6  Transactions and governance

Institutions governing product markets and corporate governance influence the nature of the markets in which firms buy and sell products.

6.1  Product markets

Product market institutions will influence the establishment of firms by shaping the markets within which firms operate. As such, they determine the scope for transactions to take place and the gains that firms can expect to achieve in return for meeting transaction costs. Product market institutions determine who can establish firms and how this must be done. The regulations include processes related to entry to and exit from markets (e.g., procedures required to start a business and processes for filing for bankruptcy), restrictions on firms from entering particular markets (e.g., restricted numbers of licences or permits to operate, border controls) and operational requirements on firms (e.g., price setting controls).

Product market regulations affect firm productivity by influencing the level of competition in product markets and therefore the pressure to be efficient and innovative. Product market regulations that protect firms from competition encourage inefficient businesses practices as firm survival is not immediately threatened by inefficiency (OECD 2002). This allows for a suboptimal use of factor inputs and affects incentives to innovate and adopt efficient production techniques.

Product market institutions also affect industry productivity by determining the makeup of an industry or the market share of market participants. These institutions increase productivity where they encourage greater participation by productive firms and less by firms that are not as productive.

6.1.1  Resource allocation

Regulations that restrict entry into a market or limit the number of firms that can operate will reduce the number of employers in an industry. Restrictive product market regulation decreases employment as there are fewer firms to hire workers, which strengthens the incentives on incumbent workers to seek protection of their jobs (Koeniger and Vindigni 2003).

Cross-market influences in labour markets can be generated by uncompetitive institutions operating in product markets. Without competition, firms are able to set prices rather than being subject to the price set by the market. There is less pressure to be cost efficient in production as excess costs can be passed on to consumers. Market restrictions enable firms to appropriate excessive profits and workers within the firm will seek a share of these profits. Nickell and Layard (1999) note that union wage mark-ups are higher in firms with greater market power. Unions are able to secure a portion of the higher rents achieved by firms protected by product market restrictions.

Inefficiencies in resource allocation created by uncompetitive markets may be exacerbated by any inefficiencies that arise as a result of labour market institutions. Firms will have less flexibility over the use of labour and, facing little pressure to control prices, can pass any associated costs on to consumers.

6.1.2  Innovation and human capital

Product market institutions have implications for the innovation potential of firms and the economy. Where they generate markets with low levels of competition, there is little pressure to innovate to secure greater market share and therefore little incentive to invest in human capital as a source of or complement to innovation.

Even where product market institutions in general create a competitive environment, individual institutions can undermine innovative activity. For example, the absence of bankruptcy laws can reduce investments as such laws limit the risks faced by individual investors. Scarpetta et al (2002) suggest the contribution that product market regulations make to innovation and technology adoption depends on the conditions they create for the birth and expansion of innovating firms as well as for the exit of obsolete ones. Restrictions on market entry and exit undermine innovation because they inhibit the dynamism of a market. Border controls can have a similar effect to domestic market controls in terms of market dynamism. International competition brings further pressure to innovate as well as exposure to new knowledge and technologies.

New firms often bring new ideas and technology and more efficient processes to the market. The effect of regulations on entry are especially important for productivity in industries where technology is rapidly evolving, such as information and communication technology (ICT) industries or industries that are characterised by high adoption of this technology (OECD 2002). New entrants to these industries play an important role in introducing new vintages of technology. Incumbents usually have a higher opportunity cost of adopting potentially superior technologies as the knowledge acquired to master the old technology is only partially transferable to the new technology (Bassanini and Ernst 2002).

Product market regulations also include the regulation and protection of intellectual property rights. Clear specification and strong enforcement of intellectual property rights support the appropriation of intellectual property by those generating it and thus encourage firms to innovate. If innovations are not appropriable there is little incentive to engage in innovative activities. However, to maximise innovation, intellectual property rights need to balance appropriation of benefits by the firms that generated the innovation with the possibilities that will arise from applying it to new technology.

Where a firm’s rents are protected by restrictive product market regulations such as restrictions on entry to markets, they will not be driven to innovate even with protection of their intellectual property rights (Bassanini and Ernst 2002). The rents the firms would receive from engaging in innovation activities would not be significantly greater than those they would receive without the innovation.

6.1.3  New Zealand product market institutions

New Zealand has substantially reformed its product market institutions. The government now plays much less of a role in regulating product markets than it has in the past, having reduced tariffs and done away with many interventions like subsidies, import licences and price controls.[19] Market regulations now aim to support competition and efficiency in market operations.

Nicoletti, Scarpetta and Boylaud (1999) included New Zealand among the five countries with the least restrictive product market regulatory environments in the OECD, as shown in Figure 5.

Figure 5 – Restrictiveness of product market regulations

Source: OECD

Gwartney and Lawson (2004) rate New Zealand 5^th overall in the Economic Freedom of the World index in terms of the economic freedom provided in product markets. This includes a ranking of 1^st in terms of price controls (or lack thereof). IMD International (2004) ranks New Zealand 1st in the World Competitiveness Yearbook in terms of price controls, protectionism and subsidies not affecting economic activity.

McMillan (2004) notes that the costs of starting up a business in New Zealand are among the lowest in the world and the procedures for registering new firms are streamlined. IMD International (2004) ranks New Zealand 2^nd for the number of days taken to start a business. The World Bank (2004) notes that it is relatively easy to open or close a business in New Zealand compared to other countries, with a system that is efficient and characterised by low costs and low complexity. It also notes that New Zealand’s insolvency system is very efficient and requires no court involvement.