The European Union and the US provide two very different models, not just of labour markets, but also industrial organization. It has been argued that the flexible labour markets and less rigid organization of industry in the US have led to the creation of a high number of new jobs. By contrast, inflexible labour markets combined with a more rigid organization of industry in European countries have led to little job creation. In Discussion Paper No 1162, Research Fellow David Audretsch, George van Leeuwen, Bert Menkveld and Roy Thurik present a theory suggesting that, through pursuing a strategy of compensating factor differentials, that is by remunerating and deploying factors of production differently from their larger counterparts, small enterprises are able to compensate for size-inherent cost disadvantages.

Based on a sample of over 7,000 Dutch manufacturing firms, the authors find considerable evidence that such a strategy of compensating factor differentials is pursued within a European context. When viewed through a static lens, the existence of such a strategy, while making small and sub-optimal scale enterprises viable, suggests that they impose a net welfare loss on the economy. When viewed through a dynamic lens, however, the findings of a positive relationship between firm age and employee compensation as well as firm age and firm productivity suggest that there may be at least a tendency for the inefficient firm of today to become the efficient firm of tomorrow. These results suggest that, even in a European context, the mean wage of small firms tends to be pulled down because of: first, the inclusion of many new firms that will not survive for long; and second, successful enterprises which will tend to experience a subsequent increase in both productivity and wages as the firm evolves and grows.

Sub-Optimal Scale Firms and Compensating Factor Differentials in Dutch Manufacturing
David B Audretsch, George van Leeuwen, Bert J Menkveld and Roy Thurik

Discussion Paper No. 1162, April 1995(IO)