Heterogeneous Mark-Ups and Endogenous Misallocation

Why are resources misallocated across firms? I study an economy where misallocation stems from firms charging heterogeneous mark-ups. The distribution of mark-ups affects both aggregate TFP as well as equilibrium factor prices. While TFP is solely affected by the cross-sectional dispersion of mark-ups, factor prices depend only on the average mark-up. Mark-ups however are the result of firms' pricing decision and hence endogenous. In my model, they are determined by the process of entry and exit. If entry is more intense, aggregate TFP and factor prices are high, as product market competition reduces both the level and the dispersion of mark-ups. The static degree of misallocation is therefore closely linked to the dynamic evolution of the economy. I test the model's prediction using regional variation in the extent of entry into the manufacturing sector in Indonesia. I show that regional differences in the entry rate are negatively correlated with the average mark-up and the mark-up dispersion as the model predicts. In terms of welfare, the theory implies that the observed differences in mark-ups between high and low entry regions in Indonesia translate into TFP differences of 2.5%, differences in the steady state level of capital of 13% and differences in aggregate consumption of 6%.