since it captures misallocation from multiple channels not being limited to pre-identified sources of misallocation. This method requires some structure as discussed below, but it does not involve specifying a full-fledged model as the direct method.

Hsieh and Klenow (2009) provide a prominent empirical framework to assess the extent of misallocation under the indirect approach (See Appendix A for detailed setup). Their basic idea is that allocative efficiency is maximized when two firms within a narrowly defined industry can access resources until their marginal revenue products are equalized. Under their framework, large dispersions in marginal revenue products among firms operating within a narrowly defined industry imply misallocation of resources in the industry. Specifically, Hsieh and Klenow (2009) 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 narrowly defined sector. The firm-specific output and capital 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 assumed away. Comparing these two measures allows to quantify the potential productivity gains from a more efficient allocation of resources. Note that this methodology does not identify the amount of misallocation deriving from specific sources but provides an all-encompassing measure (see the box for a discussion about the sources of misallocation).

# **Box 1 On the sources of misallocation**

The background paper assesses the extent of misallocation based on Hsieh and Klenow (2009) or the indirect approach. This methodology does not identify the amount of misallocation deriving from specific sources but provides an all-encompassing measure. To complement this evidence, we turn to the literature where specific factors directly affecting misallocation are examined. Specific sources of misallocation may be more transparent such as the introduction of subsidies in favor of a given sector. Specific groups of firms may enjoy distortive interventions: state-owned enterprises may access finance at distorted/more favorable rates; large firms with substantial bargaining power may face preferential treatments through specific regulatory treatment and/or lower borrowing costs.

Interestingly, although not surprisingly, none of the individual channels by itself is able to explain the magnitude of misallocation estimated using the indirect approach. A given economy may suffer from multiple sources of misallocation at once. Alternatively, or additionally, the indirect method may overestimate the extent of misallocation, in the presence of measurement error and/or departures from the assumed market structure. This box builds on Hopenhayn (2014) and Restuccia and Rogerson (2017) and reports the evidence emerging from EAP countries regarding specific sources of misallocation.

**Regulation.** A wide range of policy instruments have been considered in the literature to assess the extent to which regulatory interventions contribute to misallocation and thereby lower aggregate productivity. The focus has moved from adjustment costs, such as firing costs, <u>to the broader category of “size-dependent policies”, e.g., higher taxes that become effective</u>

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