Misallocation in a Global Economy

We develop a general equilibrium model where producers purchase intermediate goods from the lowest cost supplier in the world. Factor prices, productivities and domestic frictions (misallocation) affect the mobility of goods across sectors within a country. In our model, changes in misallocation in a given country have welfare implications in foreign countries through two main mechanisms. First, a reduction in misallocation in a given country impacts production costs, and foreign countries benefit from the access to cheaper goods as a result. Second, lower domestic frictions allow countries to substitute foreign intermediate for domestic ones, which leads to a decline in production and wages in foreign countries. The relative importance of each of these two channels determines the international welfare effects of reducing domestic misallocation. In our model we also incorporate frictions of moving final goods as well as frictions of moving goods from a different sector and country. Using information from the world’s input output databases, we are able to separate changes in productivity from changes in misallocation. Using these estimates, we run a variety of counterfactuals to show the importance of reducing misallocation for the global economy.