Product Market Competition, Efficiency and Agency Costs: an Empirical Analysis

Policy makers in Europe have been concerned that lack of product market competition have led productivity to lag behind the US. Theoretical models are ambiguous about the direction of the effect that product market competition should have on productivity. On the one hand increasing competition lowers firm’s profits and thus reduces incentives to exert effort (the Schumpeterian effect), on the other hand it reduces agency costs (or increases the risk of bankruptcy ) thus increasing incentives to exert effort. This paper uses panel data on UK establishments over the period 1980-1996 to investigate the relationship between product market competition and productivity levels and growth rates. The introduction of the European Union Single Market Programme (SMP) is used as an instrument for the change in product market competition. The SMP was ex ante expected to affect competition in some industries but not others. It is shown that the Lerner Index fell in the affected industries after the SMP by more than in the nonaffected. The results suggest that the increase in product market competition brought about by SMP led to an increase in overall levels of efficiency and growth rates. The sample of firms is then split into those with a principal-agent set up and those without. The increase in efficiency occurred in principal-agent type firms, and not in those where managerial control and ownership were more closely related. These results suggest that product market competition can play an important role in reducing agency costs and may explain some of the poor performance of European economies. JEL: D2, D43, C33 Acknowledgements: The author would like to thank James Banks, Richard Blundell, Ken Corts, Julie Holland Mortimer, Phillip Leslie, Costas Meghir, Helen Simpson, John Van Reenen and seminar participants at UC Berkeley, UCLA, Warwick and Bristol for many helpful comments and discussions. This work was funded by the ESRC Centre for Microeconomic Analysis of Fiscal Policy at the Institute for Fiscal Studies. This report has been produced under contract to ONS. All errors and omissions remain the responsibility of the author. Correspondence: [email protected]; 7 Ridgmount Street, London WC1E 7AE, UK.