Evolution of industrial diversification and its determinants in West Germany: Evidence from population data of enterprises

Abstract

Germany is among the largest countries in the world in terms of total GDP, owing largely to rapid industrialization and expansion of economic activities into several sectors. This paper contributes to the literature on German economic development by investigating the evolution of industry diversification in Germany; particularly focusing on the recent concepts of related (RV) and unrelated variety (UV) in West German regions. It also identifies the statistical and economic determinants of variation in variety over time. Among several industry structure measures; RV is the only measure that reveals a pronounced increasing trend. Since RV is composed of two parts: 1) entropy at five-digit within a two-digit classification, and 2) shares of two-digit sectors in total output, we examined which of the two components dominate. Our findings suggest that the entropy component within two-digit sectoral shares of the RV index is more dominant than the two-digit sectoral shares themselves. We further examined entries and exits of the firms among regions with top and bottom rankings in RV. Findings suggest that both the top and bottom regions experienced an increase in the total number of industries, however, exits were much less pronounced in the bottom regions. It suggests that an increase in variety among top regions is the result of the creative destruction type effect where new industries force inefficient old industries to leave the region. Finally, analysis shows support for the inverse u-shaped relationship between development and diversification.