Entry regulation: Still costly

Markus Poschke, 29 January 2011

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For most affected countries, the recent European debt crisis at its root is also a growth crisis. It is then only appropriate that structural reforms and deregulation be still on the agenda. For instance, costs due to entry regulation are still relatively high in some continental European countries, with large knock-on effects on aggregate output and productivity.

Entry regulation in Europe

Djankov et al. (2008) pioneered the measurement of costs of firm entry across countries. In their seminal contribution, they measured the cost of entry for a standardised firm in 85 countries in terms of the number of procedures, the official cost, and the official waiting time. The official cost can be substantial, and the cost of waiting and of time spent to comply with procedures comes on top of that. The World Bank's Doing Business project keeps updating these measures and makes numbers for 183 countries available. Table 1 presents recent cost measures for a number of European countries, Canada, and the US, ordered by the full cost (fees plus cost of time) in 2010.

Table 1. Firm startup costs

 
2005
 
 
 
 
2010
 
 
 
 
Procedures
Time
Official cost
Full cost
 
Procedures
Time
Official cost
Full cost
 
(number)
(days)
(% of GDP/cap)
(% of GDP/cap)
 
(number)
(days)
(% of GDP/cap)
(% of GDP/cap)
Denmark
5
7
0
2.7
 
4
6
0
2.3
Canada
2
3
1
2.1
 
1
5
0.4
2.3
US
6
6
0.7
3
 
6
6
0.7
3
France
5
7
1.1
3.8
 
5
7
0.9
3.6
UK
6
13
0.9
5.8
 
6
13
0.7
5.6
Belgium
4
34
11.3
24.2
 
3
4
5.3
6.8
Portugal
11
78
13.5
43
 
6
6
6.4
8.7
Germany
9
45
5.9
22.9
 
9
18
4.7
11.5
Italy
9
13
21.4
26.3
 
6
10
17.9
21.7
Greece
15
38
32.5
46.9
 
15
19
20.2
27.4
Spain
10
114
17
60.2
 
10
47
15
32.8

Note: Full cost is the sum of the direct cost and the value of time, which is set to a business day’s output per day of waiting time, at 22 business days per month.

While entry costs in these countries are much lower than in some developing countries (for example, the official cost of entry in Nicaragua in 2010 as a fraction of per capita GDP is more than 40 times that in the US and in some other countries, it is higher still), there is a clear dichotomy. Costs of entry are much higher in Germany, Greece, Italy, Portugal or Spain than in Canada, New Zealand and the US or some other European countries like Denmark or the UK, where they are minuscule. While the cost of entry has fallen in most European countries since measurement has started, there is still some way to go. A firm's cost of complying with entry regulation in the high-entry cost countries amounted to between $6,000 and $18,000 in 2005 and to between $4,000 and $10,000 dollars in 2010 (converted at purchasing power parity). In Denmark, on the other hand, the cost to firms is roughly one-tenth of that.

While entry regulation is usually justified as protecting some public interest, Djankov et al. (2008) show that at least on average, this is not the case. To the contrary, they show that stricter regulation of entry is associated with more corruption and a larger shadow economy and not with less pollution.

If entry regulation does not promote the public interest, it is wasteful. Indeed, when plotting the cost of entry in a country against its GDP per capita (from the Penn World Tables), a clear negative association emerges, as shown in Figure 1. This is true both within the OECD (red dots) and more broadly. (See also Mukoyama and Moscoso Boedo 2010 for more information on cross-country patterns.) Barseghyan (2008) shows that this pattern persists when other determinants of GDP per capita like property rights protection are taken into account. His estimates imply that increasing entry costs for a plant from very low levels such as those observed in e.g. Denmark to moderate ones as in Spain can reduce per capita GDP and total factor productivity by about 7.5% to 10%.

Figure 1. 

Small barriers can have large effects

What are the mechanisms at work? Elementary microeconomic analysis suggests that higher entry barriers in a market reduce the number of active firms in that market, leading to less competition, higher prices and lower output. In Poschke (2010), I quantitatively explore the effect of entry costs on the aggregate economy through this channel and through its effect on firms' choice of technology. It turns out that already quite small entry barriers (in manufacturing for instance, a regulatory burden of $8000 is not large compared to typical entry investments) may have large effects.

