Skip to main content

Advertisement

SpringerLink
Log in

Multiple market imperfections, firm profitability and investment

  • Published:
European Journal of Law and Economics Aims and scope Submit manuscript

Abstract

This paper investigates the impact of the interaction between product, labor and financial market imperfections on firms’ investment by using a panel data of European firms over the period 1994–2008. It studies the impact of product and labor market regulations on firm investment and how it changes with the degree of financial market imperfections. Findings show that product and labor market regulations negatively affect firm investment by lowering firm profitability. The presence of more efficient financial markets increases firm investment and lowers the negative effects of market regulations.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3

Similar content being viewed by others

Notes

  1. Peev (2014) analyzes the role of institutions and economic liberalization on growth of firms located in the European transition economies, while Audretsch et al. (Forthcoming) discuss the institutional drivers of entrepreneurships across countries.

  2. Example of papers that study the effects of the contemporaneous presence of markets imperfections are Nickell and Nicolitsas (1999); Belke and Fehn (2000); Arnold (2002); Blanchard and Giavazzi (2003); Spector (2004); Rendon (2004); Wasmer and Weil (2004); Povel and Raith (2004); Amable and Ekkehard (2005); Fiori et al. (2007); Griffith et al. (2007) . However, they are not concerned with investment decisions.

  3. http://ec.europa.eu/europe2020/pdf/themes/23_employment_protection_legislation.; Schmann (2014).

  4. Research on the role of product market regulation has mainly focused on its direct effects on economic performance, i.e: the allocation of resources between sectors and between firms; the productivity of existing firms; the pace of productivity growth Schiantarelli (2005). Regulatory reforms that imply a reduction in entry barriers, in the markup of prices over costs and in adjustment costs tend to increase investment Alesina (2005). Recently, Barone and Cingano (2011) find that lower service regulation has non-negligible positive effects on the value added, productivity and export growth rates of service-intensive users. For a survey of the literature on regulation and economic performance see Rincon-Aznar et al. (2010) and Arnold et al. (2011).

  5. Some authors are critical towards this popular approach. See Erickson and Whited (2000); Bond and Klemm (2004); Whited (2010), and Moyen (2004).

  6. These results are in line with Andrews and Cingano (2012), who examine the extent to which regulations affecting product, labour and credit markets influence productivity, via their effect on the efficiency of resource allocation, in the OECD countries. The authors find an economically and statistically robust negative relationship between policy-induced frictions and productivity, though the specific channel depends on the policy considered. In the case of employment protection legislation and product market regulations this is largely traceable to the worsening of allocative efficiency. By contrast, financial market under-development tends to be associated with a higher fraction of low productivity relative to high productivity firms.

  7. http://epp.eurostat.ec.europa.eu/portal/page/portal/european_business/data/database.

  8. Germany constitutes a special case in Amadeus. Most firms in this country have limited information on their balance sheets, including employment and very few financial items.

  9. The distribution of firms by sector of activity for the eight European countries refers to the year 2010, as it is the first year available with sectorial disaggregation in the Business Demography Statistics Database of Eurostat.

  10. Version 2 was excluded from this study, even though it also accounts for collective dismissal, because the series starts in 1998.

  11. See http://www.oecd.org/eco/reform/45654705 for a description of the RII indicator.

  12. However, Finland experienced a smaller contraction of its capital market than the other countries, given that it already witnessed a story of a credit-led boom-bust cycle during the 90 s and a strong financial crisis at the end of the 90 s.

  13. Profitability is modeled as characterized by random effects because the firm sample used to estimate model (1) was randomly drawn from a larger firm population. According to Green (2011, p. 371) ’..an intercountry comparison may well include the full set of countries for which it is reasonable to assume that the model is constant. If the individual effects are strictly uncorrelated with the regressors, then it might be appropriate to model the individual specific constant terms as randomly distributed across cross-sectional units. This view would be appropriate if we believed that sampled cross-sectional units were drawn from a large population’. The presence of random effects is tested by the Breusch and Pagan Lagrangian Multiplier (BP LM) test that fails to reject the null of no need of random effects (\(Var(u)=0\)), as shown at the bottom of Table 6 Green (2011).

  14. Garcia-Posada and Mora-Sanguinetti Garcia-Posada et al. (Forthcoming) analyze the impact of legal efficiency on firm dynamics, and find that higher judicial efficacy increases the entry rate of firms, while it has no effect on the exit rate. The authors argue that judicial (in)efficacy can be regarded as a fixed cost to be paid by the agents that litigate.

