CEB Working Paper

The inclusion of the lagged dependent variable among the regressors renders the model
dynamic and aims to account for the persistency in firm-level profits, wage costs and
productivity. 7 It is also likely to improve the identification of the parameters of interest (even
though the coefficient on the lagged dependent variable is not a central issue in the analysis).
Indeed, as illustrated by Bond (2002), the use of a dynamic model is necessary to obtain
consistent results when estimating a production function with serially correlated productivity
shocks and explanatory variables that are correlated to these shocks. While serial correlation
of productivity shocks may arise if the effects of demand shocks are only partially captured by
the industry-specific control variables (Hempell, 2005), the responsiveness of input factors to
productivity shocks may be explained by an endogeneity issue (see below).
3.2. Firm environments
In light of the literature review, we test whether the impact of educational mismatch differs
according to the characteristic of the environment in which the firm evolves. To this end, we
estimate equations (1) to (3) separately for different clusters of firms and compare the
corresponding coefficients across clusters.
Firstly, the technological environment is investigated using a taxonomy developed by
Eurostat (2012), the HT/KIS nomenclature. This nomenclature gives the Nace 2- or 3-digit
code, according to which some firms can be classified as high-tech/knowledge and others as
low-tech/knowledge and covers industrial and service-oriented firms. The group of hightech/knowledge
intensive firms belongs to sectors that are high-medium tech/knowledge
intensive (HT/KIS), while the group of low-tech firms belongs to sectors that are medium-low
tech/less knowledge intensive (non-HT/KIS).
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From a theoretical perspective, competitive forces should eliminate abnormal profits (McMillan and Wohar,
2011). This said, a large literature, dating back to Shepherd (1975) and Mueller (1977) and taken further by Bou
and Satorra (2007) and others, suggests that profit persistence is large and inconsistent with the competitive
framework. More recent papers further show that firms with above (below) normal profits have high (low)
barriers to entry and exit (McMillan and Wohar, 2011). In light of this so-called ‘persistence of profits
literature’, there are strong arguments for modelling profits in a dynamic way, i.e. for including the lagged
dependent variable among covariates in equation (3). The assumption of persistent productivity both at the
industry and firm level also finds some support in the literature (see e.g. Bartelsman and Doms, 2000).
Researchers ‘documented, virtually without exception, enormous and persistent measured productivity
differences across producers, even within narrowly defined industries’ (Syverson, 2011: 326). Large parts of
these productivity differences are still hard to explain. The persistence of wage costs is also highlighted in the
literature (see e.g. Fuss and Wintr, 2009; Heckel et al., 2008). Wage stickiness is notably the outcome of labour
market institutions, adjustment costs and efficiency wages’ motives.
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