Committing to Grow

The paper presented in this ZEW Research Seminar studies the implications of employment targets on firm dynamics during the privatization of the East German economy. Exploiting novel contract-level data, the authors document three stylized facts. First, the policy distorted firm size choices and generated bunching of firms around their committed employment target. Second, exploiting heterogeneous labor preferences of privatizers, they show that assigning tight commitments to firms causes an increase in employment growth and leads to higher productivity growth. Finally, tighter commitments also result in significant costs by leading to increased firm exit. The authors interpret these results through the lens of a dynamic model with endogenous productivity growth at the firm level. The model highlights that while tight commitments distort the employment decision statically and lead to a higher exit probability, they also induce a “catch-up” increase in productivity growth. This is because although firm profits are lower under tight commitments, marginal profits with respect to productivity are higher. They calibrate the model to our data and find that the policy lead to a 3 percentage points higher aggregate TFP growth thanks to the productivity improvements of firms with tight contracts.