Market distortion, factor misallocation, and efficiency loss in manufacturing enterprises

Market distortion hinders the free flow of production factors and ultimately reduces the manufacturing industry’s output level. Optimal factor allocation improves the overall output level by adjusting the allocation of factors among enterprises without increasing the input of additional factors. We applied the heterogeneous firm model to examine market distortion and factor misallocation among manufacturing firms based on China’s micro enterprise data. Our empirical findings indicate that manufacturing enterprises in China engage in a serious misallocation of capital and labor, and the degree of capital misallocation is much greater than that of labor; and the total factor productivity (TFP) of China's manufacturing industry has great potential to increase. In addition, this study introduces a time-varying elasticity production function model suitable for China's national conditions. The model more accurately explains China’s current factor misallocation situation and introduces a new method for measuring mismatch in other developing countries.