The gap between marginal revenues and marginal costs of inputs (i.e., distortions or wedges) at establishments potentially lower aggregate total factor productivity (TFP) by preventing efficient allocation of resources among incumbents, deterring entry and exit, and affecting technology choices. We investigate the impacts of distortions on aggregate TFP, entry and exit, and establishment-level productivity growth using a rich dataset of Japanese establishments falling into manufacturing industries. Our main findings are the following. First, if capital and labor were reallocated in Japan to equalize marginal products to the extent observed in the United States, aggregate TFP would increase by 6.2%. Second, the efficient size distribution of establishments that would be realized without any distortions would be more dispersed than the actual one. Third, distortions have a significant impact on entry and exit as well as establishment-level productivity growth. Finally, we investigate the factors of distortions, obtaining evidence that financial constraints result in distortions.