  15. SSchiefer and Hartmann (2013) identify four possible macroeconomic effects with regard to the EU: (1) EU-wide fluctuations, (2) national fluctuations, (3) EU-wide industry-specific fluctuations, and (4) national industry-specific fluctuations.

  16. A main concern, in addition to the Kaplan and Zingales critique, is the fact that cash flow depends on balance sheet policies, and therefore is more an accounting variable than an economic variable. Furthermore, financiers might see firms with a better liquidity position as less risky and charge them a lower interest rate. Moreover, investment may also depend on the availability of other, less volatile, financial resources Coluzzi and Ferrando (2012). See also Bond and Klemm (2004) for a discussion about measurement errors and the explanatory power of cash flow.

  17. Multiplicative interaction models are common in the quantitative social and political science literature. Institutional arguments frequently imply that the relationship between economic inputs and outcomes varies depending on the institutional context Brambor et al. (2006).

  18. This method uses equations in first-differences for which endogenous variables lagged two or more periods will be valid instruments, provided there is no serial correlation in the time varying component of the error term. This assumption is tested by performing tests for serial correlation in the first differences residuals. The equations in differences are combined with the equations in levels, for which lagged differences of the variables are used as instruments. AR(1) and AR(2) are the empirical realizations of the test statistics of first and second order residual autocorrelation. Significance means that the null hypothesis of no autocorrelation is rejected. The absence of AR(2) is the necessary condition for unbiased and efficient estimates (Blundell et al. 2000, 1998).

  19. To check whether this is an uniform pattern across the eight countries, we estimate an alternative model which controls for country differences by means of interaction terms (Country*FMD). Findings suggest that the negative impact of FMD on firm profitability is amplified for Italian, Spanish and Portuguese firms, and available upon request from the authors. Further, as Finland joined the European Union in 1995, while the other countries have been members from the 1980s and earlier, we also estimate model (1) without Finnish firms. Findings of Table 6 are confirmed and available upon request from the authors.

  20. Table 7 presents estimates for a a specification of Eq. (2) in which the interaction term PROF*FMD is left out of the model because its estimated coefficient is not statistically significant. Estimates are available upon request from the authors.

  21. The two models (1) and (2) generate a triangular system and one does not need to include all exogenous variables of Eq. (2) as instruments for the profitability Baltagi (2002).

  22. For robustness check purposes, we also draw a 15 % random sample from Amadeus to obtain an unbalanced panel of 117,072 firms and 569,980 firm-year observations, and estimate models (1) and (2) on this alternative sample. Findings of Tables 6 and 7 are confirmed and available upon request from the authors.

References

  • Alesina, A., Ardagna, S., Nicoletti, G., & Schiantarelli, F. (2005). Regulation and investment. Journal of the European Economic Association, 3, 791–825.

    Article  Google Scholar 

  • Amable, B., & Ekkehard, E. (2005). Financial and labor market interactions. Specific investment and labor market activity. Centre for Empirical Macroeconomics, Working Paper No. 93.

  • Andrews, D., & Cingano, F. (2012). Public policy and resource allocation: Evidence from firms in OECD countries, OECD economics Department Working Papers, No. 996, OECD Publishing.

  • Arnold, J., Nicoletti, G., & Scarpetta, S. (2011). Does anti-competitive regulation matter for productivity? Evidence from European firms. IZA Discussion Papers 5511, Institute for the Study of Labor (IZA).

  • Arnold, L. G. (2002). Financial market imperfections, labour market imperfections and business cycles. Scandinavian Journal of Economics, 104, 105–124.

    Article  Google Scholar 

  • Audretsch, D., Chowdhury, F., & Terjesen, S. (forthcoming) Varieties of Entreprenurship: Institutional Drivers across Entrepreneurial Activity and Country. European Journal of Law and Economics.

  • Baltagi, B. H. (2002). Econometric analysis of panel data. The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England: Wiley.

    Google Scholar 

  • Barone, G., & Cingano, F. (2011). Sevice regulation and growth: Evidence from OECD countries. Economic Journal, Royal Economic Society, 121(555), 931–957.

    Google Scholar 

  • Beck, T., Demirgc-Kunt, A., & Levine, R. (2009). Financial institutions and markets across countries and over time: Data and analysis. World Bank Policy Research Working Paper n. 4943.

  • Beck, T., Demirgc-Kunt, A., & Levine, R. (2007). Finance, inequality, and the poor. Journal of Economic Growth, 12, 27–49.

    Article  Google Scholar 

  • Becker, B., & Sivadasan, J. (2010). The effect of financial development on the investment-cash flow relationship: Cross-country evidence from Europe. The B.E. Journal of Economic Analysis & Policy, De Gruyter, 10(1), 1–49.