The reason for this is that a lower number of active firms not only implies higher prices and lower output but also has two important further effects.

  • First, the presence of fewer competitors makes it easier for weak firms with low productivity to survive. It is well-known from Foster et al. (2001) that entry of new plants and exit of weak ones are important for an economy's productivity; depending on the sector, plant entry and exit may account for a quarter to all of a sector's productivity growth. Entry costs reduce entry of new plants and thereby reduce pressure on weak firms and plants to exit, blunting the disciplining selection mechanism of the market. As a consequence, there are not only fewer active firms, but they are also on average less productive.
  • Second, firms' investment in technology is affected. An important part of technology is embodied in plant and equipment. These are selected by entrepreneurs or managers as a function of the market environment when a new production unit enters the market. In doing this, they contemplate how much additional profit the firm can expect from investing in a better technology, which is more productive but also costlier.

More productive firms can sell at a lower price. In this way, they may convince customers who were looking for a slightly different good to buy their product. As a result, more productive firms can attract more customers and make higher profits.

A reduction in the number of active production units, however, implies that fewer goods are produced, so that the ones that are produced will be less similar. As a consequence, it becomes harder to convince consumers to switch, and more productive firms find it more difficult to translate their cost advantage into higher profits. This implies that the incentive to invest in better technology is reduced. That is, entry costs can have an adverse effect on firms' choices of technology.

To measure the quantitative importance of these channels, I build a model designed to closely reflect the process of entry, exit, growth, and decline of firms observed in reality in a flexible economy such as the US. Introducing European-level moderate costs of entry of about $8,000 in this setting induces reductions in productivity, output and consumption of about 2.5%. This is a large number. It is more than 10 times the direct cost to firms of complying with entry regulation and suggests that up to one-third of productivity differences between a country like Germany and the US may be due to entry costs.

The paper also shows that these effects may even be slightly larger when firms bargain about wages with unions, because then firms only capture part of the gains from better technology. This echoes findings by Blanchard and Giavazzi (2003) that imperfections in product markets and labour markets interact. Focussing more on labour markets, Ebell and Haefke (2009) and Felbermayr and Prat (forthcoming) show that higher entry costs for firms can also raise unemployment.

Conclusion

All these findings suggest that continuing reductions in entry costs that are still quite a bit higher in many continental European countries than in Denmark, for example, may have large benefits. Recent trends are a promising start, but there is still some way to go.

References

Barseghyan, L (2008), “Entry Costs and Cross-Country Differences in Productivity and Output”, Journal of Economic Growth, 13(2):145-167.

Blanchard, O and F Giavazzi (2003), “Macroeconomic Effects of Regulation and Deregulation in Goods and Labour Markets”, Quarterly Journal of Economics, 118(3):879-909.

Djankov, S, R La Porta, F Lopez-de-Silanes, and A Shleifer (2002), “The Regulation of Entry”, Quarterly Journal of Economics, 117(1):1-37.

Ebell, M and C Haefke (2009), “Product Market Deregulation and the US Employment Miracle”, Review of Economic Dynamics 12.

Felbermayr, G and J Prat (forthcoming), “Product Market Regulation, Firm Selection and Unemployment”, Journal of the European Economic Association.

Foster, L, J Haltiwanger, and CJ Krizan (2001), “Aggregate Productivity Growth: Lessons from Microeconomic Evidence”, in CR Hulten, ER Dean and MJ Harper, (eds), “New Developments in Productivity Analysis”, NBER Studies in Income and Wealth, University of Chicago Press, Chicago.

Moscoso Boedo, HJ and T Mukoyama (2010), “Evaluating the Effects of Entry Regulations and Firing Costs on International Income Differences”, mimeo, U Virginia.

Poschke, M (2010), “The regulation of entry and aggregate productivity”, Economic Journal, 120(549):1175-1200.

Topics: International trade, Microeconomic regulation
Tags: barriers to trade, protectionism

Markus Poschke

Assistant Professor, Department of Economics, McGill University