The ruthlessness with which the global crisis exposed the lack of competitiveness in many of Europe’s economies has renewed interest in ways to encourage greater competition. These reforms are usually targeted at the domestic service sectors in continental Europe, as those sectors are still heavily regulated and, in the last 15 years, have performed badly relative to other economies, such as US.
A large literature has analysed the effects of regulation resulting in lower competition (such as, for instance, legal barriers to entry) and found that it reduces the level of output, investment and employment. Among others, Alesina et al (2005) show that reforms relaxing regulation in sectors traditionally sheltered from competition (transport, communication, and energy) can have a positive impact on investment levels. The reason is that regulation often grants to the firms in the regulated sectors a monopolistic power that results in higher profit margins and lower output levels. The effect of regulation in the services sector on downstream industries, typically manufacturing, has also been recently analysed. Barone and Cingano (2011) examine a large sample of sectors and countries and find that lower services regulation has non-negligible positive effects on value added and average labour productivity on sectors that use services intensively.
The case of Italy
In a recent paper (Forni et al 2010) we quantitatively assess the macroeconomic effects of increasing competition in the Italian services sector by simulating a dynamic general equilibrium model akin to the IMF Global Economy Model (Pesenti 2008), calibrated to Italy and the rest of the Eurozone.
Our analysis focuses on Italy for three reasons.
First, Italy has experienced more than a decade of sluggish growth compared to its main partner countries.
Second, as suggested by the IMF 2007 Art. IV staff report on Italy “...various cross-country reviews identify excessive regulation as a continuing problem in key sectors, accounting also for Italy's undersized services sector and high energy prices. In part due to these problems, Italy's ranking in cross-country surveys of the business environment is poor...”.
Third, a large number of market services are regulated (we estimate that retail, transport and communication, banking and finance, insurance, construction, electricity, gas, water, tourism, hotels and restaurants sum up to about half of Italian GDP; we do not include the public and non-profit sectors), resulting in higher services sector mark-ups than in the average of the other European countries.
In the model we allow for monopolistic competition in manufacturing and services markets. Monopolistic power is introduced through imperfect substitution between varieties, so that firms are able to set a mark-up over costs: the lower the degree of substitutability, the higher the mark-ups and the lower the output. Therefore, by modifying the parameter governing the degree of substitutability we can simulate the impact of structural reforms that raise competition. As competition increases, firms have an incentive to reduce the price of their products while the overall quantity produced increases. This stimulates investment, employment, and, through higher households’ income, consumption.
We simulate a reform that reduces mark-ups across the board in the Italian services sector; specifically, the level of mark-ups currently estimated for the Italian services sector is gradually lowered to the average Eurozone level over a five-year period.1 Results suggest positive and large macroeconomic effects. On impact,
The price reduction stimulates the demand for services and, with a lag, employment and the real wage;
The expectation of more favourable economic conditions in the future stimulates investment;
While consumption is initially dragged down by the negative wealth effect suffered by the rent recipients.
Overall, the effects on output start to be sizeable only after one year or so, when output starts growing faster than in the no-reforms scenario and keeps doing so for approximately six years, after which the effects of the reform gradually fade away.
On average during this period, the reform adds almost 1.3 percentage points to the yearly growth rate of output, the cumulative effect amounting to about 11 percentage points.
The welfare improvement for the average Italian family is equivalent to an increase of about 3.5% in the long-run level of consumption.
The higher level of real wages that results from a reform of the services sector is particularly interesting in light of the potential interactions between structural reforms. In fact, such positive spillovers could facilitate the adoption of a concurrent (or subsequent) reform aiming to relax regulation and reduce structural unemployment in the labour market itself.
The macroeconomic gains that could accrue to the Italian economy are sizeable and stem essentially from the sheer size of the stimulus: in our simulations mark-ups are reduced by a significant amount (26 percentage points) in a range of sectors covering half of GDP. More limited interventions (in terms of sectors affected or aggressiveness of the reform intervention) would correspondingly produce more modest results. Importantly, our paper does not address the issue of what specific reforms are better able to deliver such a widespread reduction in mark-ups, nor does it suggest that implementing these reforms would be easy and free of uncertainties. A number of obstacles, from political opposition to technological limits related to the structure of markets (ie, natural monopolies), are likely to emerge. Therefore our results can hardly be interpreted as a prediction of the likely outcome of any given reform that simply reduces legal barriers. They do suggest, however, that the potential gains from pursuing competition-friendly reforms are sizeable and thus they may well be worth the effort.
At the policy level, the analysis suggests that reforms in services and labour markets have a higher chance of being successful when implemented jointly or in sequence, as deregulation in the services sector brings about an increases in wages and employment and therefore should help in lowering resistance to a subsequent labour-market reform (a policy prescription similar to the one in Blanchard and Giavazzi 2003).
Authors’ Note: The views expressed in this column are those of the authors and should not be attributed to the Bank of Italy, the IMF, its Executive Board, or its management. The paper referred to in this article (Forni et al 2010) was written when Lorenzo Forni was working at the Bank of Italy.
Alesina, A, S Ardagna, G Nicoletti, and F Schiantarelli (2005), Regulation and Investment, Cambridge, MA: MIT Press, 3(4): 791–825.
Barone, G, and F Cingano (2011), “Service Regulation and Growth: Evidence from OECD Countries”, Economic Journal, 121(555): 931–57.
Bassanetti, A, R Torrini, and F Zollino (2010), “Changing institutions in the European market: the impact on mark-ups and rents allocation”, Temi di Discussione, 781.
Blanchard, O and F Giavazzi (2003), “The Macroeconomic Effects of Regulation and Deregulation in Goods and Labor Markets”, Quarterly Journal of Economics, 118(3):897–907
Christopoulou, R and P Vermeulen (2008), “Markups in the Euro Area and the US over the Period 1981–2004”, Working Paper 856, European Central Bank.
Forni, L, A Gerali and M Pisani (2010), “Macroeconomic Effects of Greater Competition in the Service Sector: the Case of Italy”, Macroeconomic Dynamics, 14(05): 677–708.
Høj, J, M Jimenez, M Maher, G Nicoletti, and M Wise (2007), “Product Market Competition in the OECD Countries: Taking Stock and Moving Forward”, OECD Economics Department Working Papers, No. 575.
IMF (2007), Italy: 2006 Article IV Consultation, Country Report No. 07/64.
Pesenti, P (2008), “The Global Economic Model: Theoretical Framework”, IMF Staff Papers, 55(2): 243–84.
1 The estimated level of mark-ups are taken from an OECD study by Høj et al (2007). In particular, their Table 1 reports the Lerner index ([P-AC]/P) – where P is price and AC in the average cost – for each industry and country. We converted the Lerner index into a measure of price mark-up over average cost (P/AC), obtaining a mark-up of 61% in the Italian services sector and 35% in the Eurozone. Similar results are obtained by Christopoulou and Vermeulen (2008), with reference to Eurozone countries, and by Bassanetti et al (2010) for Italy. Although all point estimates of mark-ups should be treated with caution, our results depend on the Italian-Eurozone differential more than on the levels of the mark-ups.