Identifying Capital Misallocation∗

Resource misallocation lowers aggregate productive effi ciency. The existing literature often infers the magnitude of misallocation from the dispersion of average revenue products. However, the methodology is subject to several identification issues. In particular, the estimator would be upward biased by the presence of unobserved heterogeneities in output and demand elasticities; adjustment costs; and measurement errors in the data. This paper develops a new method of identifying capital misallocation in environments where all the above factors can be present. Applying the method to firm-level datasets from China’s industrial survey and Compustat, we find that capital misallocation implies aggregate revenue losses of 20 percent for Chinese firms but virtually zero losses for large Compustat firms. JEL Classification: E22, O16, O47