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# **1.0 Introduction**

The economics literature amply documents the importance of total factor productivity (TFP) as a source of sustained economic growth. TFP differs greatly across countries. Dissecting the sources of TFP into various micro components reveals that these differences are also persistent across firms that operate within narrowly defined industries. What accounts for these productivity differences across countries or firms? One possible explanation is that frontier technologies and best practice methods are slow to diffuse to some countries. Recent literature argues that misallocation of resources, which is the focus of this paper, explains part of these productivity differences.

Previous studies have suggested that both slow technological diffusion and misallocation of resources are potentially relevant,<sup>1</sup> but more conventional discussion about productivity centers on technology, which requires a different set of policy prescriptions. Policies geared toward increasing technological diffusion and innovation include measures that promote research and development (R&D) and the creation of new ideas. These policies are usually complemented with ones that incentivize learning, upgrading of skills, and investment in education. However, recent views focus on the benefits of reallocation of inputs from less to more productive firms as an important component of aggregate productivity growth. Policies associated with allocative efficiencies emphasize correcting or reducing market distortions.

The conceptual idea of allocation efficiency was translated into an empirical framework by Hsieh and Klenow (2009). In their framework, they argue that the overall TFP of an industry depends not only on the TFP of individual firms, but also on how resources are being allocated across firms. In an economy with low levels of distortion, productive firms will have access to more resources—namely, labor and capital—compared to less productive ones, and this leads to an increase in the overall productivity of the sector. Therefore, to achieve maximum allocation efficiency, two firms within a narrowly defined industry should be able to access resources up to the point where they attain the same marginal revenue products. Large dispersions in marginal revenue products among firms operating within a narrowly defined industry will imply misallocation of resources in the industry.

Many studies and anecdotal details showed how corruption, regulation, or direct government involvement distort the allocation of resources from their most efficient use, especially in lower-income economies. For example, it could be the case that the government subsidizes some firms, but not others. State-owned enterprises could also be enjoying preferential interest rates, while non-state-owned enterprises face market interest rates. While distortions explain the unequal access to resources, other factors are also at play. For example, the size of a firm can affect its bargaining power; thus, larger firms may be able to borrow at lower interest rates.

Therefore, measuring the extent of resource misallocation in an economy is important because it allows us to answer three key questions. First, how important is resource misallocation in causing the productivity gaps in the manufacturing sector and industries in the sector? Second, what are the main causes of misallocation of resources? Third, what is the cost of misallocation of resources to overall economic growth?

1 See Cole et al. (2016); OECD (2015); Syverson (2011); and Restuccia and Rogerson (2008).