productive firms will have more resources (capital, labor, and materials) at their disposal compared to less productive ones, leading to an increase in the overall productivity of the sector. In an economy with high levels of distortion, however, unproductive firms have disproportionately large access to resources, hence dragging down the overall productivity of the sector.

The literature proposes two different approaches to detect resource misallocation (see Restuccia and Rogerson, 2017 for an overview and the latest empirical evidence from these methods). On the one hand, the direct approach focuses on specific sources of misallocation and quantifies their impact on productivity, typically through structural models. Specific sources of misallocation considered by the literature include, for example, regulatory restrictions (Song, Storesletten and Zilibotti 2011; Brandt, Tombe, and Zhu, 2013; and Tombe and Zhu, 2015); missing property rights (Adamopoulos and Restuccia, 2014); restrictive trade and competition policies (Khandelwal, Schott, and Wei, 2013; and Edmond, Midrigan, and Xu, 2015); and credit constraints and informational frictions (Midrigan and Xu, 2014; and David, Hopenhayn, and Venkateswaran, 2016).<sup>2</sup> On the other hand, the indirect approach provides a comprehensive measure of misallocation, capturing it from multiple channels and not being limited to pre-identified misallocation sources. This method requires some structure as discussed in Section 2, but it does not involve specifying a full-fledged model as the direct method does. The indirect approach may be, however, especially sensitive to measurement error and/or departures from the assumed market structure in the model economy.

Hsieh and Klenow (2009) (henceforth HK) provide a framework to assess the extent of misallocation under the indirect approach.<sup>3</sup> Their basic idea is that allocative efficiency is maximized when firms within a narrowly defined industry can access resources until their marginal revenue products are equalized. This occurs as more productive firms grow until the decrease in their prices matches their higher total factor productivity. Under the HK framework, large dispersions in marginal revenue products among firms operating within a narrowly defined industry imply misallocation of resources in that industry. Specifically, HK consider an economy where each firm produces according to a standard Cobb-Douglas function (with sector-specific factor shares) and outputs can be aggregated through a CES function for each industry. The firmspecific output and capital/labor may be subject to distortions (or wedges/taxes, in the language of the authors). Bringing their framework to the data allows to compute two measures of aggregate productivity: the “actual” one where distortions are present and the “potential” one where these wedges are eliminated. Comparing these two measures allows to quantify the potential productivity gains by increasing the efficient allocation of resources. This methodology does not

> 2 There is a large literature on each of these potential sources of misallocation; the suggested references rely on data from Southeast Asia, the region at the center of this paper. Interestingly, although not surprisingly, none of the individual channels by itself is able to explain the magnitude of misallocation estimated using the indirect approach discussed later. A given economy may suffer from multiple sources of misallocation at once.

> 3 HK measures misallocation without precisely identifying the sources of misallocation. They broadly classified the sources of distortions as capital and output market related distortions. The essence of their findings is that resource misallocation affects productive firms’ access to sufficient resources (in terms of capital and labor) needed for expansion, and this results in lower aggregate productivity. Therefore, reallocation of resources through the elimination of distortions in the markets is productivity enhancing as this allows productive firms to grow larger, and the less productive ones to either contract their operations or exit from the sector.

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