There is mounting evidence, especially for developing countries, that resources are often not allocated to their optimal use. This manifests itself in a failure of first-order conditions to hold, such that the marginal (social) benefit of a production factor is not equated to its marginal cost. Such misallocation is often interpreted as resulting from frictions or market failures that prevent firms from choosing optimal inputs. However, in addition to external constraints, there are several other reasons why firms might voluntarily choose to deviate from the standard first-order conditions. In particular, we will investigate the role of market power on product markets and monopsony power on factor markets.
We will first document the importance of input factor and market share misallocations in the formal sector of the Ghanaian economy using standard measures of frictions or market power from the literature. As is the case in many countries, local markets differ tremendously in overall economic activity, sectoral composition, firm-level concentration, and distance from national centers of economic activity. We will investigate both the variation in misallocation across the firm-size distribution and across different local markets. By comparing the patterns for Ghana explicitly to results in the literature for other countries, our analysis will indicate how urgent this problem is.
Next, we will zoom in on the spatial variation across local markets in the importance of misallocation. The objective is to determine whether market-level differences are more strongly correlated with variables that capture local concentration or market isolation or, alternatively, with variables that capture indicators of market failures or external constraints. To formulate appropriate policies and improve resource allocation, it is imperative to determine whether external factors or voluntary deviations are most important.