Public Policy and Resource Allocation

The correlation between a firm’s size and its productivity level varies considerably across OECD countries,suggesting that some countries are more successful at channelling resources to high productivity firms thanothers. Accordingly, we examine the extent to which regulations affecting product, labour and creditmarkets influence productivity, via their effect on the efficiency of resource allocation. Our results suggestthat there is an economically and statistically robust negative relationship between policy-induced frictionsand productivity, though the specific channel depends on the policy considered. In the case of employmentprotection legislation, product market regulations (including barriers to entry and bankruptcy legislation)and restrictions on foreign direct investment, this is largely traceable to the worsening of allocativeefficiency (i.e. a lower correspondence between a firm’s size and its productivity level). By contrast,financial market under-development tends to be associated with a higher fraction of low productivityrelative to high productivity firms. Furthermore, stringent regulations are more disruptive to resourceallocation in more innovative sectors, though the nature of innovation turns out to be important.