Markups and Misallocation with Trade and Heterogeneous Firms

Abstract

With general preferences, a monopolistic competition equilibrium can be inefficient in the way inputs are allocated towards production. This paper formalizes the welfare impact of reallocation of quantities across firms (within an industry) by comparing real income growth with the hypothetical case of no misallocation in quantities ‐ as is the case when consumer preferences are CES and producers choose a constant markup. In contrast, my monopolistic competition model is consistent with variable markups such that reallocations initiated by aggregate shocks that affect firms’ demand or cost curves can impact allocative efficiency. Open economy shocks, even by raising production overall, can have opposing consequences for the misallocation distortion depending on the adjustment of the market power distribution. Using firmlevel data from Chile for 1995-2007, a period with large terms of trade gains, I find that average productivity gains are not necessarily associated with gains in allocative efficiency because firms pass-through productivity gains into markups. From industryyear variation, there is also evidence that industries that import a larger share of their inputs have higher markup dispersions and become more misallocated as a result of appreciations compared to “open” sectors that compete globally in the sale of their output.