Mark-Up Distortions and Endogenous Misallocation

Income differences across countries are to a large degree driven by differences in aggregate TFP. Recently it has been argued that part of these differences are due to misallocation of factor across firms. In this paper we propose a structural model of this degree of misallocation. Our model is one where monopolistic competition across firms generates non-constant mark-ups, which reduce aggregate TFP relative to the competitive benchmark. Equilibrium mark-ups depend only on the distribution of firm-level productivity, which evolves endogenously according to a Schumpeterian process of creative destruction. This provides the link between the economy's innovation environment and the equilibrium degree of misallocation. In particular, the economy's entry intensity is a sufficient statistic for the invariant distribution of mark-ups and their TFP consequences. If entry is more intense, aggregate TFP is higher, as product market competition reduces the distorting effect of mark-ups. This provides a new channel how impediments to firm entry, like entry costs, reduce allocative efficiency, aggregate TFP and income per capita.