The importance of being efficient

By Rebecca Tan

SMU Office of Research & Tech Transfer – In the ebb and flow of the business cycle, once-powerful companies can lose their edge, and newer, more efficient companies spring up to take their place. This entry and exit of companies, called firm dynamics, is a central research focus for Assistant Professor Xu Jianhuan, an economist at Singapore Management University (SMU).

“I’m particularly interested in what determines why some firms can grow while other firms die; what is the mechanism by which efficient firms replace inefficient ones?” Professor Xu says. “Efficiency differences between countries is one of the most important determinants of trade and an important economic question. My research probes this issue from the point of view of the firm.”

Bigger is sometimes better

One of the fastest ways for a firm to grow is to buy over a competitor, simultaneously acquiring new assets and employees and increasing market share overnight. But while monopolies enjoy economies of scale, the absence of competitors can mean that they charge a higher amount for their goods or services than the market is willing to pay, leading to underconsumption and ultimately, a less efficient allocation of resources.

Recognising this potentially negative impact of monopoly behaviour, governments around the world have introduced anti-trust legislature to curtail the power of monopolies and increase economic efficiency. However, when Professor Xu analysed data from the US, he found the opposite to be true: mergers and acquisitions actually improve overall efficiency.

“The first evidence that mergers and acquisitions improve efficiency is that acquiring firms are usually efficient firms, while acquired firms are more inefficient. The second piece of evidence is that productivity increases after a merger,” he explains. “I interpreted this as mergers and acquisitions being a mechanism by which efficient firms kick out inefficient ones.”

Based on these microeconomic observations, Professor Xu developed a model to examine the impact of these firm-level acquisitions on the aggregate economy. Assuming a scenario where there are many firms with differing levels of efficiency and where mergers help pass know-how from efficient firms to inefficient ones, the model allowed Professor Xu to study the impact of strict anti-trust laws.

“If anti-trust authorities block many mergers and acquisitions, this reduces monopoly power but also comes at the cost of protecting some inefficient firms. By doing a cost-benefit analysis, I showed that policies that are more friendly towards mergers and acquisitions are overall beneficial to the US economy,” Professor Xu says of his study published in the Journal of Economic Dynamics and Control.

However, this does not imply that mergers and acquisitions are always desirable; the efficiency of the acquiring firm matters, Professor Xu cautions. For example, many of the mergers and acquisitions in the late 2000s in China involved state-owned firms acquiring more efficient private firms, he explains. “In this kind of situation, mergers and acquisitions can reduce the country’s efficiency, so how stringent the anti-trust regulations should be depends on how the merger and acquisition market works in that country.”

Empty vessels make the most of waste

Country-level differences in efficiency could also explain an interesting phenomenon: China’s large-scale import of waste goods such as scrap metal, scrap paper and second-hand electronic goods.

As a developing country, it makes sense that China imports waste goods as these products tend to flow from high-income economies to lower-income ones, Professor Xu explains. However, development status alone does not explain why China is the world’s top importer of waste goods, well above other lower-income economies like India.

“We argue that on top of the income problem, there is another important factor that determines why China imports so much waste goods; namely China’s large trade surplus,” he says. The trade surplus, he continues, means that the ships leaving China are fully loaded but are likely to return virtually empty. Because empty ships are dangerously light in the face of strong waves, shipping companies prefer to load up on goods on their way back to China – preferably goods that are heavy, occupy a lot of space and are as cheap as possible.

“Waste goods satisfy all three conditions. In fact, American companies even pay Chinese firms to take the waste, effectively making them negative-priced items,” Professor Xu says.

While maintaining this large trade surplus helps China by creating jobs and supporting domestic firms, importing so much waste has knock-on environmental consequences. According to a working paper by Professor Xu, his SMU colleague Assistant Professor Jungho Lee and Columbia University’s Professor Shang-Jin Wei, Chinese cities that import a lot of foreign waste goods have a cancer rate that is about 0.4 percent higher than the national average.

“While having a trade surplus is good for China as a developing country, there is no such thing as a free lunch. Maintaining the trade surplus comes with a social cost, in this case a loss of welfare for its citizens,” Professor Xu concludes.

Differences in economic efficiency across countries can be explained by many different factors, such as educational levels and the amount of capital available in each country. Professor Xu believes that the role of individual firms and their aggregate impact is an important factor that deserves further investigation.

“As these two studies show, the efficiency of the firm can affect diverse fields ranging from how strict anti-trust laws should be to the health impacts of maintaining a large trade surplus. I hope to continue this interesting angle and contribute to the understanding of what drives income differences between countries,” he says.

Back to Research@SMU Issue 59