Resource misallocation in European firms: The role of constraints, firm characteristics and managerial decisions

Although the large cross-country differentials in income per capita have been the subject of much research, accounting for sources of this dispersion has proven to be difficult. The most important factor appears to be differences in “productivity”, which Moses Abramovitz called a measure of our ignorance. In an attempt to explain “productivity” differences within and across countries, recent research pioneered by Hsieh and Klenow (2009) emphasizes the importance of firm-level misallocation of resources for aggregate economic outcomes. It is based on the insight that if there is a dispersion of marginal revenue products of inputs across firms, the economy may achieve considerable productivity, and hence output, gains by reallocating capital from firms with low marginal revenue product of capital (MRPK) to firms with high MRPK and, similarly, from firms with low marginal revenue product of labor (MRPL) to firms with high MRPL.

Using a new survey, we show that the dispersion of marginal products across firms in the European Union (EU) is about twice as large as that in the United States. Reducing it to the U.S. level would increase EU gross domestic product (GDP) by more than 30 percent. Alternatively, removing barriers between industries and countries would raise EU GDP by at least 25 percent. Firm characteristics, such as demographics, quality of inputs, utilization of resources, and dynamic adjustment of inputs, are predictors of the marginal products of capital and labor. We emphasize that some firm characteristics may reflect compensating differentials rather than constraints and the effect of constraints on the dispersion of marginal products may hence be smaller than has been assumed in the literature. We also show that cross-country differences in the dispersion of marginal products are more due to differences in how the business, institutional and policy environment translates firm characteristics into outcomes than to the differences in firm characteristics per se.