WPS3770


       Product Market Regulation and Macroeconomic Performance:

                          A Review of Cross-Country Evidence




                                           Fabio Schiantarelli

                                      (Boston College and IZA)




                                                  Abstract

The main purpose of this paper is to provide a critical overview of the recent empirical
contributions that use cross-country data to study the effect of product market regulation and
reform on a country's macroeconomic performance. After a brief review of the theoretical
literature and of relevant micro-econometric evidence, the paper discusses the main data and
methodological issues related to empirical work on this topic. It then critically evaluates the
cross-country evidence on the effect of product market regulation on mark-ups, firm dynamics,
investment, employment, innovation, productivity and output growth. A summary of what we
learn from the econometric results concludes the paper.

JEL Classification: D24, K20, L10, L51,O31,O40,O57
Key-Words: Regulation, Product Market, Performance, Productivity, Innovation, Growth

World Bank Policy Research Working Paper 3770, November 2005


The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the
exchange of ideas about development issues. An objective of the series is to get the findings out quickly,
even if the presentations are less than fully polished. The papers carry the names of the authors and should
be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely
those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors,
or the countries they represent. Policy Research Working Papers are available online at
http://econ.worldbank.org.



Acknowledgments: This research has been supported by the World Bank Latin American
Regional Studies Program. I would like to thank F. Giavazzi, R. Griffith, N. Loayza, G.
Nicoletti, A. Sembenelli, and L. Serven for useful conversations and comments.




                                                       1

1. Introduction


        During the last 15 years many countries at different levels of development have

introduced significant regulatory reforms of the product market, of factor markets, and of

the financial sector. Most of the empirical literature on the effect of product and factor

markets regulation (or regulatory reform) has focused on the labor market. Much of it has

focused on explaining the different performance of continental European countries versus

the United States and other OECD countries or the effect of relaxation of constraints in

particular countries. A substantial literature has also developed on the effect of financial

reform on a country's real performance for both developed and developing countries.

        The area that has been comparatively under-researched is the effect of product

market regulation on macroeconomic outcomes, with the exception of the effect of

barriers to trade. Yet, by now a number of contributions have appeared that have started

redressing this imbalance and have shed light on the overall effects of product market

regulation. The main purpose of this paper is to provide a critical overview of the recent

empirical contributions that use cross-country data to provide insights on the effect of

such product market regulations/reforms on a country's macroeconomic performance.

        We will start in Section 2 with a discussion of the main channels through which

regulation can affect macroeconomic performance and review a few seminal micro level

studies that are relevant for the issue under discussion. We then discuss in Section 3 the

main characteristics of the regulatory data available and the methodological challenges

that researchers face in assessing the effect of regulation on performance. Finally, in

Section 4, we review the salient empirical contributions in this area. The final outcome

measures we focus on are the demand for labor and capital, firms' innovative activity,



                                               2

and productivity and output growth. Intermediate outcome variables are mark-ups and

firms' entry, exit, and turnover rates. A summary of the main conclusions is contained in

Section 5.




2. The Effect of product market regulation on macro performance: Channels and

related micro evidence



       In this section we start from a discussion of a few theoretical contributions that

help us in understanding the complex links that exist between product market regulation

and economic performance. We then review selectively micro-econometric studies for

individual countries that either address the relationship between competition and

performance or discuss the consequences of specific episodes of regulatory reform.



       2a. Theoretical considerations

       Product market regulation affects the overall performance of an economy in

several ways (see Griffith and Harrison (2004)). It has an impact on the allocation of

resources between sectors producing different goods and between firms with different

productivity within each sector. Moreover, it affects the productivity of existing firms.

Finally, it has an impact on the pace of productivity growth by altering the incentives to

innovate and by determining the speed with which new products and processes replace

old ones.

       When regulatory reforms lead to more competitive output markets, the wedge

between prices and marginal costs is reduced and the allocation of goods and resources,




                                              3

in the absence of other distortions, will become more efficient in a static sense: more

competitive markets will allocate capital and labor more efficiently to the production of

those goods that consumers value more.1 Even more importantly, a more competitive

climate will lead to pressure for the less efficient firms to exit and market shares will shift

from lower to higher productivity firms, leading to a more efficient allocation of factors

of production.

         Blanchard and Giavazzi (2003) discuss the effect of product and labor market

regulation on employment and wages in the context of a model of identical imperfectly

competitive firms for whom labor is the only factor of production and both the product

and labor markets are non competitive. In that model, an increase in product market

reform is modelled either as an increase in the degree of substitutability between goods or

as a decrease in entry cost.

The effect of product market reform may differ between the short run and the long run.

An increase in the degree of substitutability between goods leads in the short run, for a

given number of firms, to lower mark-ups, increased employment and higher real wages.

However, there is no effect in the long run, because the reduced mark-ups lead to firms'

exit. Product market reforms that lead to a decrease in entry costs have, instead, long-run

effects as well. The entry of new firms will be associated with a lower mark-up and

higher employment and real wages. The fact that only policies that affect the cost of entry




1In some situations, for instance in the presence of natural monopolies, simple deregulation, as opposed to
regulatory reform, will not necessarily lead to an increase in competition and in the efficiency of resource
allocation.


                                                      4

have long run effects, and hence are the ones that should receive the greatest attention, is

one of the main policy implications of the paper.2

        Another class of models allows for heterogeneity between firms. Bernard, Eaton,

Jenson, and Kortum (2003) and Melitz (2003) focus on external barriers affecting the

product market and are based on the assumption of heterogeneity in productivity. These

papers allow for entry and exit of firms and show that a lowering of trade barriers

generates a reallocation of resources in favor of more productive firms. The exit of low

productivity firms and the expansion in the domestic and foreign markets of higher

productivity firms gives rise to aggregate productivity growth.3 Bergoeing, Loayza and

Repetto (2004) also allow for idiosyncratic heterogeneity differences in productivity and

focus on how the effect of a negative aggregate productivity shock depends upon

government induced rigidities in the reallocation of resources, modelled as a subsidy to

existing firms. Simulation exercises show that the existence or the introduction of such

subsidies increases the length of the period in which aggregate output is below potential

and generates greater cumulated output losses.4

        Product market reforms also have a direct effect on the productive efficiency of

existing firms. Greater competition may increase the incentives to reduce X-

inefficiencies and organize work more efficiently. The theoretical literature is immense

and, while agency models of managerial behavior can rationalize why greater



2The effect of labor market reform, captured by a decrease in workers' bargaining power in a Nash
cooperative bargain, will lead to a decrease in the real wage in the short run, but to an increase in
employment and an unchanged real wage in the long run.
3For recent micro evidence on foreign competition and trade reform see Pavnick (2002), Harrison and
Revenga (1995), Harrison (1994), Levinsohn (1993). For cross-country evidence on trade liberalization see
Rodriguez and Rodrick (2001), Vamvakidis (2002), and Yanikkaya (2003).
4Cross sectional cross-country evidence supports the existence of a positive relationship between
cumulated GDP losses and the stringency of regulation, controlling for the volatility of shocks affecting the
economy, captured by the standard deviation of the terms of trade and of domestic inflation.


                                                       5

competition tends to reduce slack, this conclusion is by no mean unambiguous. The

channels of transmissions are manifold (Nickell, Nicolitas, and Dryden (1997)). First, in a

more competitive environment it may be easier for owners to monitor managers because

there are greater opportunities for comparison which can lead to better incentives. Second,

it is plausible that an increase in competition will increase the probability of bankruptcy

and managers will work harder to avoid this outcome. Third, in more competitive

markets characterized by higher demand elasticity, a reduction in costs that allows firms

to lower prices will lead to a larger increase in demand and, potentially, profits.

