Customer Driven Establishment Dynamics and Allocative Efficiency

A common result from models of misallocation is that allocative efficiency is reflected in the correlation between size and productivity. But establishments start small which raises the question: how does the distribution of size have to evolve over the lifecycle to achieve allocative efficiency? Simply put, it must be that more productive establishments grow faster at the expense of less productive establishments. As evidence of this selection mechanism, I use establishment level data to construct cohorts of entrants and show that the spread of growth between fast and slow growing establishments is positively associated with higher exit rates. But unlike typical models that feature selection, I show that neither increases in input costs nor greater volatility are the force behind selection. To reconcile these facts, I present a model where the degree to which customers are willing to match with establishments who produce low quality goods introduces a new margin that affects selection. In the model, 60 per cent of changes in the intensity of selection come from changes in demand side behavior. To assess this new margin of selection, I recalibrate a parameter which controls the degree to which establishments can crowd out others for customers to match the slower fanning out in the evolution of the size distribution in Chile relative to the US. The model suggests that going from the US to Chile in this dimension would result in a 44 per cent loss in welfare.