Abstract
This study explores the effects of labor and product market deregulation on employment growth. Our empirical results, based on an Organization for Economic Cooperation and Development country sample from 1990 to 2004, suggest that lower levels of product and labor market regulation foster employment growth, including through sizable interaction effects. Based on these findings, the paper discusses a theoretical framework for evaluating deregulation strategies in the presence of reform costs. Optimal deregulation takes various forms depending on the deregulation costs and the strength of reform interactions. Compared with the first-best policy, decentralized decision making can lead to excessive or insufficient deregulation.
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Notes
See, for instance, Fertig and Kluve (2004) and Boss and Elender (2005) for an analysis of the economic impact of recent German reforms, including Hartz IV.
A minimum amount of regulation is a prerequisite for growth and, more generally, economic welfare. However, beyond a certain level, regulation impedes efficiency and real economic activity. Recent research tends to support the view that labor and product market regulation are excessive in many advanced countries (Jean and Nicoletti, 2004; and Conway and others, 2006).
However, the theoretical relationship underlying the complementarities between labor and product market reforms may be more involved than Blanchard and Giavazzi (2003) let on. For instance, Kauppi, Koskela, and Stenbacka (2004) analyze the effects of simultaneous labor and product market imperfections on equilibrium unemployment under exogenous as well as endogenous capital intensity and find that the long-term equilibrium unemployment is an increasing function of the relative bargaining power of labor unions, whereas there is a nonmonotonic relationship between long-term unemployment and the intensity of product market competition.
Much of this work was done at approximately the same time. See, for instance, the working paper version of our paper (Berger and Danninger, 2005). For examples of earlier work see Boeri, Nicoletti, and Scarpetta (2000); and Nicoletti and Scarpetta (2005).
See the next section for details.
A helpful analogy for interpreting the positive interaction term is that of a regulation threshold. In a hypothetical high/low regulation world, increasing regulation in a low-regulation environment would create high costs in terms of job growth. However if regulation in one market is already above the low-regulation threshold, the added negative employment effect of higher product market regulation would have a comparatively smaller added effect.
Using a dynamic general equilibrium model, Ebell and Haefke show that centralized wage bargaining regulation can lead to overhiring and hence deregulation induces labor shedding.
Kugler and Pica (2004) find that labor market liberalization leads to larger positive employment responses in less regulated product markets. Estevão (2005) shows that wage moderation—measured by the productivity and unemployment level adjusted wage change—is more effective in stimulating growth if it occurs in countries with more deregulated product markets. Annett and Debrun (2004) explore indirect evidence for the advantages of sequencing of reforms like Blanchard (2004) and find that within the euro area, product market reforms Granger-cause labor market reforms, suggesting sequential effects and one-directional spillovers. Burda (2000) discusses some of the earlier literature. See Daveri and Tabellini (2000) for an instructive discussion of the impact of taxation (in particular labor taxes) on unemployment and real growth in Europe.
The following OECD member countries are covered: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Mexico, Netherlands, New Zealand, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States.
The OECD indicators were developed to illustrate broad differences in product market policies and are described in detail in Conway, Janod, and Nicoletti (2005).
Although both the OECD's Employment Protection Legislation (EPL) and product market measure work with a zero–six scale, this does not mean that the intensity of regulation at a given level, say four, is directly comparable nor that—as a result of the rank-basing of some variables—the scale remains the same over time. We return to this issue in the empirical application.
An alternative approach would be to collapse the data set into one cross-country section, which produces comparable results. Results are available on request.
The left-hand-side variables exhibit significant autocorrelation. Alternative specifications that more directly test for cyclical effects found a positive association with lagged and current GDP growth. However, because GDP growth becomes insignificant in the presence of lagged dependent variables, and to avoid multicollinearity and endogeneity problems, GDP growth was subsequently dropped from the baseline specification.
The Hausman specification tests tend to reject random in favor of fixed effects, but there is a potential conflict between using fixed effects and the inclusion of regulatory indicators with limited time variation.
A possible explanation is inflated standard errors because of the positive correlation of the regulation variables. Product market regulation is statistically significant in models that exclude labor market regulation and the interaction term. See Nicoletti and Scarpetta (2005) for a discussion of multicollinearity and an attempt to limit the issue by generating synthetic regulatory indicators.
Results are available from the authors on request.
Given that this procedure was developed for large microdata panels, and in view of the limited time variation of the current sample, the applicability of the dynamic panel estimator is doubtful.
Electricity production, telecommunications, transportation, and postal services.