         Changes in ownership from public to private may also have important effects on

the incentives for managers and workers to reduce slack. Whether or not that happens

crucially depends upon the market structure after privatization. One must be careful, in

general, not to equate privatization or deregulation automatically with an increase in

competitive pressure, particularly in sectors where increasing returns create incentives for

the emergence of natural monopolies.

         There are several principal agent models that study the effectiveness of incentives

and its dependence on the number of players. One of the papers that address more

directly the link between competition and performance is the model by Hart (1983).5 In

that paper a fraction of firms are run by managers who respond only partially to monetary

incentives, in the sense that they care only whether or not their income exceeds (or not) a

minimum level. The resulting optimal contract could be to pay managers this minimum

provided firms' profits exceed a given floor (that can be interpreted as the bankruptcy

level), and zero otherwise. In this situation, any shock that induces profit maximizing

firms to reduce costs will be transmitted, via lower equilibrium prices, to non-profit

5See also Holmstrom (1982), Nalebuff and Stiglitz (1983), and Mookherjee (1984).


                                                   6

maximizing firms. Their managers will also try to reduce costs in order to avoid

bankruptcy and preserve the utility derived from being in control of the firm. This will

lead to an increase in the level of productivity in the economy.

        However, if we allow managers to respond to monetary incentives, the effect

becomes ambiguous. Greater competition increases the threat of bankruptcy, which is a

disciplining devise, but at the same time reduces profits in equilibrium, and with it, the

possibility to provide monetary incentives to managers (Scharfstein (1988) and Schmidt

(1997)).

        Product market reforms may affect not only the level of productivity, but also its

growth rate through the effect that greater competition has on the incentives to introduce

new products or processes that replace the existing ones. The view by Schumpeter (1942)

of growth as a process of creative destruction, in which the introduction of new processes

and products is associated with the destruction of old ones, underlies many recent papers,

such as the endogenous growth models of Aghion and Howitt (1992) and Grossman and

Helpman (1991) and the contributions by Caballero and Hamour (1994), (1996), (1998).

Impediments introduced by product or factor market regulations to reallocation of factors

of production away from low return activities to high return ones may have adverse

effects on an economy's aggregate performance. In endogenous growth models, for

instance, product market regulation may be seen as increasing the cost of introducing an

innovation.

        However, things are not so simple and there are contrasting forces at work. In

Schumpeter the expectations of monopoly profits provide the crucial incentive for

innovative activity. A decrease in monopoly profits following regulatory reform may,




                                              7

therefore, decrease the pace of innovation and therefore growth. In addition, the degree of

market power also affects the ability to innovate since it allows the accumulation of

internal financial resources that can be used to finance innovation. These internally

generated funds are crucial in the presence of information asymmetries that may make it

difficult or expensive to obtain external funds for innovation activities. Indeed in the

early quality ladder endogenous growth models by Aghion and Howitt (1992) and

Grossman and Helpman (1991) and in the product variety model by Romer (1990) a

reduction in rents generated by regulatory changes would adversely affect the incentive to

innovate and, hence, decrease steady state growth. 6 Both product variety and quality

ladder models, moreover, typically exhibits scale effects in the sense that larger

economies with more resources that could be devoted to research grow faster in the

steady state.7 In this context, product market reform in the form of trade liberalization

could have ambiguous effects on growth, since the positive scale effect is

counterbalanced by the (negative) effect generated by smaller rents that accrue to

innovators.

        Note that whereas in the product variety models the decentralized growth rate

tends to fall short of the one chosen by the social planner, in quality ladder models of

creative destruction this may or may not be the case, basically because the benefits of

faster technological progress must be traded off against the losses in rents by the

monopoly producers that are displaced. Similar ambiguities in terms of welfare

implications appear in models in which relationships are characterized by specificity that



6Regulatory reform can be though of as increasing the price elasticity of demand.

7However, minor modifications to the cost of introducing an innovation could eliminate this scale effect
(Jones (1999)).


                                                   8

generates a hold up problem, such as Caballero and Hammour (1996), (1998).

Regulations that make the reallocation of resources costly can lead to technological

sclerosis, in which low productivity units are allowed to survive too long. At the same

time, they may also cause the reallocation process to be unbalanced, in the sense that the

destruction rate is excessive, given the low creation rate, and generates too high

unemployment of the factor that appropriates part of the rent.

        In the earlier quality ladder growth models referred to above, innovations are

made by outsiders and not by the incumbents. In more recent models (Aghion, Harris,

Vickers (1997), Aghion, Harris, Howitt, Vickers (2001), Aghion, Bloom, Blundell,

Griffith and Howitt (2002)) incumbents are allowed to innovate. In these models, the

incentive to innovate depends upon the difference between post and pre-innovation rents.

Greater competition reduces both, but the latter more than the former, fostering

innovation. Basically, competition may stimulate innovation because entry and the threat

of entry provide an incentive to innovate in order to escape competition. This effect

should be stronger in industries where competition occurs between "neck-and-neck"

firms, i.e. firms with similar production costs. In other terms, competition is more likely

to stimulate innovation and productivity growth in sectors or countries close to the

technological frontier, while the opposite holds for sectors or countries below the frontier.

        Finally, there can also be another channel through which increased competition

can have a beneficial effect on innovation and growth. When principal agent

considerations such as those in Hart (1983) are inserted in an endogenous growth model,

greater competitive pressure can provide an incentive for managers to speed up the




                                              9

adoption of new technologies in order to avoid bankruptcy and the loss of benefits from

control associated with it (see Aghion, Dewatripont and Rey (1999)).

        In summary, there are many ways through which product market regulation may

have an impact on overall economic performance. Regulatory reform can affect allocative

efficiency, the extent of managerial slack, and X-inefficiency in existing firms. Moreover,

it can exert an influence on the process of firm dynamics and on the introduction of new

products, and hence on aggregate productivity growth. However, at the theoretical level

there are sufficient ambiguities or caveats concerning the direction of the effect that

empirical research in this area is absolutely essential to come to a convincing conclusion

about the overall impact of product market regulation.



2b. Lessons from micro-econometric evidence

        A seminal micro-econometric contribution that has important implications for the

issues we are discussing here is the paper by Nickell (1996), who uses firm level data for

the UK to investigate where changes in competition affect productivity levels and growth

rates. Competition is measured in several ways, including measures of monopoly rents,

concentration, import penetration, and number of competitors. By estimating a dynamic

production function with the competition variables as additional regressors, and allowing

for endogeneity of input choices, Nickell finds that greater competition has a positive

effect both on the level and the growth of productivity. Note that while firm level

variables are instrumented in the context of a dynamic panel GMM approach,

competition variables are not. However, if an increase in productivity leads a firm to

increase its market share, so that the market becomes more concentrated and less




                                             10

competitive, this would impart a downward bias to the estimates of the effect of

competition on productivity. In this case, the estimated effect represents a lower bound

on the true effect of competition on productivity.

