Policy Distortions and Aggregate Productivity with Endogenous Establishment-Level Productivity

The large differences in income per capita across countries are mostly accounted for by differences in total factor productivity (TFP). What explains these differences in TFP across countries? Evidence suggests that the (mis)allocation of factors of production across heterogenous production units is an important factor. We study factor misallocation in a model with an endogenously determined distribution of establishment-level productivity. In this framework, policy distortions not only misallocate resources across a given set of productive units, but they also worsen the distribution of establishment-level productivity. We show that in our model, compared to the model with an exogenous distribution, the quantitative effect of policy distortions is substantially amplified. Whereas empirically-plausible policy distortions in our model generate TFP that is 14 percent that of a benchmark economy with no distortions, with an exogenous distribution the same policy distortions generate TFP that is 86 percent of the benchmark, a 6-fold amplification factor.