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. …