Development strategy, resource misallocation and economic performance

This paper provides a consistent explanation for the distinct economic performance among the Less Developed Countries (LDCs) from the perspective of government development strategy. We argue that government development strategy and resource misallocation are key determinants of economic development in LDCs, i.e. China. Descriptive statistics show that China's capital-to-output ratio is negatively correlated with per-capita output, which contradicts the predictions of standard neoclassical growth theory. We incorporate governmental heavy-industry-oriented development strategy into a two-sector model to understand this puzzle. Our theoretical model reveals that a greater emphasis on heavy-industry-oriented development results in a larger capital-to-output ratio and lower per-capita output. We test our hypothesis against other theories using prefecture-level and firm data from China. We find that a larger capital-to-output ratio is associated with a greater degree of misallocation driven by government development strategy. A heavy-industry-oriented strategy will result in greater misallocation and lower TFP, which is consistent with our hypothesis.