PhD news. Microeconomic effects of competition on productivity in the EU

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1 PhD news 83 PhD news Microeconomic effects of competition on productivity in the EU Priit Vahter PhD thesis was defended at the School of Economics of the University of Nottingham, UK Supervisors: Prof. Daniel Bernhofen, Prof. David Greenaway Date of viva voce (i.e. PhD defence): 18 February 2010, Nottingham, UK It is well known by now that large differences exist in productivity, other performance indicators, and output prices across firms even within narrowly defined sectors and markets. For example, Griliches and Mairesse (1995) and Bartelsman and Doms (2000) have already shown evidence of large persistent productivity dispersion across firms within detailed single sectors. Roberts and Supina (1997), Sorensen (2000) and Baye et al. (2004) show similarly large output price dispersion even for rather homogeneous goods. During recent years, and largely due to better accessibility of detailed micro datasets, there has been an increasing interest to explain these variations. Differences in the toughness of competition are likely to be one of the major determinants of the large dispersion in productivity, costs and output prices across firms within narrowly defined sectors and geographical markets. This dissertation examines how increase in the intensity of various types of international competition affects productivity and other performance measures: at firm, industry, and geographical market levels. The dissertation combines three empirical studies of three distinct types of changes in the competition environment. The first empirical study investigates the effects of changes in foreign competition in the form of entry of multinational firms on total factor productivity growth, innovation and the intensity of knowledge-sourcing by incumbent firms. The analysis is based on firm-level panel data from Estonia. I use an instrumental variables approach to identify the effects of entry. Notably, I find no significant short-term effects on productivity growth of incumbents. However, I find that the entry of multinational firms is associated with increase in innovation activities of incumbents and knowledge sourcing from other firms. Thus, FDI is likely to have significant longer-term effects on incumbents than one might expect based on the standard contemporary approach of the literature that concentrates only on short-term effects on total factor productivity. The second empirical study investigates the effects of entry and market structure on output price distribution across firms within spatially differentiated markets. Recent heterogeneousproducer models of competition in IO and trade theory (e.g. Melitz and Ottaviano 2008) outline how tougher competition affects across-firm price, productivity and cost distributions

2 84 Baltic Journal of Economics 10(2) (2010) in the same sector and market. This chapter tests the implications of these models based on a case study of the European airline sector and a unique airfare dataset. I find confirmation to the prediction from theory that in more competitive environments, there will be less output price dispersion across a firm. I.e. competition affects not only the average airfare on a regional market but also has richer implications concerning price dispersion and upper-bound prices on a market. The third essay studies the effects of liberalisation and changes in entry costs on performance of the aviation sector. The standard problem in studies about the effects of a liberalisation event is how to construct a suitable proxy for the counterfactual case if no deregulation took place? I use an event study of the enlargement of the European Union (EU) and the Single European Aviation Market in 2004 and employ difference-in-differences and its recent extension - synthetic control method - to study their effects on volume of output of the passenger aviation sector. By employing the synthetic control method of Abadie, Diamond and Heinmüller (2009), I attempt to construct a proxy of the counterfactual case with no liberalisation and quantify the effects of Single Aviation Market.

3 PhD news 85 Implementation of labour market regulating factors for promoting entrepreneurship development in Latvia Ieva Brence The public defence of the dissertation took place at the Faculty of Economics and Management of University of Latvia on June 28th, 2010 in Aspazijas blvd. 5, Riga The dissertation is available at the Library of the University of Latvia, Kalpaka blvd. 4, Riga A full electronic version of the dissertation is available at: An important condition for economic growth and welfare increase is development of entrepreneurship and its environment. This involves many factors including those of labour market regulation. Analysis of the labour market and related factors are of special importance in Latvia, taking into account the comparatively small funding with resources of the country. Thus an essential aspect for entrepreneurship development is accessible labour force potential. This is to a great extent controlled by the frame of labour market regulating factors. The relationship between entrepreneurship and labour market regulating factors is indisputable, especially within Europe, where the labour market has traditionally been one of the most regulated economic spheres both in legislative and administrative fields - as is the sphere of collective agreements, as well as involvement of social partners. The aim of this dissertation was to investigate theoretical aspects of labour market regulation factors and their relation to entrepreneurship, to analyse Latvian and foreign experience in applying labour market regulation factors that promote entrepreneurship development and, based on that analysis, to elaborate suggestions for developing the entrepreneurship environment in Latvia. The first part of the dissertation was theoretical. Analysis of the conceptual bases of labour market flexibility and labour market regulation factors and their influence on entrepreneurship development was included, by providing more detailed analysis of minimum wage, parttime employment, and active and passive labour market policy conditions. The second part of the dissertation was devoted to evaluating entrepreneurship development and labour market regulation aspects in Latvia. In the frame of the third part, the author provided analysis on the following countries - Ireland, the Netherlands and Sweden - concentrating on their experience in combating economic slowdown and promoting entrepreneurship development. The fourth part of the dissertation was related to analysis of measures for improving entrepreneurship and labour market performance in Latvia, by assessing possibilities for minimum wage increase and differentiation based on inhabitants age, increase of part-time employment, as well as the state s need for involvement in coordinating entrepreneurship and labour market regulation factors.

