Risk-Adjusted Capital Allocation and Misallocation

We develop a theory linking “misallocation,” i.e., dispersion in static marginal products
of capital (MPK), to systematic investment risks. In our setup, firms differ in their
exposure to these risks, which we show leads naturally to heterogeneity in firm-level risk
premia and, more importantly, MPK. The theory predicts that cross-sectional dispersion
in MPK (i) depends on cross-sectional dispersion in risk exposures and (ii) fluctuates with
the price of risk, and thus is countercyclical. We empirically evaluate these predictions
and document strong support for them. We devise a strategy to quantify variation in
firm-level risk exposures using data on the dispersion of expected stock market returns.
Our estimates imply that risk considerations explain about 40% of observed MPK dispersion
among US firms and in particular, can rationalize a large persistent component in
firm-level MPK deviations. Our framework provides a sharp link between cross-sectional
asset pricing, aggregate volatility and long-run economic performance – MPK dispersion
induced by risk premium effects, although not prima facie inefficient, lowers the average
level of aggregate TFP by as much as 8%, suggesting large “productivity costs” of business
cycles.