surge that many suggested was driven by information technology. Despite the attention it received, this productivity revolution was relatively limited in geographical scope. A small group of OECD countries (including Australia, Canada, Sweden and the US) experienced a sizeable step-up in their productivity growth in the 1990s (Figure 1).^[1] For these countries, average total factor productivity (TFP) growth within the business sector rose by between 0.4 and 1.2 percentage points compared with the previous decade. However, at the same time, TFP growth rates declined across much of Europe.

Explanations for the productivity surge have focused on the production of, or investment in, information and communications technology (ICT).^[2] Looking across a sample of OECD countries, there is clearly a positive correlation between expenditure on ICT (relative to GDP) over the 1990s and the change in TFP growth from the late 1980s to the late 1990s (Figure 2). Importantly, the Australian experience demonstrates that it was not necessary to produce ICT, as had been thought, in order to reap some of its productivity benefits. Unlike the United States and most of the other ‘high-tech’ countries, Australia had no significant ICT production sector.

Even if we accept that differences in ICT investment have contributed to recent differences in TFP growth, a critical question remains unanswered. What led some countries to invest so heavily in ICT while others did not? One suggested answer is that those countries that did not invest heavily in ICT were hamstrung by rigid regulation of their labour and product markets. For example, Figure 3 shows that countries with higher levels of product market regulation (PMR) in the early 1990s tended to have lower levels of ICT investment over the 1990s. Consistent with this, Gust and Marquez (2004) estimate an econometric model of productivity growth where labour and product market regulation explain ICT investment which, in turn, explains higher growth in labour productivity.^[3]

This ‘two-step’ approach – from regulation to ICT investment to productivity – ignores the potential direct link between reforms in product and labour markets and productivity growth. Ignoring this direct link has two potential shortcomings. The first is that market flexibility (or efficiency) might accelerate TFP growth regardless of whether a country has invested heavily in ICT or not. Nicoletti and Scarpetta (2003, 2005b) and Scarpetta and Tressel (2002, 2004) argue that more flexible labour and product markets are critical for more rapid reorganisation of productive resources, thereby allowing countries to move towards the production frontier with greater speed. We argue that, in addition, the interaction of product and labour market flexibility might also be important for TFP growth. Ignoring the possibility that labour and product market regulation directly affect TFP growth also precludes an investigation of this possible interaction.

A second shortcoming of ignoring possible direct effects of regulation is that changes in TFP growth have been apparent as part of a longer-term trend that pre-dates the 1990s ‘tech boom’. As shown in Figure 1, the pattern of rising TFP growth in some countries but falling TFP growth in others has been evident in rolling 10-year averages of annual TFP growth for periods ending around the early 1980s onwards. Evidence in support of a direct link between flexible markets and TFP growth is provided in Figure 4. This shows data for the change in annual average TFP growth versus the change in product market regulation. The trend shown suggests that a single index point reduction in the regulation index is associated with a rise in annual average TFP growth of about 0.3 percentage points.

This paper attempts to address both of the above shortcomings. First, we use data spanning the past 30 years to investigate the direct effects of product and labour market regulation on TFP growth. Second, we specify our regressions so that regulations can affect productivity, both individually and in combination, through the interaction of product and labour market reforms. We find tentative support for the hypothesis that lower initial levels of regulation are associated with higher TFP growth over subsequent years, and that labour and product market deregulation have more of an effect in combination, although the significance and magnitude of these effects depends on the measure of labour market regulation used in the regressions. Also, as with any econometric modelling exercise, the presence of a relationship in the past does not guarantee that this same relationship will necessarily continue into the future. In the case of regulation and productivity, the relationship is likely to depend in part on the specific types of labour and product market deregulation pursued. Moreover, the general and relatively imprecise nature of most of those measures of labour market regulation that are both readily available and able to be used to compare developments across countries and over time, makes it difficult to attempt to link our estimates to any specific types of labour market reforms.

Before proceeding, it is important to clarify the kinds of product and labour market regulations that we are dealing with in this paper, and the relationship between these regulations and what we describe as market flexibility or efficiency. We understand a flexible labour market as one in which there are relatively few obstacles to efficiently matching jobs with employees. In the labour market, many types of regulation can affect the rate of job matching and hence labour market flexibility.^[4] An efficient product market is one in which price signals encourage movement of resources into profitable opportunities and out of unprofitable ones. In product markets, some regulations (such as those acting as barriers to entry in inherently competitive markets) can restrict competition, while others (such as anti-monopoly laws) are necessary pre-conditions for a competitive system. Our interest is in product market regulations that restrict competition where competition is feasible.

The rest of the paper is structured as follows. Section 2 provides a brief review of the literature, noting the ways in which the paper extends the existing line of research. Section 3 discusses the data and methodological issues and Section 4 presents the results. Section 5 investigates the effects of using alternative measures of labour market regulation and Section 6 concludes.

Footnotes

This paper focuses on the 18 OECD countries for which relevant data are readily available: Australia, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States. For a description of data and sources see Section 3 and Appendix A. [1]

An influential paper by Oliner and Sichel (2000) attributed around two-thirds of the step-up in labour productivity growth in the US over the 1990s to the use or production of ICT. In Australia, Simon and Wardrop (2002) estimated that IT-related capital deepening added over 1 per cent per annum to output growth in the 1990s or about one-third of the step-up in labour productivity growth over the period. [2]

Conway et al (2006) estimate a related but different set of models which estimate the direct effects of product market regulations on productivity, but omit the effects of labour market regulation. Their first regression explains labour productivity as a function of distance from the technological frontier, product market regulation, and the interaction between these two terms. Their second regression has ICT as the dependent variable and includes various measures of product market regulation as explanatory variables. While the authors feel that the effects of product market regulation would be better identified in a framework where the productivity and ICT models were estimated jointly, they are reluctant to do this without a theoretical model of how ICT affects productivity. [3]

While there are many aspects of the employer/employee relationship that can impede job matching, many things external to this relationship can also impede matching (for example, how likely people are to relocate to fill a vacancy). While there has been a tendency for labour market deregulation to shift bargaining power in favour of employers, there is no necessary link between regulation and the relative bargaining power of different agents. [4]