        The results in Nickell are confirmed by the more recent contribution by Disney,

Haskel, and Heden (2000), using a larger data set for UK firms.8 Klette (1999) extends

the approach by Hall (1986), (1988) to estimate market power and concludes, using

Norwegian plant level data, that plants characterized by greater market power tend to be

less productive. Bottasso and Sembenelli (2001) apply a similar methodology on Italian

firm level data and conclude that the EU Single Market Program has led to a decrease in

the mark-up and an increase in productivity for those firms that were expected, ex-ante,

to be more sensitive to the abolition of external barriers. There are several other micro-

econometric contributions that address the effect of regulatory reform and privatization

on productive efficiency or productivity growth. Many of these studies focus on the

service sector since regulatory changes have been particularly important in utilities,

communication, and in the transport sector. We will not review in detail the evidence

here, but the overall conclusion is that in many instances there have been productivity

gains due to the increased competition. 9

        An important paper on the effect of regulatory reform on the dynamics of

productivity is the one by Olley and Pakes (1996) on the evolution of the US


8See also Jaganathan and Srinivassan (2000) for a different way of testing the effect of competition on
agency problems, based on the relationship between leverage and profits.
9For evidence on the effect of the EU Single Market Program on mark-ups and productivity see also,
Gagnepain and Marin Uribe (2003), Goldberg and Verboven. (2001) among others. See also Martins,
Scarpetta and Pilat (1996) on mark-ups in the OECD. For a review see Ahn (2002), pp. 17-18, Ahn (2001),
pp. 24-25, and Faini et al. (2005).




                                                   11

telecommunication industry following deregulation. The industry experienced

productivity growth that was not reflective of productivity growth in manufacturing.

Olley and Pakes use their estimate of production function parameters that control for

endogeneity and sample selection to show that improved performance is due to a

reallocation of capital to more productive plants. It is the reallocation of output to more

productive plants and not an increase in average productivity growth that is behind the

increase in productivity at the industry level.

        There is indeed considerable debate on the relative importance for aggregate

productivity growth of the "within" component (coming from productivity improvement

in continuing firms), of the "between" component (due to the reallocation of resources

between continuing firms), and of the component due to entry/exit.10 Note that changes

in product market regulation that reduce entry barriers will have an effect on all

components. Results on total productivity growth decompositions differ according to the

precise formula used, according to whether one focuses on multi-factor or labor

productivity, whether one uses employment or product weights, whether they are

beginning of period or an average between the beginning and the end of period, and

according to the length of the horizon chosen for the calculation. Many estimates of the

within component of labor productivity imply that it is the most important component,

although its weight varies across studies. Foster, Haltiwanger, and Krizan (1998) show

that the contribution of net entry to aggregate productivity becomes important (and

positive) only at a 5/10 year horizon, reflecting the increasing share of entering/exiting

firms and learning/selection effects. Evidence on the importance of reallocation of market



10See Haltiwanger (2000) and Ahn (2001) for a review. In some decompositions, in addition to the
"within", "between" and entry/exit component s there is also a "cross" component.


                                                  12

shares from low to high productivity firms is also mixed. For instance Grilliches and

Regev (1995), and Scarpetta, Hemmings, Tressel and Woo (2002) find that it is small,

whereas Baily, Hulten and Campbell (1992), and Foster et al. (1998) find it is important.

        There is little evidence on the effect of regulatory changes in the product market

on productivity growth and other outcomes in developing countries.11 An exception is

Srivastava (1996) who analyzes the effect of the first phase of industrial deregulation in

India in 1985, involving a significant degree of de-licensing of entry and expansion and

liberalization of intermediate and capital imports. Using production function estimates

based on firm level panel data, he shows that the rate of TFP growth for existing firms

increased after deregulation. The increase was particularly evident in those sectors with

an above average use of imported materials. More recently, Aghion, Burgess, Redding,

and Zilibotti (2005), using a panel of industry/state level data, provide evidence that de-

regulating entry in India in 1985 and 1991 has not had an identifiable effect on entry, but

it has increased the dispersion of output levels across establishments. Moreover, they

show that output increases more after product market deregulation if labor market

regulation is less restrictive. The interaction between product and labor market reform is

an important issue that deserves further investigation.

        The empirical results concerning the relationship between innovation and

competition are mixed.12 Most studies, particularly the earlier ones, were conducted at the

industry level and they tended to rely on concentration as a measure of competition,

which is problematic because the measure of concentration does not capture the



11. See Heckman and Pages (2003) on the effect of labor market regulation in Latin America. See also
Eslava, Haltiwanger, Kugler, and Kugler (2005) for evidence on the effect of factor market reform on
employment adjustment, capital adjustment and productivity using a panel of plants in Columbia.
12See Ahn (2002) for a review. See also Geroski (1995)


                                                   13

competitive pressure coming from potential entrants. The overall results are not

supportive of the proposition that concentration exerts an unambiguous positive effect on

innovation activities.13

         More recently, Blundell, Griffith and Van Reenen (1999) found, using UK firm

level data, that firms with greater market share were more innovative, but that more

competitive industries produced more innovation. Recent firm level evidence suggests

that the relationship between mark-ups and innovation is non linear and has an inverted U

shape, as suggested by the most recent growth models. Aghion, Bloom, Blundell, Griffith

and Howitt (2005) use data on listed UK firms for which weighted patents measures of

innovation are available. The Lerner index is used as a measure of competition and the

problem of its endogeneity is addressed by using as instruments reforms linked to the EU

single market, reforms imposed on individual sectors as a result of action by the UK

competition authorities, and measures of privatization. The results are supportive of an

inverted U shape relationship with innovations being adversely affected by a very

competitive or very monopolistic environment. Note that a linear specification would

yield a positive relationship between innovation and measures of rents, as suggested by

Schumpeter. The results are stronger in neck-and-neck industries, as suggested by the

theory.

         Aghion, Blundell, Griffith, Howitt, and Prantl (2005) analyze the effect of foreign

firm entry on TFP growth and patent counts. Obviously, entry is endogenous and the

latter is instrumented with policy and foreign technology variables that are less likely to

have a direct effect on the growth of TFP or on patents. Using individual UK firm data,

entry is found to have a positive, significant and sizeable effect on TFP. The effect is

13See Cohen and Levin (1989).


                                             14

greater when IV procedures are used and it is greater for an industry closer to the

technological frontier.




3. Data and methodological issues



        In this section, we will review the main data on regulation that are available

across countries and that have been used in empirical work. We will also discuss the main

stylized fact that can be identified from the data. The available measures of regulation

condition the type of econometric evidence that can be produced, and often it represents

an important constraint for the researcher. Although there are serious issues in measuring

economic outcomes, such as total factor productivity growth or firm's innovative

activities, they are arguably not as severe as those affecting the measurement of tightness

of regulation.14

        We also discuss other important methodological issues involved in estimating the

effect of regulation on economic activity. The main issue here is to go beyond any

observed statistical association between regulation and performance and draw inferences

on the causal effect of regulation on economic outcomes.



3a. Data and stylized facts

        Product market regulation varies by countries and time and often is industry

specific. Moreover, the term "product market regulation" encompasses various

dimensions that exert different effects on agents' behavior. Perhaps the most important

aspect one would like to capture is how regulation contributes, directly or indirectly, to

14See for instance Basu and Kimball (1997) on the problems in measuring productivity growth.


                                                  15

the size of entry barriers. However, there are conceptual and practical problems in

measuring those dimensions of regulation that are relevant in this respect. Moreover,

often the data are not available at the industry-country level, but only at the country level,

and/or they are available at only one point in time or at widely spaced intervals.

