A Microeconomic Perspective on Misallocation

Conversations on Transformation, a STEG podcast

In low income countries, the most productive firms often stay small, and the least efficient ones stay in business far longer than they should. Why?

Eric Verhoogen presented his answer at January's STEG Annual Conference in Nairobi, drawn from a chapter he is writing for the forthcoming Handbook of Development Economics. He argues that economists have become good at spotting misallocation, but not yet at identifying what causes it and what policy can do to eliminate it. His search for the source takes in tax codes, labour law, credit markets, and a workshop district in Dhaka where firms adopted a more efficient motor. If we find what is causing misallocation, he tells Tim Phillips, the prize could be worth 10 to 30% of GDP.

The research behind this episode

Bergquist, Lauren Falcao, Danial Lashkari, and Eric Verhoogen. 2026. "Wedges: A Microeconomic Perspective on Misallocation." Forthcoming in Handbook of Development Economics, vol. 6. Also CEPR Discussion Paper 21034 (gated) and NBER Working Paper 34756.

Chaurey, Ritam, Gaurav Nayyar, Siddharth Sharma, and Eric Verhoogen. 2025. "Social Learning among Urban Manufacturing Firms: Energy-Efficient Motors in Bangladesh." CEPR Discussion Paper 20713 (gated).

To cite this episode

Phillips, Tim, and Eric Verhoogen. 2026. "A Microeconomic Perspective on Misallocation." Conversations on Transformation (podcast).

About the guest

Eric Verhoogen is professor of economics and international and public affairs at Columbia University, where he co-directs the Center for Development Economics and Policy. He is a CEPR Fellow in Development Economics. His research spans industrial development in poor countries, covering firm productivity, technology adoption, quality upgrading, and the frictions that keep resources from reaching their best use.

Research cited in this episode

Wedges is the term economists use for whatever stops resources flowing to their most productive use inside a firm. Verhoogen and his co-authors draw a distinction that is central to their chapter: between distortionary wedges, such as taxes or credit constraints, and technological wedges, such as spillovers, which can produce the same statistical signature even in an efficient economy.

Marginal revenue products and TFPR are the standard diagnostic tools of the misallocation literature. If two firms in the same industry get very different returns from an extra worker or an extra unit of capital, something is stopping resources moving from the low-return firm to the high-return one. Chang-Tai Hsieh and Peter J. Klenow, in "Misallocation and Manufacturing TFP in China and India" (Hsieh and Klenow 2009), used this method to estimate that reallocating resources within Chinese and Indian manufacturing to match the dispersion seen in the United States would raise measured productivity by 30 to 50% in China and 40 to 60% in India. It remains the most cited paper in the field.

Returns to capital in microenterprises: the "capital drops" that Verhoogen mentions refer to Suresh de Mel, David McKenzie, and Christopher Woodruff's randomised cash and equipment grants to Sri Lankan microenterprises, which found real returns to capital far above market interest rates (de Mel, McKenzie, and Woodruff 2008). It is one of the few settings where researchers have good evidence on how the marginal return to capital varies with firm size, and Verhoogen argues that evidence thins out fast once firms grow beyond the very smallest.

Market-access subsidies in Tunisia is a separate Verhoogen experiment, with Nadia Ali, Giacomo De Giorgi, and Aminur Rahman, in which the Tunisian government offered firms grants of $50,000 to help them break into export markets (Ali et al. 2025, CEPR Discussion Paper 20398, gated). It is one of the very few experiments with a large enough cheque to say something about medium sized, rather than micro, firms.

India's Industrial Disputes Act historically required firms with 100 or more workers to seek government permission before laying off staff, one of the regulatory wedges Verhoogen discusses. The threshold has since been raised nationally to 300 workers under the Industrial Relations Code, which took effect on 21 November 2025, after this conversation was recorded.

PEDL, Private Enterprise Development in Low-Income Countries, is STEG's sister research programme, also coordinated by CEPR, sharing its focus on firms, innovation, and productivity in developing economies.

More Conversations on Transformation episodes

No Country for Dying Firms: Evidence from India. Shoumitro Chatterjee talks to Tim about what happens to an economy when failing firms cannot easily go out of business, the flip side of Verhoogen's story about productive firms that cannot easily grow.

Navigating Industrial Policy. Beata Javorcik discusses what the return of industrial policy means for economic development, and how governments might avoid repeating the mistakes of the past as they try to correct exactly the kind of distortions discussed in this episode.

Further reading

Misallocation and Product Choice, a STEG working paper by Stepan Gordeev and Sudhir Singh, finds that ignoring the fact that firms can choose which products to make causes standard models to understate the productivity cost of misallocation between Indian farms by 28%.

Financing Costs and Development, a STEG working paper by Tiago Cavalcanti, Joseph Kaboski, Bruno Martins, and Cezar Santos, uses a Brazilian credit registry to show that dispersion in the cost of borrowing, not just credit rationing, drives much of the financial friction that Verhoogen discusses.