Industrial Policy, Misallocation, and Aggregate Productivity: Policy Implications of Firm-Specific Distortions

83 Pages Posted: 18 Nov 2019 Last revised: 20 Nov 2019

Date Written: October 20, 2019


Resource misallocation can lower aggregate total factor productivity (TFP), and industrial policy can affect the extent of misallocation as it intervenes in the allocation of resources across firms. I study a common instrument of industrial policy, that of capital subsidies to firms, within a framework in which the model economy exhibits resource misallocation: heterogeneous firms face distortions in capital and labor markets that drive wedges between the marginal products of capital and labor across firms. A subsidy is an additional distortion in the capital market. Capital subsidies can decrease TFP by exacerbating existing misallocation, but well-designed subsidies can increase TFP. I adopt this framework to analyze a capital subsidy policy in Greece using a firm-level panel dataset that includes information on firm-specific capital subsidies allocated in a discretionary fashion. I find that the existing policy decreases the manufacturing TFP by 0.15%. A counterfactual optimal (TFP-maximizing) implementation that reallocates policy resources among all firms increases TFP by 2.2%. An optimal reallocation of policy resources only among firms that applied for a subsidy increases TFP by 1%. My results also show that the optimal policy does not favor firms of a particular size or age but favors the most productive ones because of the empirical fact that these firms are the most constrained in the data-set. Interestingly, the textbook recommendation for industrial policy, subsidizing all firms in an industry at a uniform rate, can decrease industry TFP if the least-constrained firms absorb more policy resources than the most-constrained ones.

Keywords: Misallocation, Industrial Policy, Aggregate TFP, Subsidies

JEL Classification: E23, O25, O11, D24, L50, H25

Suggested Citation

Fakos, Alexandros, Industrial Policy, Misallocation, and Aggregate Productivity: Policy Implications of Firm-Specific Distortions (October 20, 2019). Available at SSRN: or

Alexandros Fakos (Contact Author)

ITAM ( email )

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