In pretty much every industry in pretty much every country, the firms exhibit a range of productivity: that is, some well-run and efficient firms produce more output given their levels of labor and capital, while others produce less. What ought to happen in a well-functioning economy is that the lagging-productivity firms should either be catching up with the leading-productivity firms over time, or the laggard firms should shrink in size while the leading firms grow in size. This process has been demonstrably important to economic growth in the past.
However, a wide range of taxes, rules, and institutions may act to inhibit reallocation of resources, and thus to slow down productivity growth. For example, if smaller farms are less efficient that larger farms, but the land use rules in a developing economy keep farm sizes small, then agricultural resources will not be reallocated. Economists refer to this as an issue of \”misallocation.\”
Diego Restuccia and Richard Rogerson discuss \”The Causes and Costs of Misallocation\” in the Summer 2017 issue of the Journal of Economic Perspectives (31:3: pp. 151-174). The IMF discusses the role of tax policy in creating and sustaining misallocation in the April 2017 IMF Fiscal Monitor, with an overall theme of \”Achieving More with Less.\” The discussion of reallocation is in \”Chapter 2: Upgrading the Tax System to Boost Productivity.\” The IMF researchers write:
\”Resource misallocation manifests itself in a wide dispersion in productivity levels across firms, even within narrowly defined industries. High dispersion in firm productivities reveals that some businesses in each country have managed to achieve high levels of efficiency, possibly close to those of the world frontier in that industry. This implies that existing conditions within a country are compatible with higher levels of productivity. Therefore, countries can reap substantial TFP [total factor productivity] gains from reducing resource misallocation, allowing firms to catch up with the high-productivity firms in their own economies. In some cases, however, the least productive businesses will need to exit the market, releasing resources for the more productive ones. For example, Baily, Hulten, and Campbell (1992) find that 50 percent of manufacturing productivity growth in the United States during the 1980s can be attributed to the reallocation of factors across plants and to firm entry and exit. Similarly, Barnett and others (2014) find that labor reallocation across firms explained 48 percent of labor productivity growth for most sectors in the U.K. economy in the five years prior to 2007.
Resource misallocation is often the result of a large number of poorly designed economic policies and market failures that prevent the expansion of efficient firms and promote the survival of inefficient ones. Reducing misallocation is therefore a complex and multidimensional task that requires the use of all policy levers. Structural reforms play a crucial role, in particular because the opportunity cost of poorly designed economic policies is much greater now in the context of anemic productivity growth. Financial, labor, and product market reforms have been identified as important contributors (see Banerjee and Duflo 2005; Andrews and Cingano 2014; Gamberoni, Giordano, and Lopez-Garcia 2016; and Lashitew 2016). This chapter makes the case that upgrading the tax system is also key to boosting productivity by reducing distortions that prevent resources from going to where they are most productive. …
Potential TFP gains from reducing resource misallocation are substantial and could lift the annual real GDP growth rate by roughly 1 percentage point. Payoffs are higher for emerging market and low-income developing countries than for advanced economies, with considerable variation across countries. …
Many emerging market economies have a relatively small number of leading firms, and a large number of laggards. If the distribution of leaders and laggards in these markets became more equal, similar to the distribution between leaders and laggard firms in US industries, the productivity gains could be large. By the IMF calculations, total factor productivity \”would increase by 30 to 50 percent in China and by 40 to 60 percent in India.\”
In their JEP essay, Restuccia and Rogerson provide a useful overview of what can cause misallocation, and how economists have sought to measure the potential gains from reducing misallocation. For a flavor of the issues and analysis, here are a few of the studies mentioned in the paper:
\”Government regulation can also hinder the reallocation of individuals across space. Hsieh and Moretti (2015) study misallocation of individuals across 220 US metropolitan areas from 1964 to 2009. They document a doubling in the dispersion of wages across US cities during the sample period. Using a model of spatial reallocation, they show that the increase in wage dispersion across US cities represents a misallocation that contributed to a loss in aggregate GDP per capita of 13.5 percent. They argue that across-city labor misallocation is directly related to housing regulations and the associated constraints on housing supply. …\”
\”Tombe and Zhu (2015) provide direct evidence on the frictions of labor (and goods) mobility across space and sectors in China and quantify the role of these internal frictions and their changes over time on aggregate productivity. The reduction of internal migration frictions is key and together with internal trade restrictions account for about half of the growth in China between 2000 and 2005. …\”
\”Restuccia and Santaeulalia-Llopis (2017) study misallocation across household farms in Malawi. They have data on the physical quantity of outputs and inputs as well as measures of transitory shocks and so are able to measure farm-level total factor productivity. They find that the allocation of inputs is relatively constant across farms despite large differences in measured total factor productivity, suggesting a large amount of misallocation. In fact, they found that aggregate agricultural output would increase by a remarkable factor of 3.6 if inputs were allocated efficiently. Their analysis also suggests that institutional factors that affect land allocation are likely playing a key role. Specifically, they compare misallocation within groups of farmers that are differentially influenced by restrictive land markets. Whereas most farmers in Malawi operate a given allocation of land, other farmers have access to marketed land (in most cases through informal rentals). Using this source of variation, Restuccia and Santaeulalia-Llopis find that misallocation is much larger for the group of farmers without access to marketed land: specifically, the potential output gains from removing misallocation are 2.6 times larger in this group relative to the gains for the group of farms with marketed land.\”
There will always be leading and lagging firms, and various hindrances to reallocation of resources across places and firms. In that sense, misallocation is never going away. But studying misallocation offers a useful reminder that productivity growth and economic growth are driven (or not!) by the dynamic forces of competition in a reasonably flexible economic setting.
Moreover, a better understanding of the gaps between leading and lagging companies–why suchh gaps persist, what might help to close them– may even help to explain one of the really big questions in the global economy, which is the overall slowdown in productivity growth. A 2015 study done by the OECD found that productivity growth among leading companies in various industries has not been slowing down; instead, the gap between leading and lagging companies has expanded, as if lagging companies are having a harder time keeping pace.