Market Power, Productivity, and Innovation

Our study looks at link between competition, productivity & innovation in Germany.

Governments around the world are attempting to combat the effects of the Covid-19 pandemic and related measures with economic stimulus packages worth billions. The USD 2 trillion stimulus package is the largest in American history.

The European Commission has put forward a proposal for a 750 billion Euro recovery plan for its member states. After the unavoidable economic slump this year, governments aim to revive economies as quickly as possible with the help of massive stimulus packages.

Whether this so-called V-shaped scenario will occur depends on many unknowns. One of these unknowns is whether the pandemic is limited to cyclical effects or whether it will also lead to profound changes in the structure of the economy.

The longer the pandemic lasts, the greater the risk of profound changes. Small and medium-sized enterprises, in particular, are increasingly running out of financial reserves. If these disappear from the markets, there is a risk that concentration tendencies that are already apparent will intensify. In our new study, we have examined the consequences this can have for Germany.

We have recorded the development of market power for about 12,000 German companies in the years 2007-2016. We wanted to know to what extent market power can explain a widespread phenomenon that has been recorded in many industrialized countries for years: the declining productivity growth. In our study, we examine the role of the competitive environment for productivity development at the firm and sector level in Germany.

Economic theory views competition as an important driver of productivity growth. First, competition leads to companies using their resources as efficiently as possible, for fear of being overtaken by their competitors. Second, competition induces resources in the market to move from unproductive to productive firms.

A third channel works indirectly through innovation. Although competition has been viewed as having an ambiguous effect on innovation, it is now mainly seen as an important driver of innovation, which, in turn, is an important driver for the productivity in companies.

Recently, arguments that see a positive correlation between market power and productivity have also gained traction with the advent of the “superstars hypothesis.”

It argues that the increase in market concentration is precisely the result of high productivity (Autor et al., 2020), as the most productive and innovative companies (i.e., the “superstars”) prevail in competitiveness and increasingly gain market share.

Market power in Germany in line with the European average

In Germany, we have not yet identified any significant market concentration trends. Market power has increased only moderately across companies and sectors. The markups are around 30-45 percent. This is in line with the average estimates for Europe (Weche and Wambach, 2018) and are rather moderate by international comparison (see also De Loecker and Eeckhout, 2018).

At the end of the observation period, we see a somewhat steeper increase in market power, as Figure 1 shows. But still, markups are well below the estimate for the USA. There, De Loecker et al. (2020) estimate markups in the order of more than 60 percent.

• Figure 1:

Across sectors, we don’t find conclusive evidence of an intensification of market power trends. Markups are relatively even across the entire company distribution. We don’t find that some companies (e.g., large ones) are outperforming their competitors. Companies across the entire distribution have been able to increase their markups since the financial crisis – the whole distribution in Figure 2 shifts to the right. This is consistent with studies for other European countries.

Van Heuvelen et al. (2019) show that the average (weighted) markup in the Netherlands has not risen in over 11 years, and Aguda, Hwang and Savagar (2019) show that concentration is flat to modestly increasing in aggregate in the U.K. since 1998.

The picture is different in the USA again. There, studies show that corporate concentration has increased in 75 percent of all economic sectors since 2000 (Grullon et al., 2019). Also, the increase in average markups from 21 percent in 1980 to over 60 percent in 2016 is also seen as contributing to a decline in the level of competition (De Loecker et al., 2020).

• Figure 2:

Competition drives productivity in Germany

As a next step, we examine the influence of markups on firms’ productivity development. As productivity indicators, we use labor productivity and total factor productivity (TFP). The latter is usually interpreted as the technological efficiency of production. We find a significant negative effect of price markups on the productivity of a company and for the economy as a whole.

An increase in markups by one percent leads to a reduction in labor productivity by about 1.3 percent and a reduction in TFP by about 1.5 percent. The negative correlation is even more pronounced in the manufacturing and trade sectors. In the latter, TFP falls by about 4.2 percent.

Things are different in the German service sector, though. Here our estimates point to a weak positive effect of markups on firm productivity. This might be in line with the “superstar-hypothesis” Autor et al. (2020) put forward for the U.S. economy. The service sector in our dataset is very heterogeneous, though, and more empirical evidence is needed to make more accurate statements on this sector.

Competition leads to more innovation

Last, we explore the role of innovation. For the economy as a whole, an increase in markups by one percent leads to a decrease in innovation expenditure by 1.7 percent. The effect is strongest in the manufacturing sector, where innovation expenditure falls by 3.7 percent. In the service sector, the negative effect is about half as large. This means that weaker competition leads to companies investing less in innovation activities, which has a negative impact on productivity.

In our sample, the estimated elasticities are between 0.05 and 0.08. For example, an increase in innovation expenditure by one percent leads to an overall increase in TFP of about 0.06 percent. This is in line with what other studies find for Germany and other countries (see Peters et al., 2018).

Conclusion

According to our study, average price markups in Germany across all industries are at 30-45 percent, lower than in the United States, but in line with other estimates for Europe. In our sample, markups exhibited a slight positive trend. In contrast, in study results for the USA, we see an increase in price markups across the entire firm-level distribution – not solely a further increase in markups by firms that already exhibit relatively high markups.

We conclude that competition is an important driver of innovation activities. This relationship is particularly strong in both the manufacturing and service sectors. In the latter sector, we find in total ambiguous effects of competition on productivity development. Much is in motion here, and more empirical research is needed to develop guidelines for wise competition policy in this sector.

Download the full study here.