Inequality and Misallocation under Production Networks

This paper examines the equity–efficiency tradeoff by showing that changes in the joint distributions of factor income and household expenditure influence aggregate productivity (TFP). I develop a general equilibrium aggregation and incidence theory for a distorted production network economy with heterogeneous households, deriving a sufficient-statistic decomposition of TFP. I define and decompose the positional terms of trade (PTT) — a household-specific efficiency wedge that maps shocks into real-consumption incidence. The model ranks factors, households, and firms by distortion, expenditure, and revenue centralities, showing that changes in who earns and who spends are generically non-neutral: allocative efficiency rises when factor income shifts from high to low distortion centrality factors and when demand reallocates toward high expenditure centrality households or high revenue centrality firms, thereby alleviating bottlenecks. Benchmarking against a constrained social planner allocation that internalizes reallocation externalities, I show that decentralization lacks the planner’s balancing property and generates first-order externalities for aggregate efficiency and welfare. Estimating the model on U.S. data (1997–2021), I find that changes in the income distribution explain approximately 20% of TFP variation. Finally, budget-neutral, progressive lump-sum transfers targeted by expenditure centrality raise aggregate TFP and improve the PTTs of lower- and middle-income households, aligning efficiency gains with favorable equity outcomes.