Market dynamism & productivity growth

Financial Express, September 03, 2011

By Aradhna Aggarwal

It is widely acknowledged that economic liberalisation has changed the incentives of the corporate sector and unleashed new investment and growth forces. But the behaviour and achievements of Indian companies remain controversial. There are two competing views: pro-market and pro-business.

The former view holds that liberalisation fostered business dynamism through removal of entry barriers and heightened competitive pressures. According to this view, competitive capitalism has been the source of the corporate sector growth in India. This view corresponds to the Schumpeterian process of creative destruction in which technologically advanced new firms are more likely to respond to the threat of entry by investing in new technologies and production processes.

In contrast, the pro-business view, while recognising the gains, attributes them to excessive market power accompanied by economic entrenchment of large dominating incumbent firms. Such entrenchment, which has deepened inequality and concentration of personal wealth, is reinforced by corporate influence over the state and creates a new rent-seeking environment with adverse consequences for growth in the medium to long term. Much of the literature on the firm performance leans towards this view and contends that the shift in government stance toward modern-sector productive activity through removing restrictions has resulted in oligarchic capitalism in which the economy is still dominated by the incumbents which are state-owned firms and business groups, and that growth accelerations have come through the transfer of profits between firms within corporate groups.

To inform this debate, in a recent analysis I along with Takahiro Sato of Kobe University have used the plant (factory) panel data set of Indian manufacturing industries to analyse market dynamics and their impact on productivity growth in the country. We decomposed productivity growth to estimate the contribution of incumbent, new and exiting plants across 22 two-digit industries for the period 2000-01 to 2005-06. Our empirical strategy is to use the productivity decomposition methodology which is inspired by the Schumpeterian process of creative destruction and more recently by Hypohayn’s analysis of market dynamism. The analysis focuses on the large corporate sector termed the ‘census sector’. The plants in the census sector are surveyed on a complete enumeration basis on an annual basis through the ‘Annual Survey Industries’. We define six categories of plants.

We observed that the number of plants in the census sector increased across all industries without any exception over this period. Overall, it increased by 45% from 12,297 in 2000-01 to 17,826 in 2005-06. Of the total 17,826 plants in 2005-06, a mere 5,982 (33.6%) were continuing survivors. The rest were either newly established or entering survivors. The share of entering survivors varied from 40% to 60% across industries while newly established plants formed 6% (as in the tobacco industry) to as high as over 38% ( as in the ‘miscellaneous’ category) share in total number of plants in 2005-06. Overall, the share of new entrants in the census sector ranged between 60-80%.

The share of survivors had been lower in relatively higher technology and capital intensive industries as compared with traditional industries. Further, over 51% of the plants functional in 2000-01 either closed their business down or reduced the scale of their operation such that they were reclassified in the sample sector by 2005-06. The distribution of these plants is fairly uniform across industries.

Interestingly, labour productivity increased across all the sectors over the period from 2000-01 to 2005-06, with coke and petroleum industry being the only exception. The strongest productivity growth came about in the office computing machinery industry. In general, the productivity growth had been relatively higher in high tech industries with the only exception of heavy machinery industry.

To analyse the impact of market dynamics on productivity growth, we decomposed productivity growth into various components as reported in Table 3.

Our analysis of productivity decomposition indicates that the improvement in technical efficiency of incumbent firms had been the key mechanisms underlying aggregate productivity changes in Indian manufacturing during the early 2000s. Market reallocation effects are also positive, suggesting reallocation of market shares from less efficient to more efficient incumbents. More importantly, however, the effects of plant turnover have also been positive and substantial. As a matter of fact, the entry effects presented here are underestimates. Indeed, a part of ‘within effects’ may be explained by the entry of new plants which expand contestability of markets and intensify local competition, putting pressure on incumbents to improve productivity.

In a disaggregated analysis, strong positive effects of entry are observed in traditional and high tech industries; in medium scale and capital intensive tech industries (such as metals and chemicals), these effects are modest. Exit effects are rather small but are positive across most industries, suggesting that most firms that downsize their activity or report sickness are less productive. In short, in medium tech industries ‘within effects’ dominate productivity growth; other effects are modest. In traditional industries, within effects are supported by entry effects also. In high tech industries all the three effects seem to reinforce their restructuring. Apparently, unlike the popular belief, tremendous pro-market dynamism is taking place in the corporate sector in India.

Aradhna Aggarwal is currently Director, CUTS International

This article can also be viewed at: