Misallocation in Chinese Manufacturing and Services: A Variable Markup Approach

• Author: Jie Luo,Yangzhou Yuan,Jinfeng Ge
• Date: 01 July 2019
• Published date: 01 July 2019
• DOI: http://doi.org/10.1111/cwe.12287

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 74–103, Vol. 27, No. 4, 2019

74

*Jinfeng Ge (corresponding author), Assistant Professor, School of Economics, East China Normal University,

China. Email: gjf121@hotmail.com; Jie Luo, Postdoctor, National Institute for Fiscal Studies and School of

Economics and Management, Tsinghua University, China. Email: luojie@sem.tsinghua.edu.cn; Yangzhou

Yuan, PhD Candidate, Department of Economics, Stockholm University, Sweden. Email: yangzhou.yuan@

ne.su.se. We thank Zheng Song and John Hassler for continued guidance. We are grateful to Paolo Epifani,

Gino Gancia, Zhe Li, Shu Lin, Chen Wang, Yongqing Wang, Youzhi Yang, Zhigang Yuan and Bo Zhao for

insightful comments. We also thank seminar participants at Fudan University, Chinese University of Hong

Kong and Shanghai University of Finance and Economics for their useful comments.

Misallocation in Chinese Manufacturing and Services:

A Variable Markup Approach

Jinfeng Ge, Jie Luo, Yangzhou Yuan*

Abstract

Cross-country comparison reveals an unusually small service sector in China. Using

firm-level data from China’s 2008 economic census, we find two facts that speak to

a novel mechanism of misallocation within service and between manufacturing and

service sectors. First, compared with the manufacturing sector, there are more state-

owned enterprises and fewer entrants in the service sector. Second, markups increase

with rm size, and the increase is more dramatic among service rms. We interpret these

facts through the lens of a monopolistic competition model with heterogeneous rms and

variable markups. A multisector model shows a new channel that translates asymmetric

barriers to entry across sectors into sectoral markup differences, which in turn cause

sectoral misallocation. Quantitative analysis shows that when reducing entry barriers

to service firms to the extent observed for manufacturing firms, the model predicts a

12-percentage-point increase in the service employment share.

Key words: misallocation, sectoral allocation, variable markup

JEL codes: D24, O11, O47

I. Introduction

Less developed economies tend to have a smaller service sector, and China is

no exception, with service industries accounting for less than 40 percent of total

employment, approximately half of the share in the US. Yet China’s service sector

deserves special attention for at least two reasons. First, service employment as a share

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Misallocation in Chinese Manufacturing and Services 75

of total employment in China is among the lowest when compared to other countries at

the same income level. When it comes to the service share in the non-agriculture sector,

China actually ranks lowest (Figure 1). Second, the mirror image of the small service

sector is China’s extraordinarily large manufacturing sector, which has made the country

“the world factory.” Understanding why China has an unusually small service sector is

one of the rst steps for rebalancing the global economy.

Figure 1. Service Employment Share and GDP Per Capita, 2011

Sources: World Bank and Penn World Table.

Notes: For country names corresponding to the abbreviations in the gure, see: https://data.worldbank.org/.

CHN, China; PPP, purchasing power parity.

Using firm-level data from China’s 2008 economic census, we document two

sets of facts that distinguish service from manufacturing and may explain the lack

of development of the service sector. First, the state share in the service sector is

approximately three times as high as that in the manufacturing sector. Moreover,

there is a robust negative correlation between the entry rate and the state share across

both manufacturing and service industries. These patterns are consistent with the

widely documented heavy regulations and high barriers to entry in many Chinese

service industries (see e.g. Rutkowski, 2015). We also nd that the dispersion of labor

productivity among service rms is 70 percent higher than that among manufacturing

firms, suggesting more severe misallocation within service through the lens of the

framework developed by Hsieh and Klenow (2009).

Second, labor productivity increases with revenue in both manufacturing and