Production Flexibility, Misallocation and Total Factor Productivity

Economy-wide institutional deficiencies causing factor misallocation have been emphasized as essential determinants of aggregate TFP differences. This paper argues that production flexibility at the micro-level is an economic characteristic that should be given priority in TFP aggregation exercises. We investigate a heterogeneous firms model with two distinct notions of flexibility: (i) the firm-specific capacity to optimize over a set of production techniques that serve to organize capital and labor; and, (ii) the industry-specific substitutability between efficient units of capital and labor. We show the presence of a strong interaction between "ability to choose techniques" and "input substitutability": high complementarity at the industry-level amplifies imperfections associated with techniques choice at the firm-level. Using the micro-founded structure, we develop measures for factor, output and technique distortions across a distribution of firms and quantify their TFP effects. For a broad range of U.S. manufacturing industry clusters, technique distortions generate more TFP losses than misallocation resulting from capital and output distortions, with larger TFP gains from removing technique distortions in industries that exhibit high degrees of factor complementarity. Our key quantitative results are robust to outliers, production function specification, mismeasurement and parameterization of the model and are strongly present in developing country datasets.