product markets negatively affect the allocative efficiency of factor inputs. The higher pass-through in sectors with lower competition implies that increased barriers to competition result in higher wage inequality due to more allocative inefficiencies.

# **9 Conclusion**

Between 2012 and 2020, Ecuador's economic performance stagnated as growth driven by factor accumulation was offset by a significant decline in aggregate total factor productivity (TFP). This decline in aggregate TFP was driven by regulatory and institutional distortions that caused a persistent misallocation of factor inputs across firms. Furthermore, these frictions constrained firm-level technical efficiency growth and impeded healthy firm entry and exit dynamics. The decline in aggregate TFP was accompanied by a change in the trend of income inequality, whose decreasing tendency before 2014 plateaued thereafter and increased since 2018. These empirical patterns suggest that distortive policies with adverse effects on aggregate TFP also impact labor outcomes.

Factor misallocation across firms in Ecuador can be attributed to distortions in labor and capital input markets, as distortionary labor regulations (such as high firing costs and ad-hoc compulsory allowances) as well as barriers to credit (such as high collateral constraints and high interest rates) hinder the fluidity of the labor market, constrain firm access to capital, and allocate factors towards less productive enterprises. These highly distortive factor market frictions also constrain firm productivity growth, as firms must divert resources from innovation and capability upgrading to finance costly factor inputs. As a result, innovation related activities, like R&D expenditures, have reduced and firm-level TFP growth is mostly stagnated across the life cycle. Furthermore, these factor market distortions along with institutional inefficiencies (such as weak insolvency regimes) yield inefficient market selection that is characterized by a large entry and low exit of unproductive firms.

The policy-driven distortions that have led to Ecuador's underwhelming aggregate productivity outcomes have also generated distributional patterns of firms and job flows that further indicate the country's poor economic performance. Ecuador exhibits an underrepresentation of large firms in terms of numbers and economic activity (i.e., employment), while micro firms are overrepresented, also highlighting allocative inefficiencies as micro firms are less productive than large firms, on average. Additionally, these market frictions, coupled with the economic slowdown, have resulted in a shift of economic activity from younger to older firms. Aggregate job flows also portray anemic trends, with small, unproductive entrants creating most new jobs, while existing jobs are primarily destroyed by old, unproductive firms that stay in the market instead of exiting. Furthermore, these distortions that generate resource misallocation also account for up to 41 percent of aggregate wage inequality. These findings suggest that to enhance workers’ outcomes, it is also essential to address distortions that affect firm dynamics.

# **References**

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