This paper combines a novel general equilibrium model with evidence from Indian plant-level data to investigate the relationship between competition, financial constraints and misallocation. In the theoretical model, steady-state misallocation arises both from variation in markups, and from the interaction of firm-level productivity volatility with financial constraints. Firms experience random, positive shocks to their productivity, in response to which they optimally grow their capital stock, subject to financial constraints.
Competition plays a dual role in affecting misallocation. On the one hand, both markup levels and markup dispersion tend to fall with competition, which unambiguously improves allocative efficiency in a setting without financial constraints. On the other hand, in a setting with financial constraints, a reduction in markups slows down capital accumulation, as the rate of self-financed investment shrinks. Thus, the positive impact of competition on steady-state misallocation is reduced by the presence of financial constraints. Empirically, I test and confirm the qualitative predictions of the model with data on Indian manufacturing. The prediction that the firm-level speed of capital convergence falls with competition is confirmed for the full panel of manufacturing plants in India’s Annual Survey of Industries.
This effect is particularly pronounced in sectors with higher levels of financial dependence. I also exploit natural variation in the level of competition, arising from the pro-competitive impact of India’s 1997 dereservation reform on incumbent plants, and again confirm the qualitative predictions of the model.
This research was funded under the Private Enterprise Development in Low-Income Countries (PEDL) Programme
Galle, S. Competition, Financial Constraints and Misallocation: Plant-Level Evidence from Indian Manufacturing. (2015) 60 pp