Allocative Efficiency and Productivity in Manufacturing: Cross-country Evidence

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1 Allocative Efficiency and Productivity in Manufacturing: Cross-country Evidence Extended Abstract Addisu A. Lashitew Department of International Economics and Business University of Groningen The Netherlands Telephone: +31 (0)

2 Numerous studies in the development accounting literature have documented that at least half of the cross-country difference in income is the result of differences in aggregate productivity (Hsieh and Klenow, 2010). At the microlevel, the productivity literature reveals enormous productivity differences across producers even in narrowly defined industry groupings (Syverson, 2010; Foster et al., 2001; Melitz, 2003). Recent theoretical models explore if the large cross-country difference of aggregate productivity can be explained by differences in the efficiency of resource allocation. The first of such theoretical models that permits analyzing and quantifying the role of resource misallocation was developed by Banerjee and Duflo (2005). Subsequently, Hsieh and Klenow (2009) built on Melitz s (2003) model of monopolistic competition to show how resource misallocation due to input and output price distortions can reduce aggregate productivity. Hsieh and Klenow (2009) show that, by allocating their resources as efficiently as the United States, China and India could improve their manufacturing TFP by 30% and 60% respectively. In a similar analysis, Bartelsman et al. (2009) find large differences across countries in the relationship between firm productivity and size which is indicative of differences in allocaative efficiency. Other works in this direction include Restuccia and Rogerson (2007), Alfaro et al. (2007), Erosa and Cabrillana (2008) and Buera et al. (2009). Although allocative efficiency could be a result market imperfections (such as under development of the financial markets), policy variables can also play a role. Examples of distortions caused by government policies include regulations in capital markets, in labor markets, and output markets. Strict capital market regulation, for example, hinders efficient capital allocation by hampering smooth flow of finance to firms that need it. Government policies that reduce firm entry 1

3 (such as high start-up capital requirements) could lead to poor allocation of resources because they reduce competition in the market. While the aforementioned studies explore the relevance of allocative efficiency in aggregate productivity, most of them are theoretical. To our knowledge, there has been no rigorous empirical work so far that analyzes the relevance of policy variables in explaining cross-country differences in allocative efficiency. In this study, we use a monopolistic competition framework developed by Hsieh and Klenow (2009) to answer the following two questions: i) what are the productivity gains from allocating resources more efficiently in different countries? and ii) what policy variables affect a country s gain from efficient resource allocation? Since countries with more distorted markets are more likely to gain from efficient allocation, the second question indirectly asks what factors underlie the allocative efficiency of a country. To answer this question, we examine different policy (and non-policy) factors that limit the efficient allocation of labor and capital among firms by creating a wedge between the factor returns of heterogeneous firms. Our analysis is based on the World Bank s enterprises survey data which covers around 24,000 firms within 11 industries 1 across 90 countries. This dataset is the first comparable firm-level dataset that spans dozens of countries and includes variables on input use and production required for measuring productivity. It also includes rich set of firm-level responses on policy constraints such as licensing restrictions, and the difficulty of labor market regulations and tax administration. This will enable us to examine if the relevance of these variables differs across countries. 1 Some of these industries are at 2-digit ISIC classification, and others are at broader level. 2

4 Following Hsieh and Klenow (2009) we conduct a hypothetical complete market liberalization by removing the allocative inefficiency plants face. This enables us to examine how severely allocative inefficiency reduces aggregate TFP by calculate resulting TFP gains. Our results, which are reported in Table 1, show that aggregate TFP could be increased by % in different countries if resource misallocation could be removed. Our results show a TFP gain of 68% for China and of 75% for India. Hsieh and Klenow (2009) had similarly calculated that full liberalization would boost aggregate manufacturing TFP by 86% 115% in China, and by 100% 128% in India. Whereas our dataset covers far smaller observations for these countries (they use large census based surveys) our results are not very far from the lower brackets of TFP gains they report. On the other hand the fact that our dataset covers a large number of countries enables us to compare results across countries. Interestingly, there is substantial difference in TFP gains across countries. Morocco stands first to benefit from liberalization, with a potential TFP gain of 154% whereas gains are smaller for South Africa (46%) and Chile (53%). How well do these numbers reflect differences in liberalization across these countries? If the results can be explained by liberalization policy differences across countries, through which cannels does liberalization or the lack thereof affect the allocative efficiency of firms? In the next part of the paper which we are still working on we try to answer these questions. 3

5 Table 1: TFP gains from full liberalization CountrY Number of Observations No of Industries TFP Gain India 1, Brazil 1, Thailand China 1, Vietnam 1, Bangladesh Mexico Pakistan Morocco South Africa Egypt Chile Colombia Ethiopia Russia The large difference across countries in which efficient factor reallocation improves aggregate productivity gives suggestive evidence that there is potentially large difference across countries in the efficiency of resource allocation. This initial finding highlights the fact that differences in efficiency of resource reallocation might be a driving force behind cross country differences in productivity. Some of the factors affecting allocative efficiency could be policy related, such as the tax rate and licensing restrictions. However, there are also non-policy factors that cause differences in allocative efficiency such as mark ups and adjustment costs due to differences in industry structure. What we will do in the next parts of the study is to flesh out the policy variables across countries that induce differences in allocative efficiency. JEL classification: O47, D24, O16 Keywords: allocative efficiency, market distortions, TFP, TFPR, manufacturing. 4

6 References Alfaro, L., A. Charlton and F. Kanczuk (2007) Plant-Size Distribution and Cross- Country Income Differences, NBER Working Paper No Banerjee, A. and E. Duflo (2005) Growth Theory through the Lens of Development Economics, P. Aghion and S. Durlauf (ed) Handbook of Economic Growth, Elsevier. Bartelsman, E, J. Haltiwanger and S. Scarpetta (2009) Cross-Country Differences in Productivity: The Role of Allocative Efficiency, NBER Working Paper Series, Working Paper Buera, F. J., J. P. Kaboski and Y. Shin (2009) Finance and Development: A Tale of Two Sectors, NBER Working Papers number Erosa, A. & A. H. Cabrillana (2008) On Finance as a Theory of TFP, Cross- Industry Productivity Differences, and Economic Rents, International Economic Review, vol. 49 (2), pp Foster, L., J. Haltiwanger, and C. J. Krizan (2001) Aggregate Productivity Growth: Lessons from Microeconomic Evidence, NBER Working Paper No Hsieh, C. and Klenow, P. J. (2010) Development Accounting, American Economic Journal: Macroeconomics, Vol. (1), Pp: Hsieh, C. and Klenow, P. J. (2009) Misallocation and Manufacturing TFP in China and India" with Chang-Tai Hsieh, forthcoming in the Quarterly Journal of Economics, Vol. CXXIV (4). Melitz, M. J. (2003) The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity, Econometrica, vol. 71 (6), pp Restuccia, D. and R. Rogerson (2007) Policy Distortions and Aggregate Productivity with Heterogeneous Plants, NBER Working Paper, no Syverson, C. (2009) What Determines Productivity? NBER Working Papers, No

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