Economics
Misallocation and Aggregate Productivity Losses
Quick fact
A classic study suggested that if China and India had the same resource allocation as the U.S., their manufacturing productivity could jump by 30–50% without any new technology.
Why this is interesting
Imagine two economies with the same technology and workers—yet one is twice as rich. The difference might not be what they produce, but who gets the resources to produce it.
Read the full explanation
Understanding Misallocation and Aggregate Productivity Losses
Think of an economy as a team working on a giant project. Each worker and each machine is a resource. If the team leader gives the hardest tasks to the least skilled workers and the easiest tasks to the best workers, the project will be slower than it could be. Misallocation is exactly that, but on a national scale. In a healthy economy, resources flow to where they are most valuable. A high-performing company that wants to expand should be able to hire more workers and buy more machines. A low-performing company that can’t compete should shrink or close, freeing resources. But in reality, barriers like restrictive licenses, tax loopholes, subsidies for large incumbents, or even social norms can prevent this. As a result, some highly productive firms are starved of inputs, while less productive ones hoard capital and labor. When that happens, the total output of the economy is less than it could be—even if every worker and machine is still used. The economy's 'aggregate productivity' (the efficiency of the whole system) falls because resources are not being put to their best use.
A deeper explanation
The underlying principle is that aggregate productivity depends not just on the productivity of each firm, but on how resources are distributed across them. Economists measure this using the concept of the marginal product of an input: the extra output gained from using one more unit of that input. In an efficient allocation, the marginal product of capital should be equalized across all firms—just as a profit-maximizing team assigns the best workers to the most critical tasks. If one firm has a high marginal product of capital and another has a low one, output can be increased by moving capital from the latter to the former until the marginal products converge. Misallocation introduces 'wedges'—factors that drive a wedge between the marginal product and the actual cost of an input. These wedges can come from taxes, subsidies, imperfect information, regulatory burdens, or market power. For example, a conglomerate with political connections might get cheap credit, allowing it to over-invest despite low productivity, while a lean startup cannot get a loan even though it could generate huge returns. The cumulative effect of many such distortions is vast. The widely cited Hsieh-Klenow approach quantifies this by measuring the dispersion of marginal products across firms. If all firms faced the same input costs and no distortions, the marginal products would be equal. The wider the dispersion, the larger the aggregate productivity loss. In developing countries, this dispersion is often much larger than in the U.S., explaining a significant part of their productivity gap. Correcting misallocation—by reducing barriers to entry, removing distorting subsidies, and improving access to finance—can yield large gains, sometimes equivalent to decades of technological progress.