What Is the Extent of Misallocation?

Abstract

Measures of institutional quality are strong predictors of cross-country differences in income and productivity. The institutional economics literature has long maintained that one way institutions influence economic growth is by impacting the efficient allocation of production factors across firms. In this study, we measure the effect of bureaucracy, labor regulations, family management and financial frictions on input misallocation across firms using a unique dataset that combines firm-level financial data with a large survey administered to company managers. We use a general equilibrium model and a new econometric methodology that is robust to production function mis-specification to infer the size of the distortions induced by these frictions in six large European Union economies. For each of the countries included in our sample, we find that the amount of output that is lost as a result of these frictions is less than 1% of aggregate manufacturing production. This is relatively small compared to previous estimates, partly because we implement a number of methodological innovations to reduce upward bias in our measurements.