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Recent research maintains that the observed productivity variation across firms reflects resource misallocation and concludes that large GDP gains may be obtained from market-liberalizing polices. Our theoretical analysis examines the impact on productivity dispersion of reallocation frictions in the form of costs of entry, operation, and restructuring, and shows that reforms reducing these frictions may raise dispersion of productivity across firms. Contrary to conventional wisdom, the model does not imply a negative relationship between aggregate productivity and productivity dispersion. Our empirical analysis focuses on episodes of liberalizing policy reforms in the US and six East European transition economies. We find that deregulation of US telecommunications equipment manufacturing is associated with increased, not reduced, productivity dispersion, and that every transition economy in our sample shows a sharp rise in dispersion after liberalization. Productivity dispersion under communist central planning is similar to that in the US, and it rises faster in countries liberalizing more quickly. We also find that lagged productivity dispersion predicts higher future productivity growth, likely because dispersion reflects experimentation by both entering and incumbent firms. The analysis suggests there is no simple relationship between the policy environment and productivity dispersion.