          One of the main data sets used in empirical work is collected by the Fraser

Institute and it contains information (in the interval 1 to 10, decreasing with stringency of

regulation) on price controls, time spent with bureaucracy, ease of starting a new business,

government transfers and subsidies (as a % of GDP), government enterprises and

government investment (as a % of GDP), non-tariff import barriers, and average tariffs.

The indicators reflect a mixture of factual information and perception and are available

up to 2000 at five year intervals. After that, they are available at a yearly frequency. No

sectoral disaggregation of the indices is available.

          Another useful data set is the OECD database on regulatory reforms containing

detailed economy wide information for 1998 and 2003 on regulations and administrative

burdens on existing and new business.15 For a subset of industries (in the general utility,

communication and transport sectors) indices of the importance of barriers to entry,

vertical integration, market structure, price controls, and of the importance of public

ownership are available on an annual basis from 1975 to 2003 (the indices range from 0

to 6 and are increasing with the stringency of regulation).16 For these sectors, the data

availability comes as close as possible to what a researcher would want. Sectoral

indicators are available for 1998 and 2003 for retail trade and professional services. For

manufacturing, no time varying data are available at an annual frequency, except data on


15See Nicoletti and Pryor (2005) for evidence that the OECD economy-wide indicators and the Fraser
Institute indicators are highly correlated, in spite of the different methodology used in their construction.
16See Nicoletti, Bassanini, Ernst, Jean, Santiago, and Swaim (2001), and Nicoletti and Scarpetta (2003).


                                                        16

tariff and non tariff barriers, public ownership, and restrictions on foreign direct

investment.

        For European countries, one can also obtain further information on the evolution

of state intervention in the economy, using the Eurostat data on sectoral and ad hoc state

aid (% of GDP), public procurement (as % of GDP), and openly advertised public

procurement (% of procurement) for the nineties. Another useful source of data is the

European Centre for Public Enterprises with Public Participation (CEEP) that provides

information on the share of public enterprises in the business sector at 4/5 year intervals.

        As we have seen, there is greater data availability on various aspects of product

market regulation for developed countries. An important source of information that

covers developing countries and transition economies as well is the World Bank "Doing

Business" database. It contains information on the ease of starting a new business,

including the number of procedures, the time involved, and their cost. The data set is

based in part on, and expands, the design in Djankov, La Porta, Lopes de Silanes, and

Shleifer (2000). It also provides useful information on other dimensions of the business

environment, such as dealing with licenses, hiring and firing workers, closing a business,

paying taxes, etc. Unfortunately these indices are available only for the period 1996-

2002 at a biannual frequency, and lack industry details.

        What are the main stylized facts about product market regulation that can be

identified from the data sets we have described? First, regulatory burdens vary widely

across the world. In particular, regulation tends to be more stringent in poor countries

compared with richer countries. There is also evidence that it is greater in countries with

a French legal origin or with a socialist legal origin. Second, the dispersion of regulatory




                                              17

regimes is greater in developing countries relative to developed countries. Third, there

has been a generalized tendency towards the relaxation of regulation concerning entry.

This has been accompanied by a decrease over time in tariff and non-tariff barriers to

trade in manufacturing. Fourth, OECD countries have experienced substantial

deregulation in services, in sectors such as telecommunication, utilities, and transport.

The timing and extent of regulatory reform has varied considerably, with the US, the UK,

and New Zealand moving earlier and more decisively compared to countries such as

France, Italy and Greece. Finally, often regulatory reform has been accompanied by

privatization, so that there has been a tendency for the share of output produced by public

enterprises to decrease.



3b. Methodological issues

        The main methodological issue facing researchers working in this area is to go

beyond any observed statistical association between regulation and performance and

draw inferences on the effect of regulation on economic outcomes. In doing so, it is

important to control for observed and unobserved factors that have an effect on

performance independently from the regulatory environment. Most papers make a serious

effort in controlling for observed factors. The main issue involves unobserved

heterogeneity.

        If outcomes are measured at the industry level and the type, level and change in

regulation is also industry specific, the availability of time varying industry specific

indicators allows one to control for time invariant country and industry effects. It can also

allow one to control for factors that vary over time and are common across sectors, like




                                              18

technological innovations or knowledge that are widely accessible by all countries or

common macro shocks. If the time varying information on regulation is only country

specific, but there continues to be time varying industry specificity in regulation, the

measurement error problem may bias the coefficient on regulation towards zero and make

it more difficult to detect the true effect of regulatory changes. At a minimum, it would

be desirable to distinguish between regulation in manufacturing and in service industries.

Yet, in the case that common regulatory changes are dominant, time varying indices at

the country level are useful in that one can control, at least, for country and sector

specific time invariant characteristics.

        If the time dimension is not available, industry variation in the product market

regulation indicators is still helpful, because, at least one can control for additive

unobserved country and industry specific effects ( but not for country specific industry

effects). All the identification in this case comes from cross-sectional country/sector

variation in the data.

        However, often one has available information that varies only by country, with no

industry specificity. This makes it very hard to distinguish the effect of product market

regulation from other country specific unobservable effects. In assessing a country's

aggregate performance, some mileage here can be gained by using interaction effects

with other variables that vary by country and time. For instance, one may believe that the

effect of regulation may be different depending upon circumstances such as distance of a

country from the technological frontier, etc. The lack of identification of the main effect

of regulation from other country specific effects remains.




                                                19

        A distinct, and less relevant problem in this area of research, occurs when one

only has country specific information on regulation even if the latter is truly the only one

that matters because there is no industry specificity, yet one uses outcomes at the industry

level as a dependent variable. Moulton (1990) points out that standard errors for the

coefficient of the variable (regulation) that varies only by country can be seriously

underestimated when the error terms are contemporaneously correlated across industries

within countries. The severity of the problem and the appropriate solutions is related,

among other things, to the number of groups (countries in our context). If the number of

groups is large, things are simpler, although one has to take into account the potential

contemporaneous correlation in the error term across sectors within a country. Things are

more complicated if the number of groups is small (see Wooldridge (2003) for an

overview).

        Another, more important, issue is the potential endogeneity of regulation itself,

even if one controls for country and industry time invariant effects. Regulation may

indeed reflect the economic performance of a country or of an industry. It is difficult to

say a priori in which direction the bias would work. For instance, negative macro shocks,

particularly if prolonged, can enhance the probability of reforms because the

unsatisfactory nature of the status quo weakens opposition to reform. However, it may be

easier to introduce reform in good times because their negative impact on particular

groups may be smaller and/or there are more resources to compensate the losers. In the

first case, OLS or Within estimators may lead to an underestimate of the true effect of

reform, in the latter case, such effects will be overestimated. Recent empirical evidence

for OECD countries suggests that poor growth experience in a given year (or in the recent




                                              20

past) leads to less regulated output markets.17 Similar results hold for trade reform, but,

interestingly, not for financial or labor market reform.18 No systematic evidence is

available for developing countries, although it is not unreasonable to conjecture that

similar patterns may be observed for product market and trade regulation. The result of

all this is that there is the risk of underestimating the effect of product market reforms,

since the outcome variables one is interested in are generally procyclical, including

standard measure of productivity.




