Policy Distortions and Aggregate Productivity with Endogenous Establishment-Level Productivity

The large differences in income per capita across countries are mostly explained by differences total factor productivity (TFP). What explains differences in TFP across countries? Evidence suggests that the (mis)allocation of factors of production across heterogenous production units is an important factor. We study factor misallocation across countries in a model with an endogenously determined distribution of establishment-level productivity. In this framework, policy distortions not only misallocate resources across a given set of productive units, but also worsens the distribution of establishment-level productivity as observed in the cross-country data. We show that in this model compared to the model with an exogenously specified distribution of establishment-level productivity, the quantitative effect of a given policy distortion is substantially amplified, by a factor of 2-fold. Moreover, the implications of the model are more in line with cross-country evidence.