Markups and Misallocation with Trade and Heterogeneous Firms

Abstract

With non-homothetic preferences, a monopolistic competition equilibrium is inefficient in the way inputs are allocated towards production. This paper quantifies a gains from trade component that is present only when reallocation is properly measured in a setting with heterogeneous firms that charge variable markups. Due to variable markups, reallocations initiated by aggregate shocks impact allocative efficiency depending on the adjustment of the market power distribution. My measurement compares real income growth with the hypothetical case of no misallocation in quantities. Using firm and industry-level data from Chile during a period with large terms of trade gains, I find that cost reductions are associated with losses in allocative efficiency because firms pass-through measured productivity gains into markups. From industry-year variation, there is also evidence that industries that import a larger share of their inputs become more misallocated as a result of exchange rate appreciations compared to open sectors whose output competition becomes fiercer.