Estimating resource misallocation: Distinguishing factor market distortions from variable markups

Abstract

This paper extends the approach of Hsieh and Klenow (2009) by relaxing the assumption of constant markup. We show that TFPR dispersion is not a sufficient statistic for misallocation under variable markup due to incomplete cost pass-through, and propose a general approach to measure the labor and capital distortions. We demonstrate that after taking into account variable markup, the extent of misallocation in China is considerably smaller in magnitude than the estimate in Hsieh and Klenow (2009).