4. Product Market Regulation and Economic Performance: Review of Cross-

country Evidence



          In this section, we will review a set of recent contributions that have a direct

bearing on the effect of product market regulation on various aspects of macroeconomic

performance. The review will be selective and focus on papers that provide cross-country

evidence. In many cases, researchers have adopted a reduced form approach and have

entered measures of regulation as an explanatory variable in equations for factor demand,

productivity or innovation. In other cases, the effect of regulation is mediated through its

effect on an intermediate variable, such as the mark-up or firms' entry, exit, and turnover

rates. We will start from reviewing the evidence on the effect of regulation on these

"intermediate" variables, and we will then discuss the effect of regulation on the ultimate

outcome variables, such as investment, employment, innovation, productivity, and output

growth.


17See IMF economic Outlook, 2004, ch. III "Fostering Structural Reforms in Industrial Countries".
18A contemporaneous bad year increases labor market regulation and past weak growth is associated with
tighter financial regulation.


                                                  21

4a. Transmission mechanism: Effect on mark-up and firms' entry/exit/turnover

         Griffith and Harrison (2004) is a good example of the two step strategy. In the

first step, they first estimate the effect of product market reforms on the level of rents,

measured by the ratio between value added and the sum of labor and capital costs. The

effect of variations in the mark-up on factor accumulation R&D and productivity is

estimated next, using product market reforms as an instrument for the clearly endogenous

mark-up. The implicit assumption is that product market reforms affects the economy

only through mark-up variations and not directly. They only use regulations that vary

with time across countries in order to be able to control for cross- sectional unobservable

differences that are relatively constant over time. The indicators of product market

regulation are the Fraser Institute index of ease of starting a new business, of price

controls, of time spent with government bureaucracy, average tariff rates, of regulatory

trade barriers, the European Center of Enterprises with Public Participation, and the

Eurostat Structural indicators on state aid, on public procurement, and on the percentage

of it that is publicly advertised. The indicators are interpolated or extrapolated if not

available for each year and are entered separately in the equations. Both in the mark-up

and factor demand equation they control for country specific cyclical factors. Their

results suggest that many of the indicators measuring tightness of regulation have a

significant positive effect on mark-ups, as one would expect. The effect of variations of

mark-ups on various economic outcomes will be discussed below.

         Several authors extend and modify the two step approach found in Griffith and

Harrison (2004), by choosing a different intermediate variable to focus on. Cincera and




                                                22

Galgau (2005) estimate first the effect of regulation on entry and exit of new firms and

then the effect of entry and exit on factor demand and productivity. Loayza, Oviedo and

Serven (2005) use firm turnover rates (the number of exiting and entering firms divided

by the total number of firms) as the intermediate variable and investigate its effect on

productivity growth and its components. Scarpetta, Hemmings, Tressel and Woo (2002),

Brandt (2004) and Klapper, Laeven, and Rajan (2004) present results on the effect of

regulation on entry, but do not investigate the relationship between entry and other

economic outcomes.

         Data sources for entry and exit rate vary across studies. The entry and exit rate

variables in Cincera and Galgau (2005) are taken from the DUN & BRADSTREET data

base on the number of entries and exits for 352 digits sectors for 9 OECD countries. The

data on firm dynamics in Loayza et al. cover six Latin American countries and nine

industrial economies and are taken from the harmonized data set on firm dynamics

constructed by Bartelsman, Haltiwanger and Scarpetta (2004). The entry and exit rates in

Scarpetta et al. and Brandt are taken, instead, from the OECD firm level data base

constructed from business registers or social security databases. Klapper et al. (2004) use

the cross-country firm level Amadeus data set to construct entry rates for Western and

Eastern European countries. In most cases the time dimension of the data on entry and

exit tends to be rather short.19

        The results obtained by Cincera and Galgau, using the first principal component

of the Fraser Institute and the within estimator, suggest that deregulation tends to be




19For instance, the data for firm demographic refer to the period 1997-2003 for most countries in Cincera
(2004), and to 1998 and 1999 in Klapper et al. (2004). In Loayza et al (2005) the period is somewhat
longer (1990-2001) for some countries, but not for others.


                                                    23

significantly associated with more entry and exit.20 When the coefficient on regulation is

allowed to differ across sectors the results are not tidy, with the sign and significance

varying across sectors. Similarly, allowing for country variations, suggest heterogeneity

of responses that are not easy to rationalize.

         Scarpetta et al. (2002) use as explanatory variable, the time invariant OECD

indicators, either country or country/sector specific. When only country level indicators

are used, one obviously cannot control for country specific effects. When

industry/country specific indices are used, the authors control for country and industry

additive effects. The more convincing results are those in which they control for country

and sector effects in the specification also including employment protection indices.

Product and labor market regulations indices are interacted with firm size dummies.

There is evidence that for firms from 20 to 99 workers product market regulation has a

negative and significant effect on entry. For the 100 to 499 class the effect is positive and

significant, which is somewhat puzzling.

         The results by Brandt (2004) are obtained using country specific time invariant

measures of barriers to entrepreneurship as the explanatory variable in an equation in

which the dependent variable is the averaged residual (across sectors and time) of a

regression of entry rate on industry, time dummies, and country specific ICT industries

dummies. The focus on barrier to entry is motivated by the fact that some of its

subcomponents are the only ones to have some explanatory power. This is not true for

indicators summarizing state control and barriers to trade and investment. The barriers to



20In the estimating equation, the author controls for lagged entry, capital and R&D intensity as a measure
of barrier to entry, and other market structure variables, as a measure of opportunities, in addition to year,
country and sector effects. Note that the use of the within estimator even in a dynamic equation with short
T is not appropriate.


                                                      24

entry coefficient is not significant, however there is some evidence that its subcomponent

representing regulatory and administrative opacity has some explanatory power for entry

rates.

         Klapper et al. (2004) focuses on the interaction effect between regulation and the

"normal" rate of entry in an industry, proxied by the corresponding entry or turnover rate

for the US. The drawback is that one cannot make a statement about the overall effect of

regulation on entry, but only on relative magnitudes. The advantage is that this approach

should be less affected by reversed causality problems, whereas in countries with

generally low entry there may be less pressure to eliminate restrictive regulations. The

results suggest that regulation reduces entry relative to the "normal" industry specific rate

one observes in a country (the US) with low barriers to entry. 21

         Loayza et al. (2005) emphasizes that the extent of firm dynamics depends also

upon the volatility of the shocks affecting each country. In particular, they include in the

equations for entry, exit and turnover the triple interaction between regulation, normal

turnover (in the US), and the standard deviation of terms of trade growth. In this case, the

question is whether economies react differently to shocks depending upon the nature of

each sector and the nature of country level regulation. 22 The evidence is supportive of

the idea that product market regulation slows down the reallocation of resources

following a shock.




21Klapper et al. use the time invariant measures on barrier to entry in Diankov et al. (2002). The equations
contain also country, industry, size and year effects. In one specification regulation is instrumented by
country of origin, with no fundamental change to the results.
22Loayza et al. construct a time invariant summary measure of regulation based on information from the
World Bank, the Heritage Foundation, and the Fraser Institute. The statistics for firm demographic cover
the period 1990-2001, while productivity refers to the 1988-200 period. The equations contain also country,
industry, size and year effects. The paper also studies the effect of labor market regulation and fiscal
burden.


                                                      25

        Considering all the empirical contributions on the relationship between regulation

and firm dynamics together leads to the conclusion that regulatory barriers in the product

market have a negative effect on firm's entry or turnover and are likely to slow the

process of reallocation of resources.



