THE EFFECTS OF ECONOMIC REFORMS ON MANUFACTURING

DUALISM: EVIDENCE FROM INDIAVinish Kathuria

IIT Bombay

(Rajesh Raj S NCMDR Dharwad

Kunal Sen University of Manchester)

PROJECT FUNDED by Economic and Social Research

Council, UK

ESDS Conference Nov 28 2011

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1.Introduction

Dualism in the organization of production activities is a permanent feature of developing countries, where a large informal sector coexists with a relatively small formal sector. Despite strong economic growth, the persistence

in the size of informal sector along with large differences in productivity between the formal and informal sectors has remained a matter of concern

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This paper examines the effects of economic reforms on manufacturing dualism

Dualism: differences in efficiency levels between informal and formal manufacturing firms

Considered absolute (AE) and relative technical efficiency (RE)

AE - extent to which firms in the manufacturing sector are producing the maximum possible output, for a given bundle of inputs, in a given industry (improvement in level)

RE - extent to which other firms are close to the most efficient firm in a given industry (improvement in equity)

Objective……

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Our objective is to investigate whether economic reforms have led to an increase in absolute technical efficiency and a decrease in RTE of informal firms relative to formal firms

Reforms would have reduced manufacturing dualism if absolute TE of informal firms have improved relative to formal firms while RTE has fallen

This implies that reforms would have had a positive effect on both the level and distribution of efficiency in the informal sector as compared to the formal sector, and therefore, would have strong pro-poor growth effects

If dualism has reduced……….

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Present study………

focuses on Indian manufacturing sector where

about 80 per cent of manufacturing employment and 17 per cent of manufacturing output is in the informal sector

we have large cross-sections of firm-level data-set for both the informal and formal manufacturing sectors for four years, beginning in 1989-90 and ending in 2005-06

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We employ a method developed by Greene (2010) that corrects for self-selection bias to obtain firm level measure of absolute and relative technical efficiency

Theoretical models predict that firms choose whether to be in the informal or formal sector depending on factors which are mostly available to the formal sector (Dessy and Pallage 2003, Straub 2005, Ulyssea 2010)

Efficiency comparison needs to address the endogeneity of firm location Else bias upwards the efficiency levels of formal firms if these levels depended on the firm being located in the formal sector.

2. Methodology – Sample Selection Framework

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First stage analysis

Firms choose between formal or informal sector subject to a set of variables that capture the benefits and costs of

formalization

We estimate probit models of the following type:

F = αZi + wi

Where F is a dummy variable that takes the value 1 for formal sector firms and 0 for informal sector firms,

Z is a vector of variables explaining the decision to formalize, α is a vector of parameters, and wi is the white