How to allocate resources geographically and overtime is really important.

With the development of the “new” NEG (new economic geography) theory and much easier access to micro-data, economists have been able to examine economic efficiency at the firm-level. One area of study has focused on the enterprise heterogeneity and improvements in resource aggregation and location efficiency. Results of these studies have indicated that varying levels of productivity between firms has become a market selection mechanism and a sorting mechanism, directly impacting the spatial distribution of economic activity. The extent of the efficiency gap between firms and the intensity of market competition are important determinants on the degree to which firm heterogeneity influences economic growth. The other area of study focuses on enterprise heterogeneity and improvements in the efficiency of resource allocation and environmental changes. Studies has shown that market distortions are an impeding factor in the effective allocation of heterogeneity between firms, which has resulted in different productivity levels between countries. Market distortions and poor allocation of resources at the firm-level significantly reduce economic efficiency.

Firm heterogeneity affects the efficiency of factor allocation

The effect of enterprise heterogeneity on efficiency of factor allocation can be divided into efficient monopolies and inefficient monopolies. In terms of static efficiency, an efficient monopoly can improve the efficiency of a monopolistic firm's internal resource allocation without negatively impacting the allocative efficiency of non-monopolistic firms.. In terms of dynamic efficiency, spillover effects from an efficient monopoly will improve allocative efficiency of other firms, for example with a monopoly on patented technological innovation or through spatial agglomeration. By contrast, an inefficient monopoly will reduce firms’ allocative efficiency both in terms of static and dynamic efficiency.

Firms decide how to allocate resources geographically and overtime on the basis of maximizing profits and minimizing risk. If a firm's revenue and operating costs are distorted such that its returns and risks are lower and the costs of implementing technological innovation and improving the level of management are the same, then the firm will give up the efficient monopoly model of improving resource allocation. This shows that inefficient monopolies impede efficient monopolies. In distorted market conditions, the characteristics of inefficient monopolies will lead to substantial influx of resource factors to inefficient firms. In firms that exhibit the characteristics of an efficient monopoly, because the proportion of the outflow of the stock of production factors and the influx of incremental production factors is relatively lower, technological innovation will lag behind expansion in the scale of investment for the whole region. In this situation, simultaneous excess capacity and supply shortage are indicative of static and dynamic inefficiency.

Inefficient monopolies decrease the efficiency of resource allocation

An important question for the public is whether the price mechanism directly guides the allocation of factors from inefficient to efficient firms in realistic situations of firm heterogeneity—situations where demand for labor is driving up wages and capital is seeking higher profits. If the answer to this question is negative, it proves that there is a distorting force in the market that transfers resources from efficient inefficient firms.

Prior research shows that introducing and strengthening market competition will make the market mechanism capable of allocating productive factors. In order to avoid risks of being blocked outside of the market, a firm’s management will reinforce the traits of an efficient monopoly by methods such as innovation and technological upgrading so as to gain core competiveness. Reductions in the segmentation of the regional market will attract other firms to vie for entry, accelerating the rate at which competition eliminates less productive firms and production factors become concentrated among more productive firms.

In a distorted market, market exchanges will change or enhance the extent to which firms exhibit the traits of inefficient monopolies. The cumulative cycle of distorted market forces and inefficient monopoly characters will lead to a gradual decrease in the proportion of profits that result from firms improving the efficiency of productive factor allocation and a gradual increase in the profits resulting from inefficient monopoly characteristics. Overtime, fewer efficient enterprises can survive as this process increasingly exacerbates distortions of market power within the region, channeling it to ineffective monopolies. Medium-productivity firms will be eliminated, squeezed out of the market by dual competition from high-productivity firms and market distortions unless they take on the characteristics of an inefficient monopoly. Ultimately, resources will be transferred to inefficient enterprises, bringing down the efficiency of resource allocation for the entire region.

Eliminating inefficient monopolies

The improvement of structural efficiency is a static and dynamic process in production factors at the firm level. When driven by the market mechanism, resource allocation is mainly about the volume and flow of the inflow and outflow of production factors. Here, the market mechanism guides the increase or decrease in scale of existing firms, their exit, and new firms' entry. Fully efficient firms will simultaneously satisfy three criterion in the process of adjustment in location space and scale: an increase in the opportunity cost of capital factors, a growth in the efficiency of labor factors, and a decrease in regional differences of factor allocation. However, in market conditions of imperfect competition, the adjustments in location space and scale of firms or industries will not necessarily be improvements in regional resource allocation.

Simultaneous excess capacity and supply shortage in the same region indicate the necessity of a change in the static and dynamic allocation structure. For static allocation, industrial transfer—recombining existing production factors—is an effective path. Adjustment of dynamic allocation is based on technological progress, technological progress with regard to sector bias (whether labor or capital intensive production is favored), and domestic and international demand. If each firm’s factor allocation is reasonable, then there is no need for static and dynamic improvement in resource allocation. In an imperfect market, poorly allocated resources within the firm indicate an imbalance of labor and capital. Poorly allocated resources at the inter-firm level indicate a the co-existence of scale economies and diseconomies, and cumulative imbalance of the structure of the economy; the misallocation of resources over time periods shows a dynamic allocation structure indicated by either excess capacity or shortage. Cumulatively, firm-level misallocation of production factors will show up in static and dynamic efficiency loss at the industry level.

In conclusion, eliminating a firm’s inefficient monopoly characteristics and strengthening its efficient monopoly characteristics will improve dynamic resource allocation between firms. This is integral for improving the structure of the economy, and can have a significant influence structural issues which fundamentally limit continuous and sound economic development.

Li Ying is from the School of Economics at Henan University and Yang Huimin is from the Institute of Finance and Economics Research at Shanghai University of Finance and Economics.

The Chinese version appeared in Chinese Social Sciences Today, Jun. 24, 2013

Translated by Zhang Mengying