Unveiling productivity and markup bias: the role of price heterogeneity

Estimates of Total Factor Productivity (TFP) and markups are often biased due to unobserved price heterogeneity across firms. This working paper adopts a structural approach to adjust for this bias. Using firm-level data from Chinese manufacturing firms for the period 1998–2007, we use a structural approach to the revenue function, incorporating firm-level input and output prices to disentangle TFP and markups from price variations. Using these estimates as a comparison, we find that omitting firm-level prices in the conventional approach significantly underestimates both the level and growth of aggregate TFP. Similarly, markup levels are substantially underestimated when firm-level price heterogeneity is omitted although markup growth is lower. These findings highlight the necessity of carefully taking into account the often-unobserved firm level price heterogeneity in order to interpret productivity and markup results meaningfully.