Markups, Productivity, and External Market Development: An empirical analysis using SME data in the service industry

During the last decade, economists and policy makers have extensively discussed what types of firms can exploit external markets by exporting and what happens to domestic firms if external competitors penetrate into the home market. Although both theoretical and empirical studies have been dedicated to these issues, few have been carried out for the service sector. Since the service sector accounts for the lion's share of GDP, the lack of those studies indicates that a large part of the actual economy still remains veiled. Our study fills this gap. We examine whether or not the Melitz and Ottaviano (2008) model remains satisfied in the service sector, using data from Japanese SMEs. From our analysis, we confirm that larger market sizes are associated with higher productivity levels and lower markups. This finding also holds true for samples including firms that see simultaneity between production and consumption. These results reveal that further productivity growth in the service sector also requires markets to be larger and more integrated, and that the markup levels become lower in those markets.