4 86 Baltic Journal of Economics 10(2) (2010) Findings from the dissertation may be considered in cases where an organisation is subject to financial problems but would be interested in keeping its employees in the frame of the dissertation, analysis is provided of possibilities to introduce part-time work in enterprises, as well as several other aspects related to labour market regulation.

5 PhD news 87 Econometric estimation of the impact of the Latvian real estate market on the state economy Kristīne Vītola The promotion paper was defended at an open meeting of the Promotion Council of Economics of the University of Latvia on 7 th of September, The promotion paper is available at the Central Library of the University of Latvia at 4 Kalpaka Blvd, Riga. A full electronic version of the dissertation is available at: The aim of this promotion paper is to study the role of real estate as an asset in the transmission mechanism of Latvia s monetary policy and by means of econometric models to estimate the impact of financial frictions, real estate prices and country risk premium on Latvia s macroeconomic indicators. The first chapter of the promotion paper covers the theoretical basis of interaction between real estate and economic growth. The role of housing as an asset in monetary transmission is studied and monetary policy response to housing price developments in various central banks is analyzed. The second chapter deals with developments in the Latvian market of standard type apartments along with lending and capacity to pay. Using the logit model, key factors that affected decisions to take mortgage loans in a period of rapid mortgage lending growth are identified and solvent demand for housing purchase is estimated. In the third chapter, the vector autoregression (VAR) model and unrestricted vector error correction (VEC) model for Latvia are estimated, the long-term relationship between housing prices and loans is obtained, and housing price deviations from the long-term relationship and speed of housing price adjustment are determined. In order to identify determinants of housing stock growth in Latvia, the housing investment model with fundamentals is estimated. In the fourth chapter, the dynamic stochastic general equilibrium (DSGE) model with real estate prices, country risk premium and financial frictions for Latvia is developed and estimated by a Bayesian approach. Within the framework of the estimated model, impulse responses of endogenous variables to exogenous shocks foreign monetary, country risk premium, credit, real estate prices, productivity and terms of trade shocks are simulated and the role of financial frictions and country risk premium in Latvia s monetary transmission asset channel is evaluated. Within the scope of empirical analysis performed in the promotion paper, the results of the logit model imply that a decision to take a mortgage loan depends on whether a person is employed or not, on the living area and income per member of the household. Furthermore, living area per member of household may affect a decision to take a loan provided that the person has sufficient income. VAR model results provide evidence that housing price growth

6 88 Baltic Journal of Economics 10(2) (2010) was largely driven by credit growth, whereas the VEC model confirms a long term relationship between housing prices and loans. The housing investment model with fundamentals leads to the conclusion that housing price-to-rent ratio determined increasing housing stock, whereas housing prices were significantly driven by accession to the European Union. In the framework of the DSGE model, the effect of foreign interest rates and country risk premium growth on decreasing household consumption, credit, demand and prices of the real estate, and nonfinancial investment was proved. The model also confirms pronounced decrease of firms debt, consumption and demand for real estate in response to increasing foreign interest rates and housing prices under higher firms loan-to-value ratio. The models tested in the promotion paper are important tools for monetary policy formation and analysis of the monetary transmission mechanism of the Bank of Latvia; they are also valuable for the government to estimate the effect of monetary, country risk premium, real estate prices, terms of trade and productivity shocks on macro variables; for commercial banks in credit policy development; for the Financial and Capital Market Commission in order to define criteria for loans issued by commercial banks. Finally, suggestions for further development of the DSGE model in order to apply the model for forecasting, as well as fiscal and monetary policy analysis, are provided.

