Do Rising Labour Costs Drive Innovation in Enterprises? Propensity Score Matching Evidence from Chinese Firms

• Date: 01 February 2017
• Author: Xianhai Huang,Gaoju Yang,Hangyu Chen
• DOI: http://doi.org/10.1111/1468-0106.12203
• Published date: 01 February 2017

DO RISING LABOUR COSTS DRIVE INNOVATION IN

ENTERPRISES? PROPENSITY SCORE MATCHING

EVIDENCE FROM CHINESE FIRMS

XIANHAI HUANG Zhejiang University

HANGYU CHEN Zhejiang University

GAOJU YANG*Zhejiang University

Abstract. This paper uses a monopolistic competition model and propensity score matching (PSM)

with Chinese firm-level data to determine whether rising labour costs drive innovation within

enterprises. The results indicate that rising wages do drive firms to invest more in R&D and use more

capital to substitute for labour to minimize costs, which improves total factor productivity. The

results are verified by several robustness tests.

1. INTRODUCTION

Since the 1970s, intra-product specialization has been ascendant. This specializa-

tion model makes full use of the advantages of each country’s factor endowment,

thus creating an opportunity for developing countries that are in an inferior

position in terms of technology and capital to participate in the production chain

with an abundant and low-wage labour force. However, developing countries

taking part in intra-product specialization and experiencing the resulting increase

in production and exports (the Chinese processing trade is a typical case) may not

automatically witness an increase in industrial competitiveness and technology.

In contrast, due to their overreliance on the comparative advantage of a low-

wage labour force, they may be caught in a low-end trap. For example, in the

electronic products industry, which is one of the world’s fastest growing

industries, Apple’s iPhone was valued at US$549 in 2010; Apple (design and

marketing) obtained a profit of US$321 (58.5%), while Korea, Japan and

Taiwan (the major hardware providers) received profits of US$26, US$3 and

US$3 (4.7, 0.5 and 0.5%), respectively, and the Chinese labour input (for assem-

bly and components production) represented revenue of only US$10 (1.8%)

(Kraemer et al., 2011). In fact, the economic interests of developing countries

such as China from the processing trade are eroding, and the comparative advan-

tage of a cheap labour force is weakening with rising wages (Xu, 2006).

The fear of getting stuck in the comparative advantage trap impels developing

countries to seek urgent industrial transformation and upgrading to offset the

declining comparative advantage and shrinking trade profits that accompany

*Address for Correspondence: School of Economics, Zhejiang University, No. 38, Zheda Road,

Hangzhou, P. R. China, 310027. E-mail: 0011666@zju.edu.cn. This research is partially supported

by grants from the National Social Science Fund of China (14AZD056, 15ZDB156), the National

Natural Science Foundation of China (71403241), the Chinese Ministry of Education

(14YJC790153), Fundamental Research Funds for the Central Universities and REOD

(11JDQY02Z).

Pacific Economic Review, 22: 1 (2017) pp. 23–42

doi: 10.1111/1468-0106.12203

© 2017 John Wiley & Sons Australia, Ltd

bs_bs_banner

rapid rising factor costs, especially wages. However, the key to industrial trans-

formation and upgrading lies in enterprise innovation. Thus, one may wonder

what kind of relationship between rising factor costs and innovation will enter-

prises be forced by rising factor costs to create for preventing profit erosion?

From the perspective of the Chinese statistical data, factor prices rise with

enterprises’profit as well as with technical innovation. Figure 1 indicates that,

after 1998, average real wages in China increased unceasingly and rapidly, as

did industrial producers’purchase prices for raw materials. The increase in

average real wages was obviously faster than the increase in industrial

producers’raw material purchase prices. Meanwhile, the proportion of profit

of the gross output value increased, with fluctuations, which implies that

while manufacturing costs, particularly labour costs, increased rapidly,

enterprise profitability also improved. Generally speaking, rising manufactur-

ing costs inevitably cause decreasing profits unless the technology of produc-

tion or the productivity of labour has improved. Thus, in the case of rising

production costs, will the pursuit of profits force enterprises to improve

technology and advance productivity? Theoretically, it would be possible

but not necessary because enterprises can choose to invest in capital, particu-

larly advanced production equipment or a skilled workforce, rather than carry

out risky technological innovation to raise production efficiency and thereby

tackle rising production costs. However, the actual statistics suggest that

technological innovation activity and the profitability of Chinese industrial

enterprises have shown an increasing trend. As indicated in Figure 2, in the

period between 1995 and 2012, Chinese large and medium-sized industrial

enterprises increased their R&D personnel, expenditures and intensity as well

as their number of inventive patents.

Figure 1. Price indices of industrial enterprises in China: 1990–2012.

Source: Chinese National Statistical Bureau Database.

Notes: PPIM denotes the purchasing price index for raw materials, fuel and

power; ARWI denotes the average real wage index; PM is profit margin, the to-

tal profit as a share of output (%, right axis). 1990 = 100 for PPIM and ARWI.

X. HUANG ET AL.24

© 2017 John Wiley & Sons Australia, Ltd