WHEN LESS IS MORE: OVERCAPACITY AND LABOUR MARKET RIGIDITY

Business cycles and demand volatility prevent demand and supply from being perfectly matched, and the existence of output gaps implies the partial dissatisfaction of either consumers or producers. More worryingly, persistent negative output gaps reveal a systematic excess of physical capacity. After the 2009 financial and economic turmoil, the issue of overcapacity turned out to be a priority in the policy agenda, especially in those countries where demand and consumptions failed to recover. The first contributions to the comprehension of excess capacity date back to the late 1970s, when available techniques and models failed to explain the counter-cyclical behavior of capacity utilization, CU, following the rise in energy prices. At the same time, the Industrial Organization literature suggested two main explanations for the rise of excess capacity. Overcapacity can arise as a result of strategic interaction (as an excessive output commitment results of Spence(1977) and Dixit (1979)) or as a reaction to demand uncertainty, as in Spencer and Brander (1992) and Gabszewicz and Poddar (1997). Also, models of international competition, such as Fagerberg (1988), explain that countries may choose to hold excess capacity to foster their international competitiveness and to match increases in demand. Although excess capacity emerges in different imperfectly competitive frameworks, the existing explanations fail to consider country or sector specific factors that firms take into account when making their capacity decisions. Throughout this thesis, we try to extend the analysis of excess capacity by looking at the impact of labour institutions. The initial hint for this analysis was provided by the dramatic excess capacity experienced by the automotive industry after the financial crises. In Detroit, the plants of the Big-3 were lining unsold vehicles, and huge parking lots, previously empty, were soon filled with cars. On the other side of the ocean, Italian, and other European, car assembly plants dramatically reduced their CU rate well below break-even. One may argue that the United States benefit from a flexible labour market, and our research question would find no fertile ground. Nonetheless, the Big-3, at that time, were forced to deal with a giant trade union, the United Auto Workers, which was able to negotiate not only unsustainable hourly wages, but also extremely costly regulations in case of lay-offs and dismissal. On the other side, Italy has always been characterized by a relatively rigid labour market, with fragmented unions and troublesome collective negotiations. Although these examples refer to a very specific sector, during a particular economic cycle, they made us wonder if and how the exogenous institutional background in which firms are to operate favors the rise of excess capacity. This thesis is thus an attempt to fill this gap in the literature. To this purpose, we initially review the existing contributions on physical capacity, and then we investigate the relation between overcapacity and labour market rigidity implementing a twofold approach. On the theoretical side, we adopt an ex-ante point of view and look at how labour institutions impact firms' capacity investment decisions, and observe that capacity is increasing in the rigidity of the labour market. Then, we evaluate the effect of labour protection on firms' short-run output adjustments to assess the impact with an ex-post perspective. We observe that the protection of skilled workers tend to increase excess capacity, with the effect being more intense in capital intensive industries.