7 PhD news 89 Welfare effects of regional policy in the constructed capital model Egle Tafenau The public defense of the dissertation took place on March 22, 2010 at the University of Tartu, Faculty of Economics and Business Administration The full version of the dissertation is available at: Regional issues have recently received considerable attention from economists, especially in the case of the EU where regional inequalities are expected to increase in the course of deepening integration. Since the mid-1990s, discussion of the effects and tools of regional policy often relies on models of new economic geography (NEG), which also predict an increase of regional disparities in response to decreases in trade costs. However, until now explicit regional policies with taxes and subsidies have not received much attention in the NEG literature. This dissertation evaluates the desirability of regional policies from the viewpoint of society as a whole based on the constructed capital model with asymmetric regions. To achieve the aim, first the main types of NEG models and their extensions are introduced to discuss the applicability of those models to practically relevant policy analysis. The general validity of those models has been questioned due to their specific assumptions and reliance on numerical analysis. However, since the first paper in the field by Paul Krugman (1991) several forms of underlying utility, production and cost functions, different assumptions about the mobility of production factors and the structure of trade costs have been implemented. Though some of the amendments (especially if a good is not tradable) reverse changes in the patterns of spatial distribution of economic activity that occur in the course of diminishing trade costs, the main conclusion stays the same: initially identical regions may develop to have very different industrial structures. In addition, the empirical literature shows that real world patterns of location of economic activity and their changes are consistent with the predictions of NEG models. Therefore, it is concluded in the first chapter of the dissertation that NEG models are suitable for analysing policy questions that are relevant in practice. The second chapter questions the necessity for government intervention in the case of NEG models. In the theory of public economics, government functions are restricted to correcting market failures, reducing income inequality and providing macroeconomic stability. Regional policy can be justified on all grounds, but in practice equity and efficiency considerations dominate. Both of these arguments are applicable in the NEG context. On the one hand, if one region hosts more than a half of economic activities, prices are lower and thus real wages are higher there than in another region, giving rise to regional inequalities. On the other hand, economic agents do not take into account the effects on others in their location decisions,

8 90 Baltic Journal of Economics 10(2) (2010) causing pecuniary externalities. Therefore, market equilibrium might be inefficient. In the NEG literature the desirability of spatial distribution of economic activity is achieved as market equilibrium is analysed mostly by relying on the utilitarian welfare function. These contributions show that economic activity can be over- or under-agglomerated, depending on the underlying model and the level of trade costs. However, policy tools for achieving welfare improvement have not been much analysed in the context of NEG models. Changes in social welfare are mostly considered in response to changes in trade costs without a resource requirement for reducing trade costs. There is also a broad literature on tax competition based on NEG models but only a few contributions that consider an explicit regional policy whose implementation is financed by levying taxes. In this line the most relevant analysis for the dissertation is Dupont and Martin (2006). In the third chapter a tax-subsidy and a location permits policy is analysed relying on the asymmetric constructed capital model due to Baldwin (1999). In this model, production factors are immobile but capital can depreciate and is replaced only if the present value of its expected return covers at least its production costs. The model has the advantage of being analytically tractable in its basic form, but welfare analysis with taxes and subsidies has to be done numerically. Final consumption expenditures are assumed to be taxed in each region at an identical rate and tax revenues are used to subsidise capital in a small (poor) or large (rich) region. Tax-subsidy policy has a higher potential for welfare improvements than location permits policy as total capital stock increases in response to that while location permits are, rather, pure redistribution. Three welfare concepts are used for the analysis. First, no pure Pareto improvement can be achieved in the asymmetric constructed capital model either in case of location permits or with tax-subsidy policy. Second, according to the utilitarian social welfare function it might be rather advisable to subsidise the large region or to permit more firms to locate in the large region as the size effect of the region dominates. However, if a social welfare function with a large weight on equity is chosen, economic activity in the small region should be supported. The third tool of analysis, the compensated Pareto criterion, reveals that a potential Pareto improvement is achievable even if the small region is subsidised. This analysis reveals that only tax-subsidy policy can lead to welfare improvement, while in case of location permits policy the market solution should be preferred. Thus, the social desirability of these simple policy measures depends on the underlying welfare concept so that caution is needed when regional policies are implemented. Literature Baldwin, R. E. (1999), Agglomeration and endogenous capital, European Economic Review 43(2), Dupont, V. and Martin, P. (2006), Subsidies to poor regions and inequalities: some unpleasant arithmetic, Journal of Economic Geography 6(2), Krugman, P. R. (1991), Increasing returns and economic geography, Journal of Political Economy 99(3),

