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Enterprise and Productivity: Harnessing Competitive Forces - TPRP 08/04

The policy framework: still room to improve?

The base of a healthy business environment is the macroeconomic stability that provides certainty for investment. A period of continuous growth and low, stable inflation gives the certainty that the expected returns of an investment will not be eroded by falling demand or high inflation.

Competitive forces demand continued improvements in firm performance

Beyond this, a competitive environment creates the incentives for entrepreneurial action by introducing the rigour of the market. The potential for new entrants into the product market encourages producers to supply what consumers demand at the lowest prices so that labour and capital resources are allocated to their most efficient uses. It encourages high productivity new entrants to a market and displaces low productivity firms that are unable to compete. It acts as a spur to innovation as firms seek greater market share and profits.

Product market and capital market competition create the incentives to improve performance…

Both product market competition and competition for corporate control are important in delivering greater firm performance. The threat of foreign or domestic takeover bids and the need to access capital markets for sources of funds impose constraints on managerial discretion and focus efforts on activities that create the greatest returns. Bloom et al (2007) find that firms with a widely held ownership structure have superior management practices than firms with narrow ownership such as family owned firms.

Overall, product markets work well and New Zealand has in place well-designed laws and institutions that provide a solid framework to underpin competition and promote efficiency. On measures of competition focused on barriers to entry, New Zealand compares very favourably. The OECD (2005b) find that relative prices are low, product market regulation is not overly burdensome and the turnover of firms suggest a strong competitive environment. New Zealand is ranked 7th out of 24 OECD countries for the quality of product market and competition regulation, however Denmark, Iceland and Ireland have improved more rapidly and overtaken New Zealand in the rankings (Conway et al, 2005).[4]

Figure 5: Product market regulation and competition index, 2003
Figure 5:  Product market regulation and competition index, 2003.
Source: Conway et al (2005)
…but New Zealand’s size and distance may be protecting some firms from competition…

New Zealand does not compare favourably with other countries on traditional measures of competition such as industrial concentration. Evans and Hughes (2003) conclude that New Zealand generally has one of the highest industry concentrations. However, a small country would not be expected to perform exceptionally well on measures of industry concentration given that minimum efficient scale requirements for firms are likely to be large compared to the total market size. The threat of entry of a new firm may be sufficient to produce competitive outcomes even if only a few firms actually supply the market. However, it could be that the small domestic market helps to shelter some firms from competition. Ongoing consideration should be given to making sure that barriers to entry remain low in order to increase levels of competition.

The competitive framework for corporate control is strong and New Zealand is open to flows of foreign investment. In 2006, New Zealand ranked 56th in terms of Foreign Direct Investment out of 141 countries, up from 83rd in 2005 (UNCTAD, 2007). While New Zealand is in the middle of the FDI performance table, it has a large stock of FDI: as a percentage of GDP, the stock of FDI in New Zealand was higher than Australia, the UK and the United States in 2004 (OECD, 2007a).

…and some firms are sheltered from capital market competition

Despite this, a number of large firms may be operating from a position that is sheltered from competition for corporate control to varying degrees due to their individual circumstances. If some large firms do not need to compete in the capital market then a source of competitive pressure and incentives for managers to perform has been removed. These protections can diminish competition and reduce the incentives for managers to improve the performance of firms.

Given a healthy macroeconomic environment, underpinned by a robust competition framework, government policies can affect the flexibility and incentives for entrepreneurship to occur. While a number of policies affect these incentives, the tax, regulatory and industry policy settings are some of the more important determinants and the paper now discusses these in turn.

The regulatory system creates benefits and costs for society

Regulation has important uses that generate economic benefits…

Regulation is typically used to internalise externalities or manage asymmetries of information or power in order to increase market access and provide the business settings that allow firms to grow. In some cases, regulation is used to reduce transaction costs. Regulation can also be a powerful lever for achieving wider economic, social and environmental objectives.

The impact of regulation on the market flows through to the decisions of firms and individuals and the way the market operates. Regulation affects the availability of business opportunities, the costs of pursuing them, and the returns from doing so. This has direct and dynamic effects on firm productivity.

