Misallocation in Chinese Manufacturing and Services: A Variable Markup Approach

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 firm size, and the increase is more dramatic among service firms. We interpret these facts through the lens of a monopolistic competition model with heterogeneous firms 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.