4b. Effect of product market regulation (PMR) on fixed capital and labor demand

        Alesina, Ardagna, Nicoletti, Schiantarelli (2005) uses country/sector time varying

information on regulation to assess its effect on capital accumulation by introducing

regulation indicators directly in an investment equation. Understanding the behavior of

investment is very important for many reasons, including the fact that often process

innovations are embodied in new capital goods. The theoretical model that underlies their

contribution is an extension of Blanchard and Giavazzi (2003) that assumes perfectly

competitive labor markets but introduces capital as a factor of production that is costly to

adjust. Product market regulation affects the size of the mark-up by altering, for instance,

entry barriers. Moreover regulation can influence the cost that even existing firms face

when expanding their capital stock.23 Regulatory reform that generates a decrease of the

mark-up or in the cost of adjusting capital is shown to lead to an increased demand for

capital. There may be however contrary forces at work. For instance, regulation may

impose a ceiling in certain sectors on the rate of return. If such a ceiling is binding, a

removal of the constraint may reduce the demand for capital. Moreover, deregulation has

sometimes been accompanied by privatization. The reduced importance of a dominant

publicly owned player facing a soft budget constraint is equivalent to a reduction in entry

barriers. However, public enterprises may have been heavy investors, either because of a

23The model allows for quadratic adjustment costs in capital.


                                                   26

political mandate imposed of them or because of their incentives to over expand either

because they are empire builders or because they want to maximize political support.

        In their empirical work Alesina et al. focus on investment in non manufacturing

industries (utilities, communications and transport) in OECD countries that have

experienced profound changes, particularly in the 1990's, in their regulatory framework.

They use time varying sector-country specific measures of regulation collected by the

OECD for the period 1975-1998. In their investment equation, they allow for a sector-

country specific fixed effect and, in some specification, for a sector specific time trend.

This is very important because one needs to control for those sector specific

technological shocks that were occurring at the time of regulatory reform and to which

reform itself may be responding.

        The overall results suggest that a reduction in regulation, particularly if it affects

barriers to entry, has a significant and sizeable positive effect on investment. The results

are robust with respect to the inclusion of several country or sector specific controls and

to estimating the model in difference by GMM, where the regulatory index is also

instrumented with lagged values of itself, with population, GDP per capita, cumulative

years of left wing government, and union density (see Djankov et al (2002) on the

determinants of regulation). When the specification also includes measures of public

ownership, the effect of a reduction in entry barriers remains significant. The coefficient

of indices of public ownership is also significant, and its sign suggest that privatization

has a positive effect on investment. Finally, there is evidence of non linearities in the

sense that more decisive and deeper deregulations have a greater marginal impact. Note

that the positive effect of deregulation on investment not only reflects a static reallocation




                                              27

of resources, but may also have growth effects, if new technologies are embodied in new

capital goods.

        Evidence on factor demand is also provided, using the two step approach by

Griffith and Harrison (2004), via the mark-up, and by Cincera and Galgau (2005), via

entry. After showing that a decrease in regulation leads to a significant decrease in the

mark-up, the results in Griffith and Harrison suggest that the mark-up is negatively and

significantly related to employment and investment (see below in 4d for the effect on

R&D and productivity). However, in both cases the test of over-identifying restriction

strongly rejects the model, meaning that some of the regulation indicators have a direct

effect on employment and investment, besides having an effect through the mark-up.

Taking account also of their direct effect leads to the conclusion that the more important

effect on labor and investment comes from the average tariff rate (negative), from price

controls (negative), and from the CEEP measure of the importance of public enterprises

(negative). Re-estimation of the employment and investment model reveals that services

are responsible for the conclusion that an increase in competition stimulates factor

demand, while this is not true for manufacturing.

        Cincera and Galgau (2005) use firm entry and exit rates as the intermediate

variable through which regulation affects various aspects of performance. Obviously, the

entry and exit rates are endogenous and need instrumenting.24 The instrument chosen by

Cincera and Galgau are current and lagged values of the first principal component of the

Fraser indices and an index of restrictions on FDI investment, which vary only by

country and account only for a portion of the industry level variation of entry. For this



24Brandt (2004) also present correlation between entry and measures of economic performance, but given
the endogeneity problem, it is difficult what to make of them.


                                                    28

reason, current and lagged values of the number of active, entering, and exiting firms are

used as additional instruments, which is a more questionable choice. Lack of rejection by

the Sargan test of the over-identifying restrictions is not reassuring. If anything, it

reminds us of the low power of the test in many circumstances, particularly when many

of the instruments have a low explanatory power in the first stage regression. Be that as

it may, the results suggest that entry is not a significant determinant of the growth in

investment, while exit is associated with a significant decrease in the pace of capital

accumulation. For employment growth, the effect is not significant or of different sign at

different lag lengths of entry, but with a close to zero net effect.

        Summarizing, the direct evidence in Alesina et al. (2004) and the indirect one, via

effects on the mark-up in Griffith et al (2004) suggest a positive effect of deregulation on

investment and employment in the service sector. For manufacturing, there is no evidence

of a positive (or for that matter, negative) effect. The results in Cincera and Galgau (2005)

suggest that entry is not a key channel of transmission of regulatory changes to the

reallocation of labor and capital.



4c. Effect of PMR on innovation

        Bassanini and Ernst (2002) present direct evidence for 18 manufacturing

industries in 18 OECD countries on the effect of product and labor market regulation on

R&D intensity (relative to output). R&D is used as an input based measure of innovative

activities by a firm. The advantage of this measure is the fact that it is more easily

available than other measures such as patent counts. The drawback is that R&D is not the

only input in the innovation process and, even if it were, R&D intensity may not capture




                                              29

changes in its effectiveness. Finally, not all innovative efforts are measured by formal

R&D spending. The regulation variables are the OECD country level time invariant

measures of domestic economic regulation (state control, legal barriers to entry, price

controls) and administrative regulation (administrative barriers for new firms, permit and

licensing systems), in addition to time varying indicators of tariffs and non- tariff barriers.

A measure of protection of intellectual property rights is also included. Controls include

industry and country dummies in addition to employment share of large firms and import

penetration. As a result, the main effect of the time invariant indices of regulation cannot

be estimated, only its differential impact across some cut in the data (high tech versus low

tech industries in this case).

        The results suggest that non-tariff barriers have a negative effect on R&D

intensity. No effect of tariff barriers is detected, although one wonders whether the

presence of the import penetration variable as a regressor or the lack of variation of this

indicator across EU countries may be responsible for this result. There is no evidence of a

differential effect of domestic or administrative barriers comparing low tech to high tech

firms. In contrast, there is a positive differential effect for employment protection in high

tech industries relative to low tech in centralized systems of industrial relations. Note

however that the high tech-centralized IR system interaction has a negative coefficient.

        Griffith and Harrison (2004) analyze also the effect of (time varying) product

market regulation on R&D through changes in the mark-up. Even allowing for a

quadratic term, for virtually all countries the mark-up has a positive and significant effect

on R&D. Also, in this case, the test of over-identifying restrictions suggests that some of

the indicators should be included directly in the equation. The results suggest that a lower




                                               30

tariff rate, fewer barriers to starting a business, and lower regulatory trade barriers are

associated with lower R&D in the business sector. The results obtained for the

manufacturing sector are similar. However, they are very sensitive to the inclusion of

Finland in the sample. When Finland is excluded, one obtains a strong inverted U shaped

relationship between R&D spending and the mark-up, with some countries such as

France, Italy and the Netherlands mostly on the downward sloping section. The

sensitivity of the results to country sample selection deserves to be investigated further.25

          Cincera and Galgau (2005) finds a negative effect of entry on R&D intensity that

is significant at the 10% level. Recall that entry is negatively related to the tightness of

regulation. The effect on the R&D spending growth rate is significantly positive

contemporaneously and negative after one year. The net effect is close to zero.

