From Zheng Song and Guiying Wu:
Capital market distortions lower aggregate productive efficiency by misallocating resources. The existing literature infers such distortions from the dispersion of the average revenue product of capital. However, the methodology is subject to a set of identification issues: unobserved heterogeneities in production technology and market power; capital adjustment costs with idiosyncratic shocks; and measurement errors in the data. This paper develops a structural econometric approach of estimating capital market distortions in environments where all the above factors can be present. Using representative firm-level data from Chinese manufacturing from 2004 to 2007, we find that capital market distortions imply aggregate revenue losses of 40 percent. We also estimate distortions for U.S. manufacturing firms in Compustat. Improving capital allocation efficiency to the level observed among the Compustat firms would increase China’s manufacturing revenue by 31 percent. Finally, we propose a simplified approach, which addresses the identification issues in a much more tractable way.