Being numerous does not yield efficiency - Productivity and entry-exit determinants in European business services

Abstract

The paper investigates whether the poor productivity performance of the European business services industry is related to scale effects, market structure, and regulatory impacts. We apply parametric and nonparametric methods to estimate the productivity frontier and so obtain the distance of firms to the productivity frontier, using detailed industry-level panel data for 13 EU countries. Subsequently, we investigate how scale effects, market structure, and national regulation explain the distance with the productivity frontier. We find that that most scale advantages are exhausted after reaching a size of 20 employees. However, scale inefficiency is persistent over time, which suggests weak competitive selection. Market and regulation characteristics explain the persistence of X-inefficiency (sub-optimal productivity relative to the industry frontier). Entry and exit dynamics increase the productivity performance, while higher market concentration works out negatively. National regulatory differences also explain part of the productivity performance, especially if this affects exit behaviour and labour reallocation costs. The most efficient scale in European business services is achieved with close to 20 employees. Scale inefficiencies show a hump-shape pattern with strong potential scale-related productivity gains for the smallest firms, while the largest firms experience persistent scale- related diseconomies, suggesting that they operate in shielded monopolist markets. The smallest firms operate under competitive conditions, but they are too small to be efficient. And since this conclusion holds for about 95 out of every 100 European business services firms, this factor weighs heavily for the overall productivity performance of this industry.