9 PhD news 91 Interest rate influence on the behavior of economic subjects Danel Tuusis The public defense of the dissertation took place on October 22, 2010 at the University of Tartu, Faculty of Economics and Business Administration The dissertation is available in Library of University of Tartu and electronically at: dspace.utlib.ee/dspace/bitstream/10062/15318/1/tuusis_danel.pdf This dissertation studies interest rate influence on the be ha viour of economic subjects companies and private persons analyzing in detail the motivations behind those different behavioural aspects, and discusses the results of analysis in the efficiency context of different channels of monetary transmission mechanisms. Whereas different activities of economic subjects exert different influences on overall economic activity, the most influential activities of economic subjects were chosen for detailed study. Those influential activities are the research tasks of the dissertation and are presented in three distinct empirical studies of the dissertation. The first research task is to find determinants of borrowing behaviour of private persons in Estonia and to evaluate interest rate influence on it. For this analysis 324 private persons all over Estonia were interviewed covering different age groups, occupational status, educational background, income levels etc. The study shows that most influential determinants of borrowing activity are related to consumption motives, whereas interest rates play a rather modest role in determining borrowing activity. Additionally, respondents consumption and borrowing habits showed high immunity to external factors, including interest rates. Whereas knowledge of financial matters among respondents was relatively good, the findings cannot be explained by poor knowledge or low education. These findings show the intertemporal behaviour of private persons differently from forward looking theories of consumption and would question the application of these models without proper explanation. The study also included behaviour of risk-group people where the determinants of risk groups are analysed. The study findings show that risk-group respondents do not differ from the total sample group by any general characteristics (age, sex, income, nationality, occupation status) but rather by attitudes and overall financial behaviour. The second research task is to find determinants of investment activity of Estonian companies. For this, a questionnaire was composed and sent to the 200 biggest non-financial Estonian companies, of which 22% replied. The first group of conclusions relates to the importance of factors influencing the investment decisions of companies. The most important group of factors influencing investment decisions includes uncertainty and risk factors. Within the study, the source of the risks and uncertainty was not specified, but based on analysis of different multiple choices used in the questionnaires; those risks are related to the investment project, rather than the failure risk of a company or the overall economy. The second group

10 92 Baltic Journal of Economics 10(2) (2010) of factors important for investment management includes liquidity factors; the third group includes business confidence determinants. The importance of the cost of capital determinants, according to our study, is rather low. Moreover, use of the cost of capital concept seems rather unpopular within the sample group of companies. As the study shows, companies would consider interest rate risks through direct influence on their financial costs and profitability rather than through the cost of capital on their shareholders value. The third research task is to investigate price setting motives and mecha nisms in companies, and analyze the influence of interest rates on pricing. In the focus of the study is implementation of the cost-plus pricing method as the most popular pricing method within SMEs. The study has been built up on case-study analysis of five companies in a highly competitive environment. The first findings of the study indicate that the cost-plus pricing method is more sophisticated than presented in a number of previous studies. First, many companies (even those with less than 10 employees) use two-level price management, where some pricing decisions are made rather often (to follow flexible raw material prices, etc.), and these decisions are dominantly based on the cost-plus method. Besides quick pricing, another part of pricing decisions are made more seldom, and are mainly not based on the cost-plus method. Therefore companies that predominantly use the cost-plus method, doing daily or weekly quick pricing decisions, might still be very concerned about competition and the overall response of customers. Second, the costs used in pricing consideration of cost-plus pricing are strongly discriminated. The basis for cost discrimination is their relative importance to the final price and their direct or indirect nature to companies products or services. Therefore, costs which might be rather significant in the overall cost structure might still have rather weak (or missing) influence on final prices, even if a company uses cost-plus pricing principles. Different to previous studies, which explain the different usage of cost-plus pricing in different industries, the current study stresses the importance of the nature of costs. Cost discrimination on implementation of the cost-plus pricing method would explain the declining importance of exchange rate influence in determining inflation discovered from several authors. There is a strong impact of the raw-material type of costs on prices in the early stages of development, whereas in a country where the value-added industries dominate the economy, this would obviously decrease the efficiency of the exchange rate channel (reducing exchange rate influence on inflation). In the concluding part of the dissertation, interest rate influence on the behaviour of economic subjects is discussed besides their possible influence on monetary transmission mechanisms. Based on the previously described studies, the financial behaviour of households would indicate the significance of the direct monetary transmission channel and exchange rate channel as well as the risk-taking channel on the monetary transmission mechanism. On behaviour of companies, the exchange rate channel, balance sheet channel and risk-taking channel are significant channels for the monetary transmission mechanism. Therefore, the most quoted traditional interest rate channel is rather insignificant transmitting monetary policy to economic subjects in Estonia. In the concluding part of the dissertation, these findings are discussed in more detail.

