More Less
More Less
December 13, 2021

How do labor market institutions affect job creation and productivity growth?

Opinion image

Capitalism entails a process of creative destruction. New ideas continuously challenge old structures, giving rise to structural transformation as successful innovations and new products, firms, and industries arise, and obsolete ones decline and vanish. When observing the economy at a few points widely separated in time, it is obvious that massive structural change has taken place: from agriculture to manufacturing in the first half of the 1900s and from manufacturing to services in the last half century. From one year to the next this deep-seated structural change is rarely noticed. The economy typically grows by a few percent per year, but this has little to do with a structural shift from low- to high-productivity sectors. Nor is it primarily about firms growing by a similar percentage or productivity rising in existing jobs because of technological change and more capital per worker. 

Instead, most economic growth is the result of shifts in production from less to more successful firms within narrowly defined industries, rather than from declining to growing sectors. At each point in time firms exist with widely differing levels of productivity. Among firms offering virtually the same goods, the productivity of some firms may be less than half of the most productive firms. 

When inefficient firms fail or contract, workers and other resources can move to expanding firms or to newly started, more productive firms making new goods in new ways. Although this is a value-creating process, it is anything but smooth. For instance, in the US, aggregate annual job growth has been close to 2% since the mid-1970s, but this modest gain is the net result of a tumultuous process: on average, one in seven jobs have disappeared every year through closures and contractions, while slightly more jobs have been gained through expansions of existing firms and entry of new firms. Thus, the sum of lost and newly created jobs—the job reallocation rate—has amounted to more than 30% of the total number of jobs in the economy. Such churning is somewhat lower in other OECD countries, but it is much higher in the most productive of those countries. High-growth firms are the main drivers of this process. A small percentage of all firms account for the bulk of net job creation.

When considerable churning is necessary for high-productivity growth, dynamism and the flow of inputs to high-productivity firms become crucial. How can this process be facilitated? Policies should support portable job tenure rights and pension plans, health insurance decoupled from the current employer, decentralized and individualized wage-setting, and government income-insurance systems that encourage mobility and risk-taking. When such reforms are undertaken, they should be part of a comprehensive package that includes other areas, notably tax and competition policies. Nevertheless, some degree of job protection is still valuable since it encourages worker commitment and incentives to invest in firm-specific human capital. Policymakers need to know where to draw the line between protections that provide job stability and those that discourage high-growth firms.

© Magnus Henrekson

Read Magnus Henrekson's full World of Labor article, "How labor market institutions affect job creation and productivity growth."

Magnus Henrekson is professor of economics and a Senior Research Fellow at the Research Institute of Industrial Economics (IFN) in Stockholm, and a Research Fellow at IZA, Germany. 

Please note:
We recognize that IZA World of Labor articles may prompt discussion and possibly controversy. Opinion pieces, such as the one above, capture ideas and debates concisely, and anchor them with real-world examples. Opinions stated here do not necessarily reflect those of the IZA.