    Google Scholar 

  • Belke, A., & Fehn, R. (2000). Institutions and structural unemployment: Do capital-market imperfections matter?. CEPS Working Document, No. 158.

  • Biosca, A.B. (2010). Growth dynamics: Exploring business growth and contraction in Europe and the US. NESTA Research report.

  • Blanchard, O., & Giavazzi, F. (2003). Macroeconomic effects of regulation and deregulation in goods and labor markets. Quarterly Journal of Economics, 118(3), 879–907.

    Article  Google Scholar 

  • Blundell, R., & Bond, S. (1998). Initial conditions and moment restrictions in dynamic panel data models. Journal of Economterics, 87, 115–143.

    Article  Google Scholar 

  • Blundell, R., Bond, S., & Windmeijer, F. (2000). Estimation in dynamic panel data models: Improving the performance of the standard GMM estimators. Nonstationary panels, panel cointegration, and dynamic panels; 15. - Amsterdam [u.a.] : JAI, 53–91, ISBN 978-0-7623-0688-6.

  • Bond, S., Klemm, A., Newton-Smith, R., Syed, M., & Vlieghe, G. (2004). The roles of expected profitability, Tobin’q and cash flow in econometric models of company investment. Institute for Fiscal Studies, London, Working Paper 04/12.

  • Bond, S., & Meghir, C. (1994). Dynamic investment models and the firm’s financial policy. Review of Economic Studies, 61, 197–222.

    Article  Google Scholar 

  • Brambor, T., Clark, W. R., & Golder, M. (2006). Understanding interaction models: Improving empirical analyses. Political Analysis, 14, 63–82.

    Article  Google Scholar 

  • Calcagnini, G. Ferrando, A., & Giombini, G. (2013). Does employment protection legislation affect firm investment? The European case. Economic Modelling. doi:10.1016/j.econmod.2013.06.036.

  • Calcagnini, G., Giombini, G., & Saltari, E. (2009). Firms’ investment in the presence of financial and labour market imperfections. Economics Letters, 102, 22–26.

    Article  Google Scholar 

  • Cingano, F., Leonardi, M., Messina, J., & Pica, G. (2010). The effects of employment protection legislation and financial market imperfections on investment: Evidence from a firm-level panel of EU countries. Economic Policy, CEPR, CES, MSH, 25, 117–163.

    Article  Google Scholar 

  • Coluzzi, C., Ferrando, A., & Martinez-Carrascal, C. (2012). Financing obstacles and growth: An analysis for euro area non-financial firms. The European Journal of Finance. doi:10.1080/1351847X.2012.664154.

  • Conway, P., & Nicoletti, G. (2006). Product market regulation in the non-manufacturing sectors of OECD countries: Measurement and highlights. OECD, Economics Department Working Papers No. 530.

  • Dellas, H., & Fernandes, A. (2007). Finance and competition. Diskussionsschriften Discussion Paper 0703, Universitaet Bern, Departement Volkswirtschaft.

  • Deloof, M. (2003). Does working capital management affect profitability of Belgian firms. Journal of Business Finance and Accounting, 30, 57388.

    Article  Google Scholar 

  • Denny, K., & Nickell, S. (1992). Unions and investment in British industry. Economic Journal, 102, 874–887.

    Article  Google Scholar 

  • ECB (2011). Financial integration in Europe. Frankfurt.

  • ECB (2013). Financial integration in Europe. Frankfurt.

  • Erickson, T., & Whited, T. (2000). Measurement error and the relationship between investment and q. Journal of Political Economy, 108, 1027–1057.

    Article  Google Scholar 

  • Fama, E. F., & French, K. R. (2006). Profitability, investment and average returns. Journal of Financial Economics, 82, 491518.

    Article  Google Scholar 

  • Fazzari, S., Hubbard, R. G., & Petersen, B. C. (1988). Financing constraints and corporate investment. Brookings Papers on Economic Activity, 1, 141–206.

    Article  Google Scholar 

  • Ferrando, A., Marchica, M-T., Mura, R. (2014). Financial flexibility across the Euro area and the UK. ECB WP 1630.

  • Fiori, G., Nicoletti, G., Scarpetta, S., & Schiantarelli, F. (2007). Employment outcomes and the interaction between product and labor market deregulation: Are they substitutes or complements? IZA Discussion Paper Series, No. 2770.

  • Garcia-Posada, M., Mora-Sanguinetti, J.S. (forthcoming) Entrepreneurship and enforcement institutions: Disaggregate evidence from Spain. European Journal of Law and Economics.

