Why is Misallocation Higher in Services than in Manufacturing?

Many advanced economies are struggling with low productivity and potential growth, coupled with high debt and limited fiscal and monetary policy space. Structural differences between the services and industry can fully explain the higher levels of allocative inefficiency in the service sector. Specific productivity shocks, which impact allocative efficiency in the presence of capital/labor adjustment costs and/or output-price rigidity, is the most important factor contributing to the misallocation differences between the two sectors.

However, the contribution of productivity disturbance is caused more from different impacts than from the difference in the magnitude of the shocks between the two sectors. The sectoral firm-size structure, proxied by the deviation of the productivity distribution, is the second most important factor explaining the misallocation differences.

A higher proportion of low productivity firms in the service sector makes the productivity distribution more right-deviated contributing to a higher level of misallocation in the service sector due to the prevalence of size-dependent policies. In particular, low productivity in the service sector and lack of catch-up can explain the experiences of productivity slowdown, stagnation, and decline observed across economies.

The proportion of young firms also has a bearing on misallocation differences between the two sectors. Young firms emerge as facing higher rental costs of capital than older firms, as an evidence of the presence of credit constraints imposed by financial institutions on young firms due to a lack of credit history or insufficient guarantees. However, the net contribution of this factor is negative, meaning that in the absence of this effect the difference in misallocation between service and manufacturing sectors would be even larger. Less productive firms appear as benefitting from capital and labor subsidies, which suggests that there might be a trade-off between employment creation and aggregate productivity. Therefore, size-contingent laws passed by governments and aimed at boosting employment creation in small or medium-sized firms, to the extent that they contribute to the survival of unproductive firms, can increase misallocation and have a strong negative impact on aggregate productivity.

The level of allocative efficiency in the service sector is significantly lower than that of the manufacturing sector. Because services are, by far, the most important sector of activity in most economies, significantly higher levels of misallocation in this sector have important implications for GDP. A significant part of the difference of allocative efficiency between the two sectors may be attributed to higher output price rigidity in the service sector. To the extent that such higher price rigidity stems from lower competition, measures aimed at increasing product market competition in the service sector will contribute to increasing allocative efficiency in the sector, thus, boosting aggregate productivity

Reducing the level of misallocation in the economy to the levels observed in the U.S. economy would increase productivity by 30-40 percent. However, if a significant difference of allocative efficiency between manufacturing and the service sector, similar to Portugal, Spain or Latvia, are present in other countries, the importance of resource misallocation to explaining productivity differences between developed and developing countries may even be higher than what the empirical evidence based on data from the manufacturing sector alone would suggest.

By shedding light on the reasons behind the higher level of misallocation in the service sector relative to the manufacturing sector this comment contributes to the understanding the policies that may contribute to increasing productivity growth, particularly in advanced economies.

The analysis suggests that boosting competition so as to reduce output price rigidity in the service sector, avoiding size-contingent laws that may contribute to the survival of unproductive firms and reducing barriers to growth by eliminating credit constraints imposed by financial institutions on young firms, are measures that can contribute to reducing within-industry misallocation, especially in the service sector, and thus to increase