Factor Misallocation, Firms' R&D Decision And Aggregate Productivity Losses

China's current economic growth model heavily relying on increasing factor inputs and demand has come to an end due to scarce resources, growing labor costs, and environmental issues. Under this circumstance, improving aggregate productivity will act as the major driving force of China's future economic growth. At present, there are still huge gaps in terms of total factor productivity between China and the developed economies. Meanwhile, the liberalization of factor market lags far behind the development of product market in the process of China's market-oriented reforms. The lagged liberalization of factor market may lead to factor misallocations. Therefore, it is of significant to understand the low productivity from the perspective of factor misallocations in China. However, we notice that factor market distortions in China differs from market imperfections in the developed countries. It can distort firms'R&D investment and lead to more severe factor misallocations. Therefore, it is necessary to consider firms'behavior of R&D investment when investigating the role of factor misallocations on aggregate productivity losses.To confront with the facts, this paper constructed a theoretical model which is more convincing to interpret China's aggregate productivity losses. The model is based on a framework of monopoly competition with heterogeneous firms by incorporating factor market distortions and firms'R&D decisions. We analyze firms'optimization behavior and then derive the aggregate productivity in the equilibrium. By comparing with the equilibrium state with no distortions, we reveal three channels which can lead to aggregate productivity losses. The first is factor misallocations among incumbents. In the equilibrium, aggregate productivity is not only determined by firm-level productivity but also market distortions. Factor misallocations can be evidenced from the dispersion of marginal revenue product (MRP) among incumbents. It implies reallocating factors from firms with lower MRP towards higher MRP firms can lead to aggregate productivity gains. The second is distortions on firm entry and exit. We analyze the relationship between firm productivity and factor market distortions in determining firm entry and exit. It shows subsidized firms can survive even with low productivity, while more productive firms with high levels of market distortions can be force to exit The two types of firms are 'zombies' and "Shadows', respectively. The third is distortions on firm R&D decisions. Market distortions can make some more productive firms quit R&D and some less productive firms undertake R&D. It can reduce the efficiency of R&D investment and lead to aggregate productivity losses. More importantly, R&D activity can not only improve the productivity of R&D performers but also force the least productive firms to exit, reallocate resource from non-R&D firms towards R&D performers, and contribute to aggregate productivity gains. On the contrary, distortions on firm R&D decisions will amplify aggregate productivity losses.The potential theoretical contribution of the paper comes from two sides. The first is that the model partially endogenize the distribution of firm productivity. It enables us to capture firm-level productivity dynamics due to R&D and firm entry/exit, and its impact on aggregate productivity. The second is the model extend the dimensions of factor misallocations. In the model, factor misallocations are no longer limited among incumbents as in the previous literature, as it can also exist among incumbents, entering and exiting firms. Therefore, the paper not only contributes to the theoretical literature, but also helps to understand the micro-channels of aggregate productivity losses in China.In the empirical section of the paper, the theoretical model is applied to analyze China's aggregate productivity losses. We first investigate causes of factor misallocations and the characteristics of firm R&D investment in China. We provide strong evidence of the existence of factor market distortions and its links with firm R&D investment from the perspective of the undeveloped financial market and government interventions. Then, a productivity decomposition method is employed to identify the source of APG. The results suggest that China's APG is largely driven by technical efficiency changes, while factor reallocations and firm entry/exit contribute less to APG. Further analysis reveal that firm R&D can increase the critical value of productivity level for producing firms and force the least productive firms to exit. Meanwhile, firm R&D can reallocate market shares from non-innovators towards innovators. However, at industry level, firm R&D has yet become the fundamental determinant of China's APG. It implies the existence of barriers on factor reallocations and firm entry/exit. Distortions on firms'R&D decisions may amplify factor misallocations and aggregate productivity losses.At last, the paper quantitatively measures factor misallocations and APL by using an approximation method with counterfactual facts. The results demonstrate that APL reached an average rate of 8.35 percentage points per year during the sample period. On average, capital and labor misallocations account for 5.60 and 2.75 percentage points, respectively. Productivity lasses mechanically lead to sizable output losses in terms of value added. The policy implications of the paper are straightforward. That is, China's future economic reforms should give priorities to improving aggregate productivity of the whole economy. To achieve that goal, it is critical to stimulating firm innovation. However, the premise is to accelerate factor market reforms for improving factor allocative efficiency.