Disentangling agglomeration economies from selection under policy distortions in China

This paper explores the competing sources of productivity gains observed in China’s urban agglomerations focusing on three pillar industries: agro-food processing, textiles and electronics. The main results reveal that the higher aggregate productivity observed in denser Chinese cities is driven by both agglomeration and selection forces. Subsequent analysis shows that industrial support policies help to mitigate the selection penalty, but come at the expense of reducing agglomeration benefits. Complementing the city-level analysis, we estimate dynamic and distributive firm-level panel data models to explore the policy rationale of propping up inefficient firms, despite creating a less competitive environment. The micro-based results reveal that inefficient firms targeted by industrial support policies benefit from productivity spillovers in denser cities, mainly in the electronics industry, providing some policy rationale for keeping them in the market.