The Real Reason Europe’s Poorer Regions Stay Less Productive Than Richer Ones

An OECD study finds that persistent regional productivity gaps in Italy and Spain are not caused by weak firms, poor competition, or bad geography, but by structural and institutional constraints that lower firm performance across entire regions. Sector mix explains little of the gap; what matters most is weaker investment conditions, labour market rigidities, and institutional quality in less developed regions.

Why do some regions remain far less productive than others, even inside the same country? A new study by the OECD’s Local Economic and Employment Development (LEED) Programme, authored by economists Carlo Menon and Wessel Vermeulen and based on firm-level data from the OECD and Moody’s Bureau van Dijk, examines this question through the lens of Italy and Spain. Despite decades of regional development funding, the answer is unsettling: the gap is not closing, and the usual explanations miss the point.

A 30% gap that time has not healed

Since the mid-1990s, less developed regions, those with incomes well below the EU average, have remained about 30% less productive than richer regions in both Italy and Spain. While productivity differences between countries have narrowed, differences within countries have widened. Spain’s poorer regions have seen modest improvement but no real catch-up. Southern areas of Italy, meanwhile, have largely stalled since the mid-2000s. The divide has become a permanent feature of the economic landscape rather than a temporary lag.

It’s not just about the wrong industries

At first glance, the explanation seems obvious. Poorer regions tend to have fewer factories, fewer exporters, and fewer high-tech firms. The data confirm this: less developed regions employ far fewer workers in manufacturing and knowledge-intensive services, which are typically more productive. But the study shows that this explains only a small part of the problem. Even if lagging regions had the same mix of industries as leading ones, most of the productivity gap would remain. The real issue is not what regions produce, but how well firms perform inside the same sectors.

Firms underperform everywhere, not just at the bottom

Using balance-sheet data for almost all incorporated firms in Italy and Spain, the authors uncover a striking pattern. Firms located in less developed regions are consistently 20–30% less productive than similar firms elsewhere. This applies across manufacturing and services, to small and large firms alike, and to young startups as well as long-established businesses. Importantly, this is not because poorer regions are clogged with failing companies. The entire productivity ladder is shifted downward. Even the best firms in lagging regions tend to underperform compared to their peers in richer areas.

Competition itself is not weaker either. Productive firms grow and unproductive ones exit at similar rates across regions. The most productive firms account for roughly the same share of employment in both rich and poor regions. In short, markets work much the same everywhere, but they deliver systematically lower outcomes in some places.

Lower productivity means lower pay and fewer opportunities

Lower productivity shows up quickly in everyday life. Firms in less developed regions generate lower revenues, earn lower profits, and pay significantly lower wages, often more than 20% less. While cheaper housing narrows the gap when incomes are adjusted for local prices, the authors caution that this does not eliminate real disadvantages. Higher unemployment, fewer career paths, weaker public services and limited mobility continue to weigh heavily on people living in lagging regions.

Geography offers only limited comfort. Large cities boost productivity, but even major urban centres in poorer regions, such as Naples or Seville, rarely reach the productivity levels of the weakest regions in richer parts of the country. Being urban helps, but it does not close the gap.

Institutions matter more than location

The clearest contrast between Italy and Spain lies in institutions. In Italy, firms in poorer regions are not only less productive but also smaller and less capital-intensive. Investment per worker is much lower, reinforcing a cycle of weak growth. Spain shows a different pattern: productivity gaps exist, but firms are not dramatically smaller or less invested, especially in services.

Labour market rules help explain this difference. Italy’s highly centralised wage-bargaining system limits firms’ ability to adjust wages to local productivity, discouraging hiring and investment in weaker regions and contributing to higher unemployment. Spain’s reforms in the 2010s, which allowed firm-level wage agreements, improved alignment between pay and productivity. Institutional quality also matters. Firms in Italy’s lagging regions face far greater obstacles in access to finance and report much higher levels of corruption than those in richer regions, a gap far smaller in Spain.

The policy lesson is clear and uncomfortable. Lagging regions are not held back by bad firms or weak competition. They are held back by structural and institutional barriers that affect all firms at once. If those barriers remain, Europe’s regional productivity gap will remain with them.