Market Power and TFP: Service differentiation in quality

Author Name KODAMA Naomi  (Consulting Fellow, RIETI) /KATO Atsuyuki  (Research Associate, RIETI / Asian Development Bank Institute)
Creation Date/NO. December 2010 10-J-058
Research Project Research on Productivity Growth in Service Sector
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Although the factor share approach is used to estimate total factor productivity (TFP) in many empirical papers, its validity is very controversial. This approach is justifiable if and only if the market of inputs and outputs is perfectly competitive, the production function follows constant returns to scale (CRS), and the products are not differentiated. Among these strict assumptions, this paper relaxes the assumption of firm homogeneity in the product markets. Using qualitative data, we first examine the correlation between TFP and the market power of firms and then investigate what provides these firms with their market power. From this research, we obtained the following three main results. First, the TFP estimates based on the factor share approach include the effects of prices. Second, the gaps in product quality yield lead to the gaps in prices, and the quality factors related to the market power are the brand, specialization, and originality. Third, the service industries are not homogeneous; the TFP estimates by the factor share approach reflect more technical efficiency in the personal service sector than in the business service sector. Thus, the TFP estimates based on the factor share approach can be directly interpreted in policy discussion for the former sector. On the other hand, the sources of differentiation and the possible upward bias in the TFP estimates should be carefully considered in devising reasonable industrial policies for the business service sector.