Markups, productivity and external market development of the service SMEs

Abstract

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. On the other hand, firms with higher markups tend to develop their business in smaller markets, conditional of the 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. In addition, the markup levels become lower in those markets.

Keywords:

• productivity
• markup
• external market development
• service sector

JEL Classification:

• D24
• L11
• L25

Acknowledgements

Martin, R. provided us with technical advice on our research programme. We thank the Ministry of Economy, Trade and Industry for providing access to the data used in this research. We also thank participants at the RIETI DP seminar, and at Eco-Ena third annual conference.

Notes

¹ In Japan, the service sector accounts for 72.6% to GDP in 2009.

² As a more recent study, Kruger and Verhoogen (2014) incorporated endogenous choice of input and output quality into the Melitz model and discussed correlations between prices and export status as well as those between plant sizes and wages, using the Colombian manufacturing data.

³ Kato (2010) discuss the service sector, but internationalization is examined only as difference in performances between domestic and foreign firms.

⁴ Dalian in China and Bangalore in India are the centres of international ITO and BPO.

⁵ Each of these characteristics is not always satisfied in all services.

⁶ Our estimation implicitly assumes that the price of each input is identical across firms. Although this assumption is very restrictive and ad hoc, Eslava et al. (2005) reveals that ignoring input prices give little effects on productivity estimation using Columbian data.

⁷ This assumption on capital is largely applied to empirics of productivity analysis because it takes time to activate the invested capital in production.

⁸ Without this assumption, it is impossible to estimate both productivity and markup simultaneously.

⁹ Some empirical studies, i.e. Kato (2012) rejected the assumption of the constant returns to scale in the service sector.

¹⁰ To control exit probability, we also use BSSME in 2008. We assume that the firms exited from the markets if we find them in 2007 BSSME but not in 2008. Thus, the firms that refused to answer to this survey are also considered as exited firms, and our exit probability can be overestimated.

¹¹ The data of working hours are available from Monthly Labour Survey.

¹² The service sector is also characterized by intangibility and heterogeneity of products.

¹³ This is a brief analysis because we need to discuss such simultaneity from both demand and production functions for detailed investigation.

¹⁴ Simultaneity seems to largely be satisfied in the retail trade industry but not in the ICT industry.

¹⁵ McKinsey Global Institute (2000).