This working paper published by Galle (2016) develops a novel general-equilibrium model of the relationship between competition, financial constraints and misallocation, and tests its implications using Indian plant-level panel data. In the model, steady-state misallocation consists of both variable markups and capital wedges. The variable markups arise from Cournot-type competition, whereas the capital wedges result from the interaction of firm-level productivity volatility with financial constraints. Firms experience random shocks to their productivity and in
response to positive productivity shocks they optimally grow their capital stock, subject to financial constraints. Competition plays a dual role in affecting misallocation. On the one hand, both markup levels and markup dispersion tend to fall with competition, which unambiguously improves allocative efficiency in a setting without financial constraints. On the other hand, in a setting with financial constraints, a reduction in markups is associated with slower capital accumulation, as the rate of self-financed investment falls. Thus, the positive impact of competition on steady-state misallocation is reduced by the presence of financial constraints. Empirically, he tests and confirms the qualitative predictions of the model with data on Indian manufacturing. The prediction that the firm-level speed of capital convergence falls with competition is confirmed for the full panel of manufacturing plants in India’s Annual Survey of Industries. This effect is particularly pronounced in sectors with higher levels of financial dependence. He also exploits natural variation in the level of competition, arising from the pro-competitive impact of India’s 1997 dereservation reform on incumbent plants, and again confirms the qualitative predictions of the model.