There’s a agreement that there exists a strong link between too much regulation, called “market frictions”, and economic under-performance. Indeed, a growing body of literature claims market frictions are to blame for the divergent performance in productivity and employment of continental European versus US economies during the 80s and 90s. But, if European markets should be deregulated, why doesn’t it happen? While product market reforms are slow-moving in Europe and some sectors are still virtually served by monopolies, labour market deregulation is even less pronounced (Gönenç et al., 2000).
Most explanations stress the role of interest groups in determining government intervention. Any reform that reduces the market power of firms proves difficult to implement. Also the main reason why frictions remain in European labour markets, says Saint-Paul (2000), is that reforms face opposition from employed workers. The high frictions in Europe are said to provoke a “European Sclerosis”. Because frictions in European product and labour markets are high, interest groups enjoy high rents and oppose changes more. Thus, the markets that most need a reform, are most stuck.
The contribution of the current paper is threefold. First, it looks for a way out of this impasse by exploiting the complementarities that exist between some deregulatory reforms in product and labour markets. We combine a product market where firms are involved in Cournot competition à la Vives (2002) and a labour market where employers are hiring in accordance with an efficiency wage (Shapiro and Stiglitz, 1984). Using the degree of market integration and employment protection legislation (EPL) as measures for product and labour market regulation respectively, we find that the loosing side of one reform is the winning side of the other reform. This means that synchronising reforms across markets makes a more performing economy easier to accomplish.
We further claim that when synchronising reforms, higher frictions in the one market make it easier to deregulate the other market. Therefore, a sclerosis in one market can cancel out a sclerosis in the other market. Second, we argue that complementarities between reforms can explain the observed high positive correlation between frictions in both markets. Table 1, taken from Nicoletti et. al. (2000) and based on work on the OECD countries, makes the point. The cross-country relation between the two indexes is striking; a positive correlation of 0.73 is found (significant at the 1% level). In countries where product markets are highly regulated, such as Italy and Greece, workers tend to be highly protected. This may be explained by the fact that deregulation in one market might be easier accomplished if it is done in synchronisation with the other market. Third, it is a first theoretical attempt to claim that product market frictions can be removed by the deregulation of labour markets.
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Synchronising Deregulation in Product and Labour Markets
