Research in progress.
Project last updated on: 20 Feb 2015.
This project offers an analysis of the trade-off between capital misallocation and competition (measured by markups) in the context of India’s manufacturing sector. This analysis integrates reduced form empirical evidence with a theoretical model in order to allow for counterfactual analysis of India’s liberalisation episode. The analysis proceeds in three steps. First, this project demonstrates which theoretical conditions are sufficient to generate a trade-off between capital misallocation and competition. These conditions are based on the interaction of firm-level financial constraints with firm-level productivity shocks. In the presence of financial constraints, a firm needs to rely on internal financing to accumulate capital in response to a positive productivity shock. The basic idea is then that the speed of firm-level capital accumulation decreases with competition, as competition puts downward pressure on firm-level profitability.
In a second step, this project provides empirical evidence for the model’s theoretical predictions in the context of India’s manufacturing sector. These theoretical predictions relate to the three main dimensions of the model: capital misallocation, productivity volatility and competition. First, we analyse how productivity volatility is associated with capital misallocation. Second, we document the magnitude with which, given a certain level of productivity volatility, an increase in competition leads to higher capital misallocation. For this purpose, we use data on the reforms during India’s liberalisation episode, which constitute an arguably exogenous change in the degree of competition. Third, we investigate how the previous two mechanisms are amplified by stronger collateral constraints, i.e. we ask whether the negative impacts of productivity volatility and intensified competition are stronger for firms that face tighter collateral constraints. By implementing these empirical checks, the project achieves two things. First, it documents the existence of a trade-off between competition and misallocation in the Indian manufacturing sector, thereby demonstrating the empirical relevance of the model. Second, it estimates the magnitude of the elasticity with which competition increases capital misallocation. The magnitude of these elasticities will then be relevant for the counterfactual simulations of the model.
These counterfactual simulations, which are the third step of the project, perform two tasks. A first task is to document the implied welfare losses (or gains) of India’s liberalisation episode. Specifically, we ask what the welfare loss is of the liberalisation reforms, given the estimated magnitude with which competition increases misallocation. The second task is to simulate the dynamics of alternative reform paths. For instance, if liberalisation had been implemented more gradually, what would the counterfactual welfare change have been?
The theoretical component of this paper builds on Midrigan and Xu (2014) and Moll (2014). Both papers examine the interaction of productivity volatility and financial constraints in shaping capital misallocation. This project is complementary to their analysis, as it focuses on the relation between capital misallocation and competition, and provides an analytical description of the role of competition in shaping capital misallocation. Moreover, this project provides causal reduced form evidence for the theoretical predictions of the model, whereas Moll (2014) focuses on an extensive theoretical analysis with closed-form solutions, and the empirics in Midrigan and Xu (2014) consist of model simulations with calibrated parameters. Another relevant paper is Itskhoki and Moll (2014), which discusses the social planner’s optimal policy response to capital misallocation. Compared to Itskhoki and Moll (2014), the contribution of this paper lies in extending the set of policy tools for minimising capital misallocation. The specific contribution of this paper is the focus on the comparative statics for competition policy, describing and mapping out the trade-off between competition and capital misallocation.
Empirically, this project is closely related to the work by Asker et al. (2014) on capital misallocation. They document the empirical relationship between productivity volatility and capital misallocation across US industries and across a number of countries. The theoretical explanation of this relation between productivity volatility and capital misallocation in Asker et al. (2014) is based on adjustment costs in capital, which delay the firm’s response to a productivity shock. However, as explained by Midrigan and Xu (2014), Moll (2014) and this project, this relation can also be driven by finance constraints.
This paper also relates to the Peters (2013), who argues that increased competition diminishes misallocation. The current project can be viewed as complementary to Peters’ analysis, as his analysis focuses on misallocation based on heterogeneous markups whereas our project analyses capital misallocation as a function of the degree of competition.
In terms of its focus on India, this paper is motivated by the observation that misallocation in India has continuously increased during the past two decades, despite extensive liberalisation (Hsieh and Klenow, 2009; Bollard et al., 2013). At the same time, the importance of financial frictions for the Indian economy has been documented at the micro-level (Banerjee and Duflo, 2014). In light of the above-mentioned theoretical work on capital misallocation, it is natural to ask if and how these stylised facts for the Indian economy – increased misallocation after liberalisation, in the presence of financial constraints – are causally related to one another.
Several papers have studied the impact of India’s reforms on its economy (Aghion et al. (2008); Alfaro and Chari (2014); Bollard et al. (2013); Chari (2011); Topalova and Khandelwal (2011). Here, Alfaro and Chari (2014) is the paper closest to this project, as it also studies the effect of the delicensing episode on misallocation. They find evidence of a shrinking middle in response to the delicensing episode in India, as well as a decrease in overall resource misallocation. This paper complements their analysis by utilising a more comprehensive dataset (ASI Census instead of Prowess, which documents firms registered on the stock market), and by focusing on capital misallocation in particular instead of overall resource misallocation. Additionally, this paper has a more structural nature than most of the existing reduced-form analysis of India’s liberalisation reforms. More specifically, the empirical analysis is guided by a clear theoretical framework, and the goal is to derive structural estimation equations from the model. As such, the overall contribution of this paper to the literature, is its integrated empirical, theoretical and counterfactual analysis of capital misallocation, productivity volatility and competition in the context of India’s liberalisation episode.
Aghion, P., R. Burgess, and S. J. Redding (2008). The unequal effects of liberalization: Evidence from dismantling the license raj in India. American Economic Review 98 (4), 1397–1412.
Alfaro, L. and A. Chari (2014). Deregulation, misallocation, and size: Evidence from India.Harvard Business School BGIE Unit Working Paper (13-056).
Asker, J., A. Collard-Wexler, and J. De Loecker (2014). Dynamic inputs and resource (mis)allocation. Journal of Political Economy 122 (5), 1013–1063.
Banerjee, A. V. and E. Duflo (2014). Do firms want to borrow more? testing credit constraints using a directed lending program. The Review of Economic Studies 81 (2), 572–607.
Bollard, A., P. J. Klenow, and G. Sharma (2013). Indias mysterious manufacturing miracle. Review of Economic Dynamics 16 (1), 59–85.
Chari, A. (2011). Identifying the aggregate productivity effects of entry and size restrictions: An empirical analysis of license reform in India. American Economic Journal: Economic Policy 3 (2), 66–96.
Hsieh, C.-T. and P. J. Klenow (2009). Misallocation and manufacturing tfp in China and India. Quarterly Journal of Economics 124 (4).
Itskhoki, O. and B. Moll (2014). Optimal development policies with financial frictions. Technical report, National Bureau of Economic Research.
Midrigan, V. and D. Y. Xu (2014). Finance and misallocation: Evidence from plant-level data. American Economic Review 104 (2), 422–458.
Moll, B. (2014). Productivity losses from financial frictions: Can self-financing undo capital misallocation? The American Economic Review 104 (10), 3186–3221.
Peters, M. (2013). Heterogeneous mark-ups, growth and endogenous misallocation.
Topalova, P. and A. Khandelwal (2011). Trade liberalization and firm productivity: The case of india. Review of economics and statistics 93 (3), 995–1009.
Project last updated on: 20 Feb 2015.