This paper combines a novel general equilibrium model with evidence from Indian
plant-level data to investigate the relationship between competition, financial constraints
and misallocation. In the theoretical model, steady-state misallocation arises both from
variation in markups, and from the interaction of firm-level productivity volatility with fi-
nancial constraints. Firms experience random shocks to their productivity and in response
to positive productivity shocks they optimally grow their capital stock, subject to financial
constraints. Competition plays a dual role in affecting misallocation. On the one hand,
both markup levels and markup dispersion tend to fall with competition, which unambiguously
improves allocative efficiency in a setting without financial constraints. On the
other hand, in a setting with financial constraints, a reduction in markups is associated
with a slower capital accumulation, as the rate of self-financed investment shrinks. Thus,
the positive impact of competition on steady-state misallocation is reduced by the presence
of financial constraints. Empirically, I test and confirm the qualitative predictions of
the model with data on Indian manufacturing. The prediction that the firm-level speed of
capital convergence falls with competition is confirmed for the full panel of manufacturing
plants in India’s Annual Survey of Industries. This effect is particularly pronounced in
sectors with higher levels of financial dependence. I also exploit natural variation in the
level of competition, arising from the pro-competitive impact of India’s 1997 dereservation
reform on incumbent plants, and again confirm the qualitative predictions of the model.