  • Goddard, J., Tavakolib, M., & Wilson, J. O. S. (2005). Determinants of profitability in European manufacturing and services: Evidence from a dynamic panel model. Applied Financial Economics, 15, 1269–1282.

    Article  Google Scholar 

  • Green, W. H. (2011). Econometric analysis (7th ed.). Upper Saddle River, New Jersey: Prentice Hall.

    Google Scholar 

  • Griffith, R., Harrison, R., & Macartney, G. (2007). Product market reforms, labour market institutions and unemployment. Economic Journal, Royal Economic Society, 117, C142–C166.

    Google Scholar 

  • Haltiwanger, J. (2011). Firm dynamics and productivity growth. EIB Papers, 16(1), 116–136.

    Google Scholar 

  • IMF (2013). EURO AREA POLICIES. IMF Country Report No. 13/231.

  • Kaplan, S., & Zingales, L. (1997). Do investment-cash flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics, 112, 169–215.

    Article  Google Scholar 

  • Levine, R. (2005). Finance and growth: Theory and evidence. In Aghion P., & Durlauf, S. N. (eds.) Handbook of economic growth, Volume 1A, Elsevier B.V., 865–934.

  • Levine, R. (2002). Bank-based or market-based financial systems: Which is better? Journal of Financial Intermediation, 11, 1–30.

    Article  Google Scholar 

  • Levine, R., & Zervos, S. (1998). Stock markets, banks, and economic growth. American Economic Review, 88, 537–558.

    Google Scholar 

  • Levine, R., Loayza, N. V., & Beck, T. (2000). Financial intermediation and growth: Causality and causes. Journal of Monetary Economics, 16, 31–77.

    Article  Google Scholar 

  • Love, I. (2003). Financial development and financing constraints: International evidence from the structural investment model. Review of Financial Studies, 16(3), 765–791.

    Article  Google Scholar 

  • Moyen, N. (2004). Investment-cash flow sensitivities: Constrained versus unconstrained firms. Journal of Finance, 59, 2061–2092.

    Article  Google Scholar 

  • Nickell, S., & Nicolitsas, D. (1999). How does financial pressure affect firms? European Economic Review, 43, 1435–1456.

    Article  Google Scholar 

  • OECD (2011). Product market regulation database, www.oecd.org/economy/pmr.

  • Papaioannou, E. (2008). Finance and growth: A macroeconomic assessment of the evidence from a European angle. In X. Freixas, P. Hartmann, & C. Mayer (Eds.), Handbook of European financial markets and institutions. Oxford, UK: Oxford University Press.

    Google Scholar 

  • Peev, E. (2014). Institutions, economic liberalization and firm growth: Evidence from European transition economies. European Journal of Law and Economics. doi:10.1007/s10657-014-9450-3.

  • Povel, P., & Raith, M. (2004). Financial constraints and product market competition: Ex ante versus ex post incentives. International Journal of Industrial Organization, 22, 917–949.

    Article  Google Scholar 

  • Rajan, R., & Zingales, Luigi. (2003). The great reversals: The politics of financial development in the twentieth century. Journal of Financial Economics, 69, 5–50.

    Article  Google Scholar 

  • Rajan, R., & Zingales, L. (1998). Financial dependence and growth. American Economic Review, 88(3), 559–586.

    Google Scholar 

  • Rendon, S. (2004). Job creation and investment in imperfect capital and labour markets. centrA, Documento de Trabajo, E2004/35.

  • Rincon-Aznar, A., Graf, N., Paterson, I., Schwarzbauer, W., Sellner, R., Siebert, S., & Yildirim, C. (2010). Regulation and economic performance: Literature review. SERVICEGAP Review Paper 4.

  • Rumelt, R. P. (1991). How much does industry matter? Strategic Management Journal, 12(3), 167–185.

    Article  Google Scholar 

  • Schiantarelli, F. (2005). Product market regulation and macroeconomic performance: A review of cross-country evidence. World Bank Policy Research Working Paper, No. 3770.

  • Schiefer, J., & Hartmann, M. (2013). Industry, firm, year, and country effects on profitability in EU food processing. Institute for Food and Resource Economics, University of Bonn. Discussion Paper 2013:2.

  • Schmann, I. (2014). Labour law reforms in Europe: Adjusting employment protection legislation for the worse?, Working Paper 2014.02, European Trade Union Institute.

  • Spector, D. (2004). Competition and the capital-labor conflict. European Economic Review, 48(1), 25–38.

