Causes and Consequences of the "Missing Middle" of Manufacturing Firms in India

Project Summary

This project examined the "missing middle" in India—the fact that employment is concentrated in very small and very large firms, with few mid-sized firms. In particular, the project aimed to examine the employment size distribution of firms in India, explain its causes, and identify the consequences for firm productivity in the manufacturing sector.

Background

Historically, India has sought to protect and regulate its domestic manufacturing firms in a variety of ways, including trade barriers, licensing requirements for large firms, limits on foreign direct investment (FDI), and the reservation of a number of products for manufacture by small enterprises. In 1991, following a balance-of-payment crisis, India began to liberalize many of these policies. This research seeks to understand the effects of the liberalization on the growth and productivity of manufacturing firms in both the informal and the formal sectors.

Methodology

We created two unique datasets that allowed us to investigate potential causes of India's unusual employment size distribution, analyze the determinants of productivity growth in India before and after the sweeping 1991 reforms, and explore the importance of policy changes, including labor market regulations, as well as trade and industrial policies, for between- versus within-firm changes in productivity.

Findings

Key findings to date include:

• India's trade liberalization—specifically, a reduction in tariff barriers on final goods—increased average productivity among small, informal firms. Evidence suggests that at least part of this effect was driven by the forced exit of the smallest, least productive firms.
• The trade liberalization also increased productivity among larger, formal firms. However, in this case, the more important policy change was a reduction in tariffs on the intermediate inputs used by these firms.
• Immediately following the start of India's major trade and industrial reforms in 1991, productivity growth in the formal sector was driven by the reallocation of market shares towards larger, more productive firms. However, over the 20-year period from 1985 to 2004, productivity growth was largely driven by within-firm learning. This learning was linked to the policy reforms, notably the reduction in input tariffs and the FDI liberalization. The liberalization of industrial licensing policy also increased productivity among the large firms that were most affected by these regulations.
• India's dismantling of its policy to reserve certain products for manufacture by small firms reduced employment growth among smaller, older incumbents, but encouraged growth among larger incumbents, and among entrants into the previously reserved product markets. We also document that younger and larger firms grow faster than smaller, older firms. In keeping with these two facts, we find that districts that experienced greater de-reservation saw larger increases in formal sector employment.

An important contribution of this project is the compilation and dissemination of historical data on India's trade and industrial policies.

Related Publications

RAND Publications

External Publications

Ann Harrison, Leslie Martin and Shanthi Nataraj, Learning Versus Stealing: How Important are Market-Share Reallocations to India's Productivity Growth?, World Bank Economic Review, 27(2): 202-228, 2013

Shanthi Nataraj, The Impact of Trade Liberalization on Productivity: Evidence from India's Formal and Informal Manufacturing Sectors, Journal of International Economics, 85: 292-301, 2011

Sponsor

National Science Foundation

This material is based upon work supported by the National Science Foundation under Grant No. 0922332. Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author(s) and do not necessarily reflect the views of the National Science Foundation.