Ready, Set, Unify: The Uneven Race between Trabants and BMWs

Talk by Matthias Mertens (MIT) as part of the Research Seminar Series of the IOS Economics Department.

Even 30 years after the reunification, regions in East Germany (the former GDR) live in considerably different economic conditions, with the average GDP per capita still about 20 percent below the average level in the West German regions. In this paper, we explore the factors that impeded faster convergence despite massive support to the East, with a particular focus on technological differences and firm behavior. In the immediate aftermath of the reunification, production in the former GDR exhibited a rapid catch-up with the West, with a pick-up in labor productivity. But the convergence tapered off quickly thereafter, with a stark difference between East and West German firms’ product qualities persisting ever since. We build a quantitative model of innovation, competition, and regional integration that can mimic these dynamics and provides a suitable setting to evaluate alternative policies that could have altered these dynamics. We show that large initial technological differences depressed Eastern firms’ incentives to compete and invest in technology improvements, perpetuating initial gaps. Delaying reunification, that is, opening up to competition from the West, would not help Eastern firms build up capacity. Sustained support for R&D in the East from the West could have helped shrink persistent gaps in product quality and income, although more effective alternatives appear to be subsidies to Western firms via either R&D support, with knowledge spillovers lifting also Eastern technology, or direct income support to facilitate technology transfer to the East via licensing.