Monopsony Makes Firms Not Only Small But Also Unproductive: Why East Germany Has Not Converged

The Fall and Rebound of Average Establishment Size in West Germany

“…Second, we establish an economically meaningful relation between the average establishment size and the size wage premium. This is in line with the findings of Bachmann, Bayer, et al (2022), who argue that average establishment size differences between East and West Germany are largely driven by differences in their size wage premiums. However, we are the first to establish this link within West Germany.…”

“…Hence, variation in average establishment sizes across countries stems from variation in the extent of misallocation across countries, a view in line with previous work of Bento and Restuccia (2017), Hopenhayn (2014) and Hsieh and Klenow (2014). In a recent paper, Bachmann, Bayer, et al (2022) propose an alternative mechanism of misallocation that distorts the average establishment size, namely the downsizing of establishments due to an increasing size wage premium. The rise in this premium gives establishments an incentive to stay small, which dampens aggregate productivity in the economy.…”

“…Hence, an increasing size wage premium generates a misallocation of labor from productive to less productive establishments. Bachmann, Bayer, et al (2022) argue that differences in the size wage premiums between East and West Germany largely explain persisting productivity differences between the two regions. In this paper, we follow their line of reasoning.…”

“…Hence, this premium substantially increased during the 1990s and early 2000s and declined afterwards (see Colonnelli et al, 2018;Lochner et al, 2020). Following Bachmann, Bayer, et al (2022), we interpret the size wage premium as an upward-sloping labor supply curve to the firm and, hence, as an indicator of monopsony power in the labor market. Therefore, we argue that an increasing size wage premium induces establishments to reduce their employment levels since it incentivizes establishments to stay or become small to avoid increasing wages and maximize profits (and vice versa if the size wage premium decreases) (see Bachmann, Bayer, et al, 2022).…”

“…Following Bachmann, Bayer, et al (2022), we interpret the size wage premium as an upward-sloping labor supply curve to the firm and, hence, as an indicator of monopsony power in the labor market. Therefore, we argue that an increasing size wage premium induces establishments to reduce their employment levels since it incentivizes establishments to stay or become small to avoid increasing wages and maximize profits (and vice versa if the size wage premium decreases) (see Bachmann, Bayer, et al, 2022). Exploiting regional variation, we find a statistically significant and sizeable negative relation between average establishment size and the size wage premium (i.e., the level of monopsony power).…”