Abstract:    The digital economy has profoundly changed the way products are produced, sold and consumed, but its impact on factor markets is still unclear. Therefore, based on the measurement of the digital economy development index and factor market distortion index at the city level, this paper used the panel data from 286 Chinese cities from 2011 to 2020 to test whether the development of digital economy has improved the degree of factor market distortion and to explore the mechanism of transaction costs and industrial structure, and examined the moderating role of business environment, urban innovation capability and fiscal transparency. The study revealed that both capital and labor markets exhibit varying degrees of distortion, and the proliferation of digital economy has effectively alleviated these distortions in China. The development of digital economy has not only reduced transaction costs for factors but also propelled industrial restructuring and upgrading, thereby ameliorating factor market distortions in China. Furthermore, the business environment, urban innovation capacity, and fiscal transparency all play a positive moderating role. The paper also found that the positive impacts of digital economy development on reducing factor market distortions show significant regional and city-level heterogeneity. This study provided valuable insights into how to rectify distortions in the factor market through the development of the digital economy.

Key words: digital economy, factor market distortion, business environment, urban innovation capability, financial transparency