    Article  Google Scholar 

  • Venn, D. (2009). Legislation, collective bargaining and enforcement: Updating the OECD employment protection indicators. www.oecd.org/els/workingpapers.

  • Warusawitharana, M. (2012). Profitability and the lifecycle of firms: Finance and economics discussion series divisions of research & statistics and monetary affairs federal reserve board. Washington, D.C.

  • Wasmer, E., & Weil, P. (2004). The macroeconomics of labour and credit market imperfections. American Economic Review, 94(4), 944–963.

    Article  Google Scholar 

  • Whited, T. (2010). What can cash shortfalls and windfalls tell us about finance constraints? In Giorgio Calcagnini & Enrico Saltari (Eds.), The economics of imperfect markets. New York: Springer.

    Google Scholar 

Download references

Acknowledgments

This paper benefited from comments and suggestions from two anonymous referees, and participants at the international conferences: Beyond the short run: productivity growth, market imperfections and macroeconomic disequilibrium held in Rome on 11–12 May 2012; the Swedish Entrepreneurship Forum on Regulations, Entrepreneurship and Firm Dynamics held in Stockholm, 23–24 August 2013; the 34th Italian Conference on Regional Science, held in Palermo, 2–3 September 2013; the annual conference of the Italian Economic Association, held in Bologna, 24–26 October 2013; the annual conference of the Eastern Finance Association held in Pittsburgh, 9–14 April 2014. We are especially grateful to R. Chirinko, G. Maffini, E. Saltari, E. Sterken, and G. Travaglini. The usual disclaimers apply.

Author information

Authors and Affiliations

  1. Department of Economics, Society and Politics, Università di Urbino Carlo Bo, Urbino, Italy

    Giorgio Calcagnini & Germana Giombini

  2. Mo.Fi.R, Ancona, Italy

    Giorgio Calcagnini & Germana Giombini

  3. European Central Bank, Frankfurt am Main, Germany

    Annalisa Ferrando

Authors
  1. Giorgio Calcagnini
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Annalisa Ferrando
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Germana Giombini
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Germana Giombini.

Appendix 1: variable definitions

Appendix 1: variable definitions

  • AGE is the number of years since incorporation;

  • ASSETS is the natural log of total assets (in mil), expressed in real value. It is used as a measure of firm size;

  • I/K is the ratio of capital expenditure at time t to tangible total assets at time t−1. Capital expenditure is computed as the annual change in tangible fixed assets plus depreciation;

  • LIQ is the ratio of cash and cash equivalents to total assets;

  • PROF is the ratio of operating profits to total fixed assets;

  • EPL is the Employment Protection Index, Version 1 (OECD 2004) . The index includes the costs for employers of firing workers with regular contracts and it is measured according to the strictness in the regulations for regular procedural inconvenience, notice and severance pay for no-fault individual dismissals, and difficulty of dismissals. It also includes the degree of strictness of labour regulations for temporary workers related to hiring practices such as type of contracts considered acceptable or number of successive contracts or renewals. The index is measured both for the fixed-term contracts and for temporary agency workers. The overall EPL index ranges theoretically from 0 to 6;

  • RII is the sectoral regulation impact index, based on OECD Regulation Impact indicators (Conway and Nicoletti 2006). This indicator measures the knock-on-effects of non-manufacturing regulation on the cost structures faced by firms that use the output of non-manufacturing sectors as intermediate inputs in the production process. The index is calculated as follows

    $$\begin{aligned} RII_{k,t}=\sum _{j} {NMR}_{j,t}*w_{j,k} \end{aligned}$$
    (6)

    where the variable \(NMR_{j,t}\) is an indicator of anti-competitive regulation in non-manufacturing sector j at time t and the weight \(w_{j,k}\) is the total input requirement of sector k for intermediate inputs from non- manufacturing sector j;

  • CAP MK is the Capital market size index. The measure is the sum of outstanding stocks, bonds and bank loans as a share of GDP (ECB 2013);

  • FIN EFF is the Financial Efficiency index. It is measured as private credit by deposit money banks and other financial institutions to GDP (from the World Bank Financial Structure Dataset);

  • FIN DEV is the Financial Development index. It is measured as Deposit Money to Central Bank Assets (from the World Bank Financial Structure Dataset).

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Calcagnini, G., Ferrando, A. & Giombini, G. Multiple market imperfections, firm profitability and investment. Eur J Law Econ 40, 95–120 (2015). https://doi.org/10.1007/s10657-014-9454-z

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10657-014-9454-z

Keywords

JEL Classification

Search

Navigation