Academic journal article Economic Inquiry

Firms and Flexibility

Academic journal article Economic Inquiry

Firms and Flexibility

Article excerpt


Differences in labor market outcomes between the United States and Europe have been well-documented. (l) One popular explanation of these observed differences has been the lack of flexibility in European countries. (2) Labor market outcomes, however, are tightly connected to firm dynamics (3) through firm entry and exit, and hiring and firing decisions. Moreover, the allocation of workers across firms, reflected by these dynamics, is an important determinant of average labor productivity. Although differences between the United States and Europe in labor market outcomes have been widely studied, differences in firm-size distributions and dynamics have not been extensively documented. We first present evidence from Bartelsman, Scarpetta, and Schivardi (2003) and Bartelsman, Haltiwanger, and Scarpetta (2004) (4) on the distributions of firms and workers over five firmsize bins for the United States and France in Figure 1. (5)

As Figure 1 shows, over 80% of firms employ 20 workers or less and about half a percent employ more than 500 workers, both in France and the United States. At 23.2 workers per firm, the average firm size in the United States is smaller than that in France, which is 27.4. One notable difference between the United States and France is the higher concentration of workers in large firms (500 employees or more) in the United States, reflected in the worker distribution in the left panel of Figure 1. This reflects a squeeze in the firm-size distribution in France relative to the United States; mid-size firms make up a larger fraction of the firm population and employ a higher fraction of workers in France than in the United States. Entry and exit rates of firms are higher in France. The annual firm entry rates in the United States and France are 10.4% and 15.9%, respectively, while the exit rates are 9.1% and 11.6%. Average labor productivity in France is 101% of that in the United States for the same time period that we examined the firm dynamics in the two countries.


To summarize, despite differences in firm dynamics, the United States and France have very similar average labor productivity levels. (6) To reconcile these observations with documented differences in labor market rigidities between the United States and France, we introduce a model that explicitly combines labor market rigidities with a theory of the firm-size distribution. Our model consists of two main theoretical components. The first component, based on Lucas (1978) and Chang (2000), is that each firm is managed by an entrepreneur. Whether or not people become entrepreneurs in Lucas' (1978) span-of-control model depends on their innate entrepreneurial ability. In contrast, members of the labor force in our model are ex-ante identical. People who do not work develop one business idea in every period. Depending on the quality of their idea, they decide whether to start a business or look for a job instead. Hence, the marginal entrepreneur who starts a business equates the expected value of starting a business to the expected value of his/her labor market opportunities. The second component, similar to Hopenhayn and Rogerson (1993), is firm dynamics under labor adjustment costs. In Hopenhayn and Rogerson, low productivity firms exit because they face a fixed operating cost; however, firms in our economy do not incur such a fixed cost. What drives firms to exit in our model is that their managers will close shop if their outside labor market opportunities exceed the expected value of continuing their business.

We use our model to consider the joint effects of firing costs, firm entry costs, unemployment benefits, a tax wedge between wages, and labor costs, on firm-size dynamics and labor productivity. First, we calibrate the preference and technology parameters in a version of the model without rigidities to match the main summary statistics of U.S. firm-size dynamics. …

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