          Summing up, the cross-country studies are not supportive of a strong positive

effect of lower regulation on direct input measures of firms' innovative activities.

Actually, the evidence suggests that lower mark-ups associated with product market

reform lead to lower R&D for most countries. However, this evidence is sensitive in

manufacturing to the particular sample of countries selected for estimation.



4d. Effect of PMR on productivity and output growth

          There are several papers that address the relationship between product market

regulation and productivity or output growth. In an early contribution, Koediik and

Kremers (1996) find a negative cross sectional relationship between per capita GDP

growth or TFP growth and product market regulation in 11 European countries. More


25Very recent empirical work conducted at the Institute for Fiscal Studies and still in a draft stage confirms
that the inclusion or exclusion of Scandinavian countries affects deeply the shape of the relationship
between the mark-up and innovation. I thank R. Griffith for useful comments and information on this point.


                                                   31

recently, using the economic freedom index published by the Fraser Institute and

averaging data over five year periods, Card and Freeman (2004) fail to find a significant

effect of regulation on the level of output per capita (or per worker) or on its growth rate,

once they control for year and country effects26.

        Nicoletti and Scarpetta (2003) provide perhaps the more detailed empirical

contribution on this issue. They focus on the effect of regulation on total factor

productivity levels, using cross-country data for several industrial sectors and including

the regulatory variable directly in the productivity equation. Their approach is inspired by

the contribution by Griffith, Redding, and Van Reenen (2004), (2003) who use an

endogenous growth model to rationalize both a direct effect of R&D on growth through

its effect on innovation creation, and an indirect one through the absorption of new

technology. The importance of the indirect one depends positively upon the distance from

the world frontier of each industry. The authors substitute R&D with their measure of

product market regulation and also allow for a direct and indirect effect.27

        The productivity measure is calculated for 17 manufacturing and 6 service

industries for 18 OECD countries. Three sets of results are presented. In the first one the

authors use the wide coverage, but time invariant country level measures of liberalization

collected by the OECD in 1998 (which is towards the end of their sample period). The

regulation variables are not significant on their own in regressions that do not (cannot)

include a country effect. They are significant when interacted with the technology gap in

an equation that lacks country effect. The latter could have been used instead of the



26The only significant effect is on employment growth.
27Note that the results for the effect of regulation on productivity in Nicoletti and Scarpetta (2003)
subsume and extend the ones in Scarpetta , Hemming, Tressel and Woo (2002).



                                                       32

insignificant time invariant indicators, in order to make a more robust statement about the

significance of the differential effect of regulation, depending upon the technology gap.

The time invariant character of the indicators precludes an assessment of the significance

of the total effect that is robust to unobserved country heterogeneity.

        The time varying measures of privatisation are introduced on their own and they

tend to have a positive and significant effect on productivity growth. When a time

varying measure of liberalization based on information in seven service sectors is

introduced, the privatization index becomes not significant, while the time varying

measure of regulation is significant and positive. The problem here is whether the

regulatory reforms for the service sector can be used for the economy as a whole.

        In another set of results, a time varying measure of entry liberalization in

manufacturing, based on data on trade liberalization, is used in conjunction with the time

varying measure of liberalization in the service sector. In that case, basically no

significant direct or indirect effect can be detected. Only when liberalization in

manufacturing is redefined as the average of trade liberalization and entry liberalization

in non manufacturing, one observes a significant direct positive effect of deregulation on

TFP growth.

        Finally, the 1998 time invariant sector specific OECD measures of liberalization

are combined with the time varying measure of liberalization for manufacturing and for

services. The equations contain country, industry, and year dummies. The results suggest

that entry liberalization in services has a positive effect on productivity growth. The only

significant interaction is the one between entry liberalization in manufacturing and the




                                              33

technology gap. Privatization continues to have a positive direct effect on productivity

growth.

        Summarizing, there seems to be some evidence of a positive effect of

privatization and entry liberalization on TFP growth. There is also evidence that entry

barriers in manufacturing may affect the pace of technology absorption, especially for

countries that lie away from the world frontier.

        Additional evidence on the effect of regulation on per-capita GDP growth for

industrial countries is contained in chapter III of the IMF World Economic Outlook

(2004), while Loayza, Oviedo, and Serven (2004) is one of the very few papers that

looks at the effect of regulation on the economic performance of a wide set of countries,

including developing countries. The IMF study concentrates on 15 developed countries

with a maximum of five observations on growth rates calculated over three-year

averages. The estimated equation contains standard controls for cross-country growth

regressions and a menu of structural policy indicators, including (present and lagged)

values of the time varying average product market regulation indicator developed by the

OECD for seven non-manufacturing sectors, and average effective tax rates. The sample

size is therefore small and the product market regulation indicator captures only a subset

of the economy. The model is estimated by GMM dynamic panel data methods and

suggests that both product market reform and trade reform have a positive and significant

effect on growth, although it may take time for the full effects to be realized.

        The main challenge when dealing with developing countries is the availability of

detailed indices of product market regulation that reflect the cross sectional and time

variability of product market regulation, although some of them, such as tariff barriers,




                                             34

are available at annual frequency and the indices of the Fraser Institute at five year

intervals for many countries. The Loayza et al (2004) paper focuses on time invariant

indices constructed from information from the World Bank, the Heritage Foundation, and

the Fraser Institute and are meant to capture the fiscal burden, and product market

regulation, the latter a composite of entry, trade, financial markets, bankruptcy, and

contract enforcement indices. An index of labor market regulation is also constructed.

         The indices are used as regressors in standard cross sectional average growth

regressions for output per capita over the 1990's, allowing their effect to depend on an

index of the quality of governance. Their effect on output volatility is also considered.

The inability to control for country specific unobserved effects and the time invariant

nature of the indices over a period that witnessed substantial change is the main limit of

the exercise. The effort made by the authors to instrument for regulation itself and the

fact that they allow for an interaction with the quality of governance are two attractive

features, together with the focus on a sample including developing countries. 28

         The results suggest a negative and significant direct effect of product (and labor)

market regulation on growth, but the coefficient of the interaction with governance is

significant (except for the fiscal burden index), and its sign suggests that better

governance reduces the negative effect of regulation. Actually, the size of the coefficients

are such that the overall effect of regulation is sizeable and negative for most developing

countries, while it is zero or even mildly positive for countries with quality of governance

similar to the US and the UK (and presumably other OECD countries). The results for

macroeconomic volatility are similar: regulation increases volatility, but the effect is


28Legal origin, fraction of the population that speaks a major European language and initial per capita GDP
are used as instruments. The test of over-identifying restrictions does not suggest misspecification.
Concerns about the power of such test should, however, not be forgotten.


                                                     35

attenuated by good governance. Note that these results, obtained by introducing the

interaction with governance, contrast with those that find a positive effect of product

market reform on growth for industrial countries.

