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Why (firm) size matters: Research from the MIT Sloan School of Management sheds new light on the steep cost of labor market regulations in France 

Organizations choose to remain small to avoid the cost of regulation, denting growth

Cambridge, Mass., November 17, 2016— Tough labor market regulations in France provide a disincentive for smaller firms to grow—an effect that depresses the country’s overall economic output by about 3%, according to a new study* by John Van Reenen, Professor of Applied Economics at the MIT Sloan School of Management.

The study’s findings arrive at a time when the costliness of labor market laws, including the United States’ Affordable Care Act (ACA), is a hotly debated topic among policymakers.

“Labor market regulations cast a long shadow in the economy,” says Van Reenen. “Many firms become reluctant to expand in order to escape the costs associated with compliance. This has a negative impact on growth. It’s clear that in France at least, these regulations have many unintended consequences.”  

French firms with 50 or more employees face “a veritable tsunami” of burdensome and expensive rules and regulations, according to Van Reenen. They must form work councils for their employees, allow for more union representation, and deal with increased firing costs, among other things. 

“As a result, many firms choose to remain small. They’re making a rational choice but it leads to inefficiencies in the economy, which hurts productivity and performance by around 3% of national income.”

Quantifying the costs of labor regulations has long proven elusive. The World Bank and other agencies have developed cost indices based on ratings by lawyers, accountants, and other experts. The results, however, have an arbitrary component. 

Van Reenen and his colleagues, Luis Garicano, a professor at the London School of Economics, and Claire Lelarge, of the Banque de France, took a different approach. The team looked at France’s firm-size distribution to determine whether it followed what economists call a ‘power law’—in this case, a log-linear relationship between the size of firms and the corresponding number of firms. In France, this power law is broken at exactly 50 employees, a clear indication that many companies are electing to stay just below that threshold. 

“There is a disproportionally large number of companies whose number of employees hovers around 47, 48, or 49,” says Van Reenen. “Interestingly, these companies have figured out ways to be productive without increasing the size of their workforce lest they become subject to regulations. In some cases, they have their employees work longer hours; in other cases, these companies invest heavily in machinery and equipment to get efficiencies elsewhere.”

Some of the cost of regulation is borne by French workers in the form of lower pay, according to the study. “Typically we think that regulations are meant to protect workers. But because of this downward pressure on wages, the regulation is harming them.”

The study’s findings have implications for other size-dependent regulations, such as the ACA. Under the ACA, companies with 50 or more full time equivalent employees must offer health care insurance to their workers or face “Play or Pay” penalties. Critics of the law claim that this reduces incentives to grow. Van Reenen argues that the greater flexibility of wages in the U.S. labor market compared to France means that these regulations won’t have as big effect on growth—but they do need to be monitored. 

“Our research shows that labor regulations like this one can have a negative impact on growth,” Van Reenen says. “The benefits of the laws must be weighed carefully against its potential costs.”

The MIT Sloan School of Management, based in Cambridge, Massachusetts, United States, is one of the world's leading business schools. MIT Sloan is devoted to its mission: to develop principled, innovative leaders who improve the world and to generate ideas that advance management practice. Learn more at: mitsloan.mit.edu  

* Firm Size Distortions and the Productivity Distribution: Evidence from France by Luis Garicano, LSE, Claire Lelarge, and John Van Reenen; American Economic Review

Find the French version of this press release here.