The report of the Australian Productivity Commission (2005) provides a comprehensive account of such costs. Hughes Hallet, Jensen, and Richter (2005) show that high up-front costs can be another barrier to reform.
The modeling framework is reminiscent of oligopoly theory, except that in our case “collusion” among decision makers may be welfare-enhancing. The main reason is that regulatory authorities are assumed to maximize social welfare, albeit from a partial perspective. Here, collusion helps to internalize possible spillovers among their activities.
We derived the theoretical results in both discrete and continuous form models, and both setups yield similar results as far as the optimality of the reform effort. No relevant information is lost using the discrete specification, and we can limit the discussion of the reform costs (about which we have limited knowledge) to a necessary minimum.
The objective functions of market regulators can be interpreted as utility functions. Alternatively, one could think also of two bureaucrats maximizing sectoral employment growth functions. In this case, each regulator would consider a production function with the functional form ΔE i =ᾱ−α i R i +γR i R ≠ i , which adds up to total employment growth ΔE=νΔE i +(1−ν)ΔE ≠ i , where ν is the market i's weight in total employment growth. This may lead to excessive reform activity beyond what the utility function approach implies. Additional results are available on request.
Refining the Nash equilibrium concept, while requiring additional assumptions, could help eliminate one of the two equilibria in the coordination cost range—albeit without guaranteeing an efficient result.
Higher or lower reform costs would lead us into area [7] or [1], respectively, where one regulator's actions would no longer be influenced by the counterpart's decision.
In Germany, for instance, labor courts play an important role in determining the effective level of labor market regulation (Berger and Neugart, 2006).
The sequential setup assumes that regulators move in sequence, but effects of reforms occur at the same time. In all other aspects—regarding preferences, reform costs, and notation—the model is similar to the simultaneous game.
Among the more influential papers on the political economy behind (de)regulation are Stigler (1971); Becker (1983); and Peltzman (1976 and 1989), who stress the role of powerful interest groups. In a voting framework, Fernandez and Rodrik (1991) argue that uncertainty about individual winners and losers can lead to a bias against reforms. Coate and Morris (1999) point out that adjustment to political action might inherently lead to political pressures against (further) changes. Dewatripont and Roland (1995) show that, in a more complex political-economic setup, policy complementarities might be compatible with a gradual (or partial) reform approach, if this helps build support for the overall policy program, and “big bang” reforms are more costly to reverse.
The diagonal line in Figure A.2 replicates the (A, A) line in Figure 1.
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Additional information
*Helge Berger is a professor of Monetary Economics in the Department of Economics, Free University Berlin. Stephan Danninger is an economist in the European Department of the IMF. The authors are indebted to Alfonso Arpaia, Jörg Decressin, Marcello Estevão, Andy Hughes-Hallet, Giuseppe Nicoletti, Werner Schule, Marcel Thum, Bob Traa, and participants at the European Commission's Workshop on Sequencing and Incentives of Reforms and the IMF European Department's research seminar for insightful comments. Jair Rodriguez provided excellent research assistance.
Appendix
Appendix
Simultaneous Game
Equilibria
Assuming a Nash solution strategy, the equilibrium regulation outcome (R i *, R ≠i *) satisfies W i (R i *, R ≠i *)≥W i (R i , R ≠i *) and W ≠i (R i *, R ≠i *)≥W ≠i (R i *, R ≠i ).
Optimal reform strategies
Equilibrium strategies can be determined by deriving the players’ reaction strategies at different levels of costs. Appendix Figure A.1 and Table A.1 summarize the optimal strategies and equilibria of the simultaneous game, which are discussed below.
If deregulation costs are prohibitively high, neither player will conduct a reform even if the other market is deregulated: ΔR i (α i −γR≠i)<C i , for i=LM, PM. Both players will reform if net benefits are positive, even if the other player does not deregulate: ΔR i (α i −γR̄ ≠i )≥C i . Both cases result in a symmetric equilibrium in dominant strategies.
At cost levels sufficiently high or low for one player, ≠i, to have a dominant strategy, partial, joint, or no reform is possible. In this case, player i's reform strategy depends on ≠i's decision. If R ≠i =R≠i, i will choose to reform if ΔR i (α i −γR ≠i )≥C i . If R ≠i =R̄ ≠i , i will choose to reform only if ΔR i (α i −γR̄ ≠i )≥C i .
