Instability, Misallocation and Productivity

Thomas Sargent and Rodolfo Manuelli

No 1043, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: Many less developed countries are characterized by inefficient and fairly unstable policies. It is well understood that inefficient policies can result, in some cases, in lower measured productivity. When policies have a stochastic component, fluctuations can add to the standard inefficiencies but, in general, the impact is of second order of importance. However, in the presence of discrete decisions the effect of fluctuations is amplified. In this paper we study the decision to become an entrepreneur or a worker ---a discrete choice--- in an environment in which relative prices are changing. We view these changes as being driven by large changes in policy. For example, large devaluations result in significant changes in the price of traded and non-traded goods. Following Lucas (1978) we view individuals as endowed with basic skills. However, unlike the agents in Lucas' economy, we study an environment in which all individuals have a two dimensional skill vector. Each of these two dimensions can be associated with different tasks. In a simple example one dimension is a measure of the individual's managerial skills (Ã la Lucas), and the other is a measure of his financial skills or his ability to make changes to financial variables. In this version of the paper we consider a very simple model. The production technology depends on a storable input ---we view it as an intermediate good used by many sectors--- and labor. The productivity of this technology depends on the manager's ability. We consider an environment in which firms have access to a market for collateralized credit. We assume that insiders (producers) can get a signal that is correlated with future changes in the price of the input. At this point, the entrepreneur can borrow ---subject to the limits imposed by the market--- in order to purchase the input. Individuals differ in the cost of changing their financial status, and this corresponds to the second dimension of skill. In this setting, we allow insiders to purchase (and keep in inventory) the intermediate input at a low price and to realize the capital gain when the price increases. We study a continuous time version of the model in which individuals choose their occupation (entrepreneurs and workers) and maximize the expected present discounted value of utility. We show that, compared with a stable economy, fluctuations in the price of the input induce misallocation of talent between the entrepreneurial and the salaried sector. In particular, in a stable economy individuals who have high financial skills do not have any advantage in production and the model boils down to Lucas (1978). However, in the presence of fluctuations, some individuals with low managerial skills prefer to be entrepreneurs since they can realize significant profits during the crises periods ---which we associate with period in which relative prices change significantly--- even though their gains from "ordinary" production activities. The model has implications for the timing and nature of entry and exit, as well as the time series of profits.

Date: 2013
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed013:1043

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