Abstract: The large differences in income per capita across countries are mostly accounted for by differences in total factor productivity (TFP). What explains the differences in TFP across countries? Empirical evidence points to factor misallocation across heterogeneous production units as an important factor. We study factor misallocation in a model where establishment-level productivity is endogenous. In this framework, policy distortions not only misallocate resources across a given set of productive units, but also worsen the productivity distribution of establishments and this effect is substantial quantitatively. Reducing the dispersion in revenue productivity by half to the level of the U.S. benchmark in the model implies an increase in aggregate output and TFP by a factor of 7.8-fold. Improved factor allocation accounts for 38 percent of the gain, whereas the change in the productivity distribution accounts for the remaining 62 percent.
Keywords: distortions, misallocation, investment, endogenous productivity, establishments.
JEL Classification: O1, O4.