Product Market Regulation and Market Work: A Benchmark Analysis
Fang, Lei, Rogerson, Richard, Federal Reserve Bank of Atlanta, Working Paper Series
Working Paper 2009-7
Abstract: Recent empirical work finds a negative correlation between product market regulation and aggregate employment. We examine the effect of product market regulations on hours worked in a benchmark aggregate model of time allocation as well as in a standard dynamic model of entry and exit. We find that product market regulations affect time devoted to market work in effectively the same fashion that taxes on labor income or consumption do. In particular, if product market regulations are to affect aggregate market work in this model, the key driving force is the size of income transfers associated with the regulation relative to labor income, and the key propagation mechanism is the labor supply elasticity. We show in a two-sector model that industry-level analysis is of little help in assessing the aggregate effects of product market regulation.
JEL classification: E24, J22, L5
Key words: labor supply, product market regulation, entry barriers
Time devoted to market work differs greatly across OECD economies: total hours of work per person of working age are currently more than 30% lower in Belgium, Prance, Germany, and Italy than they are in the US. A growing literature seeks to understand the causes of these differences. (1) Any explanation for these differences must consist of two components: driving forces and propagation mechanisms. The driving forces are those factors that differ across these economies, and the propagation mechanism is the economic channels through which these factors influence hours of work. Many driving forces have been suggested in the literature, including taxes, labor market regulations, and unions. A recent literature has emerged on the importance of product market regulations for labor market outcomes. Empirical work by Boeri et al (2000), Bertrand and Kramarz (2002), and Lopez-Garcia (2003) finds a strong negative correlation between product market regulation and employment. Theoretical work includes contributions by Nickell (1999), Fonseca et al (2001), Blanchard and Giavazzi (2003), Messina (2006), and Ebell and Haefke (2004, 2006).
Interpreting the results of purely empirical analyses can be difficult. On the one hand, there is always the danger that the results only reflect a correlation of the variables of interest, and are not evidence of causation. Second, even if the empirical evidence is taken to imply a causative relationship, a full understanding requires knowledge of the important economic mechanism that underlies the causation. But a purely empirical analysis cannot provide this information. A deeper understanding of how product market regulations potentially affect labor market outcomes requires a systematic assessment of the channels through which these regulations affect equilibrium outcomes in various economic environments. This paper contributes to this effort by examining the effects of one prominent aspect of product market regulations increased entry costs on labor market outcomes in a simple benchmark model of aggregate time allocation embedded in a model of entry.
Our analysis generates two important insights about the effect of product market regulations which take the form of entry barriers. First, from the perspective of influencing time devoted to market work, the key driving force is the size of nonlabor income relative to labor income that accrue to households as a result of the regulation. Second, the extent to which this driving force leads to less market work is completely determined by the elasticity of labor supply. These two insights taken together imply that understanding the effects of product market regulations on time allocated to market work in this setting is isomorphic to the problem of understanding the effects of labor income taxes on time allocated to market work. In both cases the key driving force is the size of transfers relative to labor income, and the key parameter of the propagation mechanism is the labor supply elasticity.
Two conclusions follow from these results. First, the importance of product market regulation relative to taxation of labor income is completely dictated by the relative magnitude of the nonlabor income payments induced by each. Second, entry barriers that consist of real resource costs have no impact on the volume of market work. Specifically, in this case it does not matter how large the barriers are, since they do not generate any transfer payments in equilibrium. We emphasize that effects on hours of work are only one dimension through which entry barriers can affect economic outcomes. Even when entry barriers do not have any effect on hours of work, they do entail welfare costs by affecting the amount of entry.
We first establish our results in the context of a simple static model, since this allows us to derive the results analytically and best highlights the key economics at work. We consider a dynamic model of entry and exit that is able to replicate the key stylized facts about entry and exit. This setting is of interest because it allows for effects on the selection of firms in operation as well as allowing for positive profit flows in steady state. Since we cannot establish analytical results in this setting, we report the results of policy changes in a calibrated version of the model. The findings in this more empirically reasonable model of firm entry and exit are effectively identical to those in the simpler static model. We also relate our findings to those of Hopenhayn and Rogerson (1993) regarding the effect of firing taxes, and show that a key qualification regarding their results is that they assume that firing taxes are used to fund a lump-sum transfer payment. When this assumption is removed, say because the firing tax represents a real resource cost, we find that firing taxes do not lead to lower hours, just as is true for the case of entry barriers.
Our results are most related to those obtained in Messina (2006), and suggest that his analysis overstates the effect of entry barriers on hours of work. He assumes that the entry barrier is a payment which effectively leads to a transfer payment to consumers. But he calibrates the size of the entry by using data from Djankov et al (2002), which is based on measures of time costs. But if one models the entry barrier as a time cost then there are no transfer payments generated and the impact on hours would be zero. Similarly, Ebell and Haefke (2006) consider a model with trading frictions, and their quantitative analysis shows that changes in regulations which reflect real resource costs have virtually no effect on unemployment.
An outline of the paper follows. The next section lays out the static model and characterizes how labor taxes and entry barriers affect equilibrium hours worked. Section 3 shows that the results in Section 2 continue to hold in several extensions of the simple static model. Section 4 presents the dynamic model and calibration results. Section 5 concludes.
2 Static Analysis
This section lays out the benchmark static model of monopolistic competition and characterizes the equilibrium allocation for the model. We then analyze the implications for the effect of taxes and product market regulation on equilibrium hours of work.
2.1 Model and Equilibrium
There is a representative household with preferences defined over consumption of a final good (c) and leisure (1 - h) given by:
[alpha] log(c) + (1 - [alpha]) [(1 - h).sup.1-[gamma]]-1/l-[gamma]. (2.1)
where 0 < [alpha] < 1 and [gamma] [greater than or equal to] 0. We adopt this specification of preferences because it is consistent with balanced growth and permits a parsimonious way of incorporating a range of labor supply elasticities. All of the results derived below continue to hold in the more general case of any utility function consistent with balanced growth.
There are two production sectors: an intermediate goods sector and a final goods sector. Each point on the positive real line represents a potential intermediate good. Each intermediate good i can be produced using a linear technology y(i) = h(i), where h(i) is labor input for the intermediate good i, but there is a fixed cost [phi] > 0 associated with operating any of these technologies. We assume that the fixed cost is in units of labor. For the purposes of the decentralization we will also assume that each point on the real line corresponds to a different firm.
The final goods sector combines the available intermediate goods into the final good (i.e., consumption) via the CES production function:
c = y [[[[integral].sup.[infinity].sub.0] y[(i).sup.[rho]] di].sup.1/[rho]]]. (2.2)
We assume that the final goods sector is competitive, and hence for simplicity we assume that there is a single representative firm in this sector. The representative household owns all of the firms and hence receives any profits that might accrue in equilibrium.
We study an equilibrium in which the consumer behaves competitively in both the output and the labor markets and the final goods firm behaves competitively in both the final goods market and the intermediate goods market, while intermediate goods firms behave as monopolistic competitors in output markets and as perfect competitors in the labor market. Given the symmetry imposed on the environment,