The quality of institutions is considered to be a central explanation of the differences in income and growth rates between countries. New Zealand today has a comprehensive set of regulatory laws and institutions typical of a modern, developed economy and is generally regarded as having low compliance costs and low barriers to enterprise. In some areas, however (for example, telecommunications and energy markets), regulations are relatively new, and as such, their performance may be expected to develop as both regulators and industry build experience.

There is a reasonably widespread view that the quantity of regulation in New Zealand has increased over the past decade. In part, this is likely to reflect an adjustment to the relatively light-handed approach to regulation introduced through the late 1980s and early 1990s. It is difficult to find good quantitative measures of changes in the stock of regulation over time. Pages of new legislation is sometimes cited, but this is a poor measure, failing to take account of the nature of legislation, its economic significance or the nature of any regulatory regime that the new legislation replaces.

…but growth in regulation also imposes costs on business

Therefore, the manner in which any increase in regulation affects the overall quality of the environment for business is less clear. However, it is expected that with increases in regulation, compliance costs will increase. While the compliance cost of a single piece of legislation may not be high, cumulative costs of regulation can reduce the returns to economic activity to a degree that it is no longer worthwhile undertaking the activity. Further, growth of regulation increases the administration and enforcement costs for the public sector and can take resources away from more productive uses.

The latest Business New Zealand and KPMG Compliance Cost Survey shows that environment-related compliance costs, including the Resource Management Act, local authority requirements, hazardous substances, border controls and bio security, comprised 19% of total compliance costs for business in 2007, up from 14% in 2006. Many respondents commented that recent changes to legislation and regulatory requirements had resulted in increased compliance costs. In addition to these costs, regulation also affects the choices firms make. If regulation is overly burdensome, businesses may choose not to comply or not to go ahead with a potentially profitable investment.

It is also important to consider the potential benefits of regulation. Regulation is used to pursue economic, social and environmental goals from which the community derives benefit. The challenge is to ensure that such regulation delivers the maximum net benefit to society. This will necessarily involve making trade-offs, for example a prescriptive regulation may impose greater compliance costs on businesses, but it may also provide greater certainty for both businesses and consumers, providing the necessary confidence to take advantage of market opportunities.

Gains in the quality of regulation will occur by taking a more strategic approach to regulation: ensuring that the right tools are used to achieve the desired outcomes. Good regulatory management begins with asking three critical questions:

Is there a genuine benefit to the community being generated from the imposition of regulation?

Do the benefits exceed the costs of regulating, including both direct compliance costs and indirect impacts on growth?

Is there another way of meeting the objectives of regulation that generates greater net benefits?

Improvements in the regulatory environment will come from systematically assessing the stock and flow of regulation…

Good regulatory management also requires that the regulatory environment improves over time and remains fit for purpose. This requires not only providing quality assurance on the flow of new regulation, but also systematically reviewing the existing stock of regulation. To effectively review existing regulation, the complexity of regulatory regimes needs to be understood, in particular the cumulative and lagged effects of regulation and any unintended consequences. High quality regulatory systems are of a quality that consistently generates regulation that benefits the overall economy, removes and updates regulation that fails to generate benefits and avoids regulating where it is not necessary or better options exist.

…focussing on areas of greatest economic benefit…

It is important to focus these efforts on the areas that offer the greatest benefits. There will need to be an ongoing focus on the key regulatory regimes that have a pervasive impact on the economy. In areas where institutions are underdeveloped, identifying and moving to best practice will better position the economy to take advantage of opportunities as they arise. Similarly, the best solutions for New Zealand may look different from how they look now in a world where productivity performance and growth rates are increasingly determined by the international competitiveness of our firms.

…and backed by effective implementation

Good regulatory design needs to be followed by effective implementation and review, and clear communication across government and business. In a small economy, capability is a key concern. It will take time for business and regulators to reach optimal levels of compliance and enforcement, for precedents to be set and for necessary improvements to be incorporated. A strategic approach to regulation would help identify valuable lessons for improving implementation capability.

Notes

  • [4]The index is comprised of measures of the degree of state ownership and control, barriers to entrepreneurship and barriers to trade and investment.
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