Misallocation, Establishment Size, and Productivity

We construct a new dataset using census, survey, and registry data from hundreds of sources to document a clear positive relationship between development and average establishment size in manufacturing across 134 countries. We rationalize this relationship using a standard model of heterogeneous production units that features endogenous entry and productivity investment. The model connects small operational scales to the prevalence in poor countries of higher productivity elasticities of distortions. The model also rationalizes the finding in poor countries of low establishment-level productivity and low aggregate productivity investment. The model provides a tractable framework to decompose the importance of factor misallocation, life-cycle productivity investment, and entry-level productivity in accounting for aggregate productivity differences across countries. A calibrated version of the model implies that when the productivity elasticity of distortions increases from 0.09 in the U.S. to 0.5 in India, aggregate productivity falls by 53 percent and average establishment size by 86 percent. Establishment productivity at entry and factor misallocation roughly account equally for the entire reduction in aggregate productivity, whereas the reduction in life-cycle productivity growth is fully offset by its effect on establishment entry.