Deregulation, Misallocation, and Size: Evidence from India

by Laura Alfaro & Anusha Chari

Overview — India carried out wide-ranging deregulation policies in 1991. Significant sectors of the economy were opened up for private participation through de-licensing and allowing entry to industries previously reserved exclusively for the state-owned sector. This paper analyzes 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. Did industrial delicensing in India, which relaxed entry barriers and capacity constraints on firm size, lead to a change in firm size distributions within industries? Key concepts include:

Pro-market reforms in the 1990s rapidly deregulated significant sectors of the Indian economy previously kept off-limits to private participation.
Deregulation of entry and the end of industrial licensing (also known as the "License Raj") in all but a small subset of industries had the capacity to transform the competitive environment in which firms operated.
Deregulation in India may have created a winner-take-all environment where the largest firms drive out any competition.
While deregulation leads to more small firms in the sample, the size distribution that the authors 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.
Small firms may continue to face constraints in their attempts to grow.
Distortions have decreased over time with higher gains for deregulated industries.

Author Abstract

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.