RDP 2025-05: How Costly are Mark-ups in Australia? The Effect of Declining Competition on Misallocation and Productivity 2. Related Literature

There is a large and growing literature trying to quantify the effects of competition and (its inverse) market power on productivity. Most closely related to our work is the portion of this literature that focuses on how misallocation of resources across firms (i.e. some being too large and some too small) due to distortions like mark-ups can affect aggregate productivity.

This literature is often traced back to Harberger (1954). He explored these costs using industry-level data and concluded that the misallocation costs of monopoly, the so-called ‘Haberger triangle’, were very small.

More recently though a number of papers have begun to re-examine this question, exploiting firm-level data to better capture firm heterogeneity. Two early papers in this literature were Restuccia and Rogerson (2008) and Hsieh and Klenow (2009), which argue that misallocation of resources across firms due to various ‘wedges’ (such as mark-ups) can lead to significant productivity and output losses. The latter paper measured these distortions as the dispersion of capital and labour productivity at a firm level.^[3] They argued that dispersion in measured productivity, which they took as an indicator of dispersion in marginal productivity, meant there was a loss in productivity due to misallocation: it would increase aggregate productivity if the economy shifted resources and output towards those firms with high marginal productivity. They found that such misallocation could account for a large share of the gap in productivity between the United States and both China and India.

In a similar vein, Baqaee and Farhi (2020) derive a general non-parametric set of formulas for decomposing productivity into technical efficiency (i.e. the technological progress) and allocative efficiency (i.e. whether resources were being put to their most productive use) in the presence of wedges and distortions like mark-ups, which they take to be exogenous. Applying these to US data, they find that allocative efficiency rose (and so misallocation fell) from 1997 to 2015 as resources reallocated towards high mark-up, high (marginal) productivity firms. But eliminating markup dispersion in 2015 would still have raised productivity, specifically total factor productivity (TFP), by around 15 per cent. These costs are around two orders of magnitude larger than those found by Harberger (1954).

Most closely related to our paper is EMX, whose model we calibrate to Australia. They construct a heterogeneous firm model under general competition structures. They calibrate it to the US manufacturing sector and find that the TFP costs of misallocation are around 2–6 per cent. These estimates of costs are lower than Baqaee and Farhi (2020), in large part because EMX focus only on variation in mark-ups (and so misallocation) that can be explained by variation in firm size, noting that the rest could capture other factors such as mismeasurement, rather than true misallocation.^[4] In this sense they have endogenous mark-ups that are micro-founded, unlike the exogenous markups in Baqaee and Farhi (2020). They also apply the model to calculate the overall welfare costs of mark-ups, accounting for deadweight losses associated with the level of mark-ups, as well as flow-on effects of distortions into investment and the size of the economy. They find these to be quite large, reflecting both the misallocation channel and the level of mark-ups.

Some papers have looked at these questions in Australia in a more reduced-form, dynamic sense, using empirical regressions rather than full models. Andrews and Hansell (2021) show that the pace of reallocation of labour towards more productive firms within industries (dynamic rather than static allocative efficiency) has slowed since the mid-2000s, and that this reflects structural rather than cyclical factors. Taking a simple back-of-the-envelope calculation, they found that this slowing could account for a moderate portion of the slowdown in labour productivity growth in Australia. Hambur (2023) shows that this slowdown in reallocation is worse in sectors with rising mark-ups, thus linking slower reallocation and productivity growth to rising mark-ups in the Australian context.^[5] He also found that mark-up increases in Australia have tended to reflect within-firm increases, rather than reallocation of resources to high-productivity firms as in the United States (De Loecker et al 2020). Moreover, dispersion in mark-ups increased significantly. Both of these findings suggest that the level of misallocation due to mark-ups is likely to have risen in Australia. Finally, Elkington (2022) applied the Baqaee and Farhi (2020) approach to Australia. He found that the misallocation costs were significant and of an order of magnitude similar to Baqaee and Farhi (2020) for the United States. This provides strong motivation for analysis of these dynamics in the EMX framework.

Footnotes

More precisely, they used a revenue- rather than quantity-based measure of productivity. [3]

This is similar to the argument made by Haltiwanger, Kulick and Syverson (2018) that much of the distortions in Hsieh and Klenow (2009) may not be a true sign of inefficiency, but rather, for example, demand shifts. [4]

Hambur and Andrews (2023) make a similar finding for capital and total factor productivity. [5]