Competitive, but too small - productivity and entry-exit determinants in European business services

The paper investigates whether scale effects, market structure, and regulation determine the poor productivity performance of the European business services industry. We apply parametric and nonparametric methods to estimate the productivity frontier and subsequently explain the distance of firms to the productivity frontier by market characteristics, entry- and exit dynamics and national regulation. The frontier is assessed using detailed industry data panel for 13 EU countries. Our estimates suggest that most scale advantages are exhausted after reaching a size of 20 employees. This scale inefficiency is persistent over time and points to weak competitive selection. Market and regulation characteristics explain the persistence of X-inefficiency (sub-optimal productivity relative to the industry frontier). More entry and exit are favourable for productivity performance, while higher market concentration works out negatively. Regulatory differences also appear to explain part of the business services' productivity performance. In particular regulation-caused exit and labour reallocation costs have significant and large negative impacts on the process of competitive selection and hence on productivity performance. Overall we find that the most efficient scale in business services is close to 20 employees and that scale inefficiencies show a hump-shape pattern with strong potential scale economies for the smallest firms and diseconomies of scale for the largest firms. 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.