Finally, both players could operate in an intermediate cost range. In this case, positive net benefits from reform accrue only if the other player also reforms; that is, we have for i: ΔR i (α i −γR̄ ≠i )<C i ≤ΔR i (α i −γR≠i), and for ≠i: ΔR ≠i (α ≠i −γR̄ i )<C ≠i ≤ΔR ≠i (α ≠i −γR i ). This situation describes the essential features of a coordination game. Two pure-strategy Nash equilibria exist. (1) No reform equilibrium: Assume that player i chooses no reform, R̄ i , in equilibrium, then it does not pay for ≠i to deviate from no reform if ΔR ≠i (α ≠i −γR̄ i )<C ≠i . In the relevant cost region this condition always holds. A similar condition holds for player i. Thus no reform is an equilibrium strategy. (2) Full reform equilibrium: Assume that player i chooses reform, R i , in equilibrium, then it would pay for ≠i to reform as well if ΔR ≠i (α ≠i −γR i )≥C ≠i , and a similar condition holds for i, and both are fulfilled in the relevant cost region. Thus, full reform is also an equilibrium strategy.
Sequential Game
This variant of the model assumes that deregulation in market i will be determined ahead of market ≠i, but (for the sake of simplicity) the effects of reforms materialize at the same time. This leaves us with the following sequence of events for i=LM, PM:
- Stage 1::
-
i decides on R i and credibly commits to its decision
- Stage 2::
-
≠i decides on R ≠i
- Stage 3::
-
simultaneous implementation and payoffs
Under full information and certainty, the equilibrium of the game between the two players, the regulatory authorities in markets i and ≠i, can be found by recursively solving the optimization problems.
Deregulation at stage 2
Player ≠i's welfare is W ≠i =−α ≠i R ≠i −γR i R ≠i −C ≠i . Given the sequence of events, player ≠i takes player i's decision as given. If player i does not reform—that is, if R i =R̄ i —player ≠i will reform if ΔR ≠i (α ≠i −γR̄ i )≥C ≠i . On the other hand, if player i does reform—that is, if R i =R i —player ≠i will reform if ΔR ≠i (α ≠i −γR i )≥C ≠i . Note that the cost threshold in the latter case, ΔR ≠i (α ≠i −γR i ), is higher than in the former, ΔR ≠i (α ≠i −γR̄ i ). This implies the following decision rule for player i:
Deregulation at stage 1
Player i operates under full information, guided by a welfare function symmetrical to ≠i's, W i =−α i R i −γR i R ≠i −C i , and taking ≠i's decision rule into account. In particular, player i's deregulation decision depends on ≠i's response to the first-stage reform decision. We will discuss the three ensuing scenarios in turn. (a) Player ≠i always reforms: In this case, player i will reform if ΔR i (α i −γR≠i)≥C i . (b) Player ≠i reforms only if player i reforms: Given player ≠i's decision rule, player i's choice boils down to choosing between a situation in which both players reform and a situation in which neither player reforms. Thus, player i will reform and chose the former scenario if ΔR i α i −γ(R̄ ≠i R̄ i −R≠iR i )≥C i . (c) Player ≠i never reforms: In this case, player i will reform if ΔR i (α i −γR̄ ≠i )≥C i .
It is straightforward to show that the cost thresholds for the three cases can be ranked: ΔR i α i −γ(R̄ ≠i R̄ i −R≠iR i )<ΔR i (α i −γR̄ ≠i )<ΔR i (α i −γR≠i); that is, the cost threshold in scenario (b) is smaller than the threshold in (c), which is smaller than the one in (a). Note that for (b)<(c) we require R̄ ≠i R̄ i −R≠iR i >ΔR i R̄ ≠i or R̄ ≠i R̄ i −R≠iR i >R̄ i R̄ ≠i −R i R̄ ≠i , implying R≠i< i R̄ ≠i , which holds by assumption.
Equilibria and Welfare Analysis
Figure A.2 illustrates the resulting recursive finite game full information equilibria.
Comparing the results with the first-best benchmark (Figure 1), we find the reform effort in the sequential game falls short at intermediate cost levels.Footnote 28 Although the partial reform regions marked by horizontal stripes at the top left and bottom right of Appendix Figure A.2 are similar to the respective areas in Figure 1, the (solid gray) full reform area around the origin is smaller than the relevant area determined by the social planner. Also note that sequential decision making implies the impossibility of the excessive reform identified in area [5] of Figure 2 in the simultaneous setup.
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Berger, H., Danninger, S. The Employment Effects of Labor and Product Market Deregulation and Their Implications for Structural Reform. IMF Econ Rev 54, 591–619 (2007). https://doi.org/10.1057/palgrave.imfsp.9450014
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DOI: https://doi.org/10.1057/palgrave.imfsp.9450014