RDP 2007-04: Productivity Growth: The Effect of Market Regulations 2. Literature Review

Investigations of the reasons for divergent growth between countries have been around since the Wealth of Nations. More recent studies have been motivated by the phenomenon of ‘eurosclerosis’.^[5] For example, Drèze and Bean (1990) found that the effect of unemployment on wage settlements in Europe is generally weak and that productivity gains were quickly absorbed in higher wages. Blanchard (1997) found that European countries responded to labour shocks in very different ways than Anglo-Saxon countries, and that this difference led to generally higher unemployment in Europe. The common explanation for these different behaviours was differences in labour market institutions. However, while the role of institutions was thought to be qualitatively well understood, these earlier papers did not directly quantify the role of institutions.

More recent papers have directly addressed the influence of institutions on macroeconomic variables including productivity. In particular, papers such as those by Blanchard and Wolfers (1999), Hornstein, Krusell and Violante (2002) and Nicoletti and Scarpetta (2003) have examined whether indices of product or labour market regulation can explain various measures of macroeconomic performance. In general, they find that overly restrictive institutions can have a deleterious effect on some macroeconomic outcomes, including productivity. Blanchard and Wolfers suggest that rigid institutions can entrench the effect of negative shocks. Hornstein et al show that differences in labour market institutions affect the changes in unemployment and wage inequality arising from a technology shock. Nicoletti and Scarpetta examine panel data across countries and across industries and show that an index of product market regulation has significant explanatory power for TFP growth. They argue that the ability of firms to innovate, adopt new technologies and reorganise productive processes depends on the extent of restrictive regulations in product markets, and present evidence that countries with fewer regulations move toward the technological frontier more quickly. However, they only make use of variation in the extent and speed of reforms in a limited way (ignoring, for example, significant changes in labour market regulations over time), nor does their industry-level data allow for the possibility that reforms matter for aggregate productivity growth via a reorganisation of productive activities.^[6]

This paper adds to the literature exploring the link between productivity growth and labour and product market institutions, exploring similar questions to those posed by Nicoletti and Scarpetta (2003) and Scarpetta and Tressel (2002, 2004), but extending these analyses in two key respects.

First, we use data pre-dating the ‘tech boom’ to examine the direct effects of product and labour market flexibility on TFP growth, both independently and in combination. Specifying our regressions this way captures an idea formalised in Nicoletti and Scarpetta's (2005a) analysis of the effect of product and labour market regulation on employment: that the changes in employment arising from deregulation in one market might depend on regulation in another. Applying this concept to productivity, the idea is that while reforms that are limited to (say) product markets may enhance competitive pressures and encourage innovation, without flexible labour markets the ability of firms to restructure may be restricted, and the entry of new firms may be limited. Similarly, labour market reforms may be less potent in the face of only limited product market reforms, which would potentially impede innovation, reorganisation and new entrants.

Second, this paper focuses on aggregate TFP growth. As noted in Conway et al (2006), studies that focus on industry-level data may underestimate the effects of regulatory changes on aggregate productivity. This is because they ignore the fact that institutional changes may encourage reallocation of resources across industries in a way that encourages aggregate productivity growth. Conway et al (2006) note that the reallocation of resources across industries has to date played a relatively small role in explaining cross-country differences in aggregate productivity growth in the OECD. Even so, using aggregate data also allows us to capture the fact that reforms which help to spur productivity in some industries could have important spill-over effects for all industries by reducing the costs of business inputs, thereby lowering costs for new entrants.^[7]

Footnotes

For example, Bruno and Sachs (1985), Drèze and Bean (1990) and Blanchard (1997). [5]

For further discussion of this paper and an overview of the theoretical and empirical literature on the relationship between competition and economic growth and productivity, see Aghion and Griffith (2005). [6]

The OECD's indices of the ‘knock-on’ effects of regulation in the non-manufacturing sector (Conway and Nicoletti 2006) are designed to capture these effects at a sectoral level. [7]