        Griffith and Harrison (2004) also present evidence for the effect of regulation on

productivity for developed countries, using their two step approach, where the

intermediate link is the mark-up. When the level or the growth rate of labor or total factor

productivity in the business sector is regressed on the mark-up (the latter instrumented by

the regulatory variables) they tend to find a positive and significant effect of the mark-up

on both the level and growth rate of productivity. The conclusion that a higher mark-up

has a mostly positive effect on productivity is not altered by allowing for non linear

effects of the mark-up or by the direct inclusion of some regulation indices in the

regression. Taken at face value, these results are consistent with the idea that monopoly

rents provide the crucial incentive for productivity enhancing innovative activity. An

alternative explanation is that the new jobs created by deregulation are in lower

productivity sectors. Note in this respect that the mark-up coefficient is negative and

larger in absolute value in the service sector. An alternative explanation is that the time

period available for estimation does not allow one to capture the complexity of the

relationship between mark-up and productivity. For instance, the new firms that enter

following a reduction in regulation may be initially less productive than incumbent

surviving firms and it may take time for them to achieve higher levels of productivity. It

is interesting to note that the positive relationship comes from the within variation in the

data. If one does not include country dummies in the regression, allowing the between




                                               36

variation to play a role as well, the relationship between mark-up and productivity tends

to become negative and significant.

        Cincera and Galgau (2005) present results on the effect of entry and exit on output

growth and labor productivity growth instrumented with regulation and other variables.

Note that the coefficient of entry does not capture only the direct effect of entry on

productivity, but also the indirect effect that entry has on the productivity of existing

firms. There is some evidence at the 10% level that entry has a positive effect on labor

productivity growth, while exit has a significant positive effect on it at the 5% level.

        Loayza et al (2005), use a similar two steps approach to explain labor productivity

growth in manufacturing for their subset of developed and developing countries, using

turnover (divided by the standard deviation of terms of trade growth) as the intermediate

variable. Standardized turnover is interacted with the average US turnover and it is

instrumented by product market regulation, labor regulation, and fiscal burden. Average

GDP per capita, the average growth rate of the terms of trade, and the output gap over the

period are included as controls. Although the regulation variables are time invariant, so

that the authors cannot control for unobserved heterogeneity, an interesting twist in their

contribution is the decomposition of productivity growth into the "within" component,

the "between" component and a component representing the portion of productivity

growth due to entry and exit. A specification in which each regulatory variable is

included directly in the productivity equations is also estimated by OLS. The overall

results suggest that the portion of turnover explained by business regulation flexibility

has a positive and significant effect on overall labor productivity growth. However, the

only component that is significantly affected is its net entry component.




                                              37

         In summary, most of the studies that include measures of regulation directly in the

regression (alone or interacted) tend to find a negative effect of tighter regulation on total

factor productivity or per capita output growth. The results for TFP growth are strong

particularly in the service sectors, while the effect on the level of governance on growth

needs to be investigated further. However, studies that use the mark-up as the channel of

transmission find that decreases in the mark-up associated with deregulation are

associated with lower productivity growth (or level).29 Controlling for the mark-up, there

is no evidence of an additional positive direct effect of deregulation on productivity

(sometimes the opposite is the case). The cross-sectional dimension of the data suggests

that countries with higher mark-ups have lower productivity growth rates, but one has to

be aware that in this case we are not controlling for other country effects besides their

competitive environment. On balance, relying on turnover or entry as the variable

through which the effect of deregulation is transmitted suggests a positive effect of

lowering regulatory burdens on overall productivity growth, but more work is needed in

order to understand how that is distributed between the within, between and entry/exit

components. The general conclusion that can be drawn at this point is that most, but not

all, the evidence points towards a positive effect of less stringent regulation on

productivity growth.




5. Summary and Conclusions



         What are the overall lessons that can be derived from this review of the available

cross-country evidence on the effect of product market regulation? We have certainly

29Note that higher mark-ups are associated also with more R&D spending.


                                                   38

learned a lot from the recent econometric work in this area, but there is still ambiguity on

some of the issues.

       There is considerable evidence that product market regulation that raises barriers

to entry contributes to higher mark-ups. Moreover, the results support the conclusion that

regulatory barriers in the product market have a negative effect on firm entry or turnover

and are likely to slow the process of reallocation of resources.

       As far as factor accumulation is concerned the direct evidence and the indirect

one via effects on the mark-up suggest a positive effect of product market deregulation

on investment and employment in the service sector. The result for investment is

particularly important because often new processes are embodied in new capital goods

and find their way into the economic systems through the investment process. For

manufacturing there is no evidence of a positive (or for that matter, negative) effect,

although that may be the result of lack of adequate sector specific and time varying

measures of regulation. Entry does not seem to be a key channel through which changes

in regulation affect the demand for labor and capital, although there is clear evidence that

entry responds strongly to the regulatory climate. The effect of entry on the reallocation

of factors of production requires additional investigation.

       The cross-country studies are not supportive, at this stage, of a strong positive

effect of less stringent regulation on direct input measures of firms' innovative activities.

Actually, the studies that use the mark-up as the transmission mechanism find that lower

mark-ups discourage innovation. However, this result is sensitive to the choice of the

sample of countries used in estimation. There is, instead, some evidence that non-tariff

barriers have a negative effect on R&D. The results based on the mark-up are at odds




                                               39

with some recent micro evidence for individual countries on the existence of an inverted

U shaped relationship between the mark-up and firms' innovative activities. Clearly,

more work is needed to resolve the theoretical ambiguities concerning the effect of

product market regulation on firms' innovative activity and to come to more definitive

conclusions on this issue. Progress in this area depends upon the availability of cross-

country data on firm's innovative activities that go beyond R&D spending, such as patent

counts, measures of firm's innovative investment, survey measures on the introduction of

innovations, etc. It also requires a deeper understanding of how the nature of a country's

industrial structure, the distance of a country from the technological frontier, the

availability of human capital, and other initial conditions may lead to different results.

       Finally, most of the studies that include measures of regulation directly in the

regression (alone or interacted) tend to find a negative effect of tighter regulation on total

factor productivity or per capita output growth. This cross-country evidence is consistent

with the micro-econometric evidence that finds a positive and significant association

between competition and productivity growth. These results are not confirmed by studies

that use the mark-up as the channel of transmission, since in that case a decreases in the

mark-up following deregulation is associated with lower productivity growth (or level).

Relying on entry or turnover as the variable through which the effect of deregulation is

transmitted suggests a positive effect of lowering regulatory burdens on overall

productivity growth, but more work is needed in order to understand exactly how that is

distributed between the within, between and entry/exit components. The general

conclusion that can be drawn at this point is that most, but not all, the evidence points

towards a positive effect of less stringent regulation on productivity growth.




                                              40

         This result is very important on its own, but also has an interesting consequence

on a macro variable that has not been the focus of our survey, namely inflation. The faster

rate of productivity growth associated with less stringent product market regulation

reduces, ceteris paribus, inflationary pressure. In addition, if we consider the evidence

that lower regulatory barriers lead to a smaller mark-up, it follows that regulatory reform

may have favorable effects on inflation at short as well as longer horizons. Further

systematic evidence on this issue would be very useful.30

         There is another important topic for future research. As we have mentioned in the

introduction, many countries have introduced reforms that affect not only the output

market, but also the labor market and the financial sector. It is important to investigate

how the effect of product market reform depends upon the rules and regulations in the

labor market, upon the regulatory structure and level of development of the financial

sector, and upon other institutional features of a country. Progress in this area will

sharpen our understanding of the macroeconomic effects of product market and other

reforms.




30See Neiss (2001) for cross sectional evidence on the relationship between the mark-up and inflation in
OECD countries and Cavelaars (2002) for an cross sectional analysis of the effect of product market
regulation.


                                                    41

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