11 PhD news 93 Alignment between factors of the innovation process and public sector innovation support measures: an analysis of Estonian dairy processors and biotechnology enterprises Dorel Tamm The defense took place on December in University of Tartu, Faculty of Economics and Business Administration. Thesis is available electronically at: The majority of countries attempt to support the innovativeness of their firms because innovativeness is seen as the most important component of competitiveness. Also, firms are interested in being innovative because successful innovative projects are usually linked to increases in profits and/or other indicators describing the economic success of the enterprise. To support innovations in enterprises the government could implement public sector innovation support measures targeting the most important problems in the innovation process. Often, implementation of public sector innovation support measures is inefficient. To increase the efficiency of innovation support measures, every country has to identify the barriers or problematic stages of the innovation process for enterprises in that specific country and design innovation support measures accordingly. In other words, there has to be alignment between factors influencing the innovation process and innovation policy measures. Without such alignment, resources may be wasted and the efficiency of the innovation policy measures lower than expected. The implementation of support measures and possible inefficiencies in them are evaluated rather often. In Estonia, the most recent evaluation was conducted by the National Audit Office of Estonia, and the results of that report were very critical of Estonian support measures. In this thesis, the (in)efficiency of innovation support measures was evaluated on the basis of the alignment concept. The aim of the thesis was to provide suggestions on how to increase the efficiency of public sector innovation support measures based on the results of alignment analysis. To implement the alignment analysis, the author had to develop instruments to do so. Alignment analysis was based on a comparison between the factors of the innovation process in one specific sector and specific country, and innovation support measures implemented in that specific country. The analysis revealed the areas where factors of the innovation process causing problems for enterprises were not targeted by innovation support measures, so, misalignment existed. The findings were used to develop suggestions for dairy processors, biotechnology enterprises and Estonian policy makers on how to increase the efficiency of public sector innovation support measures. Dairy processors and biotechnology enterprises were chosen because of the differences and similarities existing between them.

12 94 Baltic Journal of Economics 10(2) (2010) Dairy processors have been classified as belonging to a traditional manufacturing industry and biotech enterprises represent high-tech enabling technology. At the same time they are interlinked and some cooperation takes place between those two areas in Estonia. This enabled a study of alignment based on two rather different economic activities, which at the same time are interlinked. Analysis of the alignment between factors influencing the innovation process in dairy processors and biotech enterprises, on the one hand, and Estonian innovation support measures, on the other, disclosed no big differences across the two groups of enterprises on a general level. A more detailed analysis revealed existing differences. Problems causing misalignment for dairy processors were linked to issues connected to entering the Russian market and limitations related to enterprise size while applying for support from different innovation support measures. Misalignment for biotechnology enterprises was linked to regulations implemented in the EU and the weak VC market. Many similar problems also existed across groups of enterprises. To make the support system more efficient and find ways to support better Estonian dairy and biotech enterprises, public sector employees have to gain more experience working within the legal framework put forward by the EU, and find ways to apply for special conditions if needed by Estonian enterprises. It is also important to understand that a national innovation system has to exist for enterprises and research institutions but not for public sector organizations. Enterprises should conduct innovation and develop innovation strategies more systematically and formally. This will help to create some stability in a changing internal and external environment.