Deregulation, Misallocation, and Size: Evidence from India

This paper examines the impact of the deregulation of compulsory industrial licensing in India on firm-size dynamics and the reallocation of resources within industries over time. Following deregulation, we find that the extent of resource misallocation declines and a considerable thickening of the left-hand tail of the firm-size distribution suggesting a significant increase in the number of small firms. However, the dominance and growth of large incumbents remains unchallenged. Quantile regressions reveal that the distributional effects of deregulation on firm size are significantly non-linear. The size distribution we observe—namely, a large number of small firms and a small number of large firms—can be characterized as the “missing middle” in Indian manufacturing and suggests that small firms may continue to face constraints in their attempts to grow. JEL Classification: F43, G31, G38, O12, O14, L10. * Laura Alfaro, Harvard Business School, Morgan 267, Boston MA, 02163, U.S.A. (email:[email protected]). ** Anusha Chari, Department of Economics, CB #3305, University of North Carolina at Chapel Hill, Chapel Hill NC 27599, U.S.A. (email:[email protected]). We thank participants at the Columbia University India workshop in New York and New Delhi for helpful comments and suggestions. Work on this paper has been supported by Columbia University’s Program on Indian Economic Policies, funded by a generous grant from the John Templeton Foundation. The opinions expressed in the paper are those of the authors and do not necessarily reflect the views of the John Templeton Foundation. Introduction The misallocation of resources across firms can have important effects on aggregate efficiency. Policy distortions can adversely impact the allocation of resources between firms with different productivities such that the more efficient firms produce less output or employment than they would in the absence of these distortions (Restuccia and Rogerson, 2008). Recent evidence also suggests that resource misallocation is a significant factor in explaining the aggregate productivity gap between the United States, China, and India (Hsieh and Klenow, 2009). The general consensus is that not only do developing countries have fewer productive resources they are also less efficient at allocating these resources across productive uses. The rapid transformation of India’s economy presents a unique and important opportunity for economists to examine the causes and consequences of the accelerated development. While many institutions and policies can distort resource allocation, in our view, regulations governing free entry and firm size are a critical source of inefficiency. In this paper, we analyze the efficiency impact of the removal of a specific distortion: compulsory industrial licensing that regulated firm entry and imposed output capacity constraints on Indian firms prior to 1991. Theory suggests that the regulation of entry into an industry determines both the entry costs faced by firms and the degree of competition between firms (Blanchard and Giavazzi, 2003; Alesina et al., 2005; Ardagna and Lusardi, 2009, 2010). The deregulation of entry can therefore reduce and redistribute rents, leading to new distributions of firms within industries over time. Incumbent firms may either decline in the face of new competitors or consolidate their positions further if the economy and hence the size of the market grows. Episodes that involve Alfaro, Charlton, and Kanczuk (2009) find that differences in the allocation of resources across heterogeneous plants are a significant determinant of cross-country differences in income per worker in a sample with plant-level data for 79 developed and developing countries. 2 An industrial license not only regulated whether a firm could enter an industry, it also specified the maximum amount a firm could produce.