6 A key challenge highlighted by IMP3 and other national plans is the need to raise the productivity of the manufacturing sector. In particular, the IMP3 outlines several recommendations, including upgrading of knowledge and skills of the workforce, adopting and absorbing new technologies, fostering innovation, and benchmarking to best management practices. It<sup>8</sup> also emphasizes developing technological capabilities and enhancing innovation through research and development (R&D). However, a strategy of promoting innovation and greater absorption of technology must be complemented by other policies. This paper highlights the importance of ensuring well-functioning product, labor, and credit markets. It also notes the need to institute policies that foster greater domestic competition so that resources can be allocated efficiently and unproductive firms or sectors do not overutilize the available resources in the economy.

# **3.0 Literature Review**

As granular data become more readily available, micro data are increasingly being used to ascertain why some firms are more productive than others, and more recently, why productivity differences persist even in narrowly defined industries. Specifically, many studies examine whether resource misallocation is a significant channel in explaining productivity differences across firms or countries.

# **3.1 The Direct Measure of Misallocation**

Studies that assess the implications of misallocation on productivity can be divided into two categories: those that adopt the direct approach, and others that adopt the indirect approach. Studies using the direct approach attempt to obtain a direct measure of factors or specific regulations that cause misallocation of inputs. These studies build a case for the importance of misallocation by assessing the implications of these regulations on sectors of the economy.

For example, Hopenhayn and Rogerson (1993) show that firing taxes distort the allocation of labor across firms, which results in TFP loss of about 2% and output loss of 5%.<sup>9</sup> Lagos (2006) also studies the implications of labor market regulation such as unemployment insurance and employment protection on the allocative efficiency of resources. Lileeva and Trefler (2010) study the impact of reductions on trade tariffs on firm productivity in Canada. Along the same lines, Epifani and Gancia (2011) argue that trade barriers influence the degree of competition and hence affect markups. These varying markups are sources of distortions and misallocation of resources. Eslava et al. (2013) focus on whether large changes of tariffs in Colombia are associated with misallocation of resources.

Other studies attempt to link credit market imperfections with misallocation.<sup>10</sup> Banerjee and Duflo (2005) provide evidence that suggests that misallocation of capital arising from credit constraints and institutional failures is an important source of productivity differences across countries. Other related studies such as Erosa (2001), Buera, Kaboski, and Shin (2011), and Midrigan and Xu (2010) have all produced estimates of the effects of varying measures of

> 8 The Second National Science Technology Policy (2002-2010) and many of the Malaysia Plans beginning in the mid-1980s also discuss the importance of R&D initiatives in driving growth and competitiveness.

> 9 Hopenhayn and Rogerson (1993) use the general equilibrium model of Hopenhayn (1992), where the parameters in the model are calibrated based on the US manufacturing firm level dataset. 10 See Boyd and Prescott (1986); Jeong and Townsend (2007); and Cole, Greenwood, and Sanchez (2016).