Market frictions prevent the efficient allocation of factors of production, slow down structural transformation and lead to costs in terms of lower output and aggregate total factor productivity (TFP).
We use a theoretical framework developed by Aoki (2012) featuring sector-specific frictions on capital and labor à la Chari, Kehoe and McGrattan (2007), and compute capital and labor misallocations in China and India using data for 26 sectors over the period 1980-2010.
Our findings show that large factor misallocations exist in the two countries. We estimate the potential gains in terms of aggregate TFP stemming from an efficient allocation of factors to range from 25% to 35% in China and from 35% to 40% in India.
Finally, we discuss the implications for structural transformation and the relationship between the observed allocation inefficiencies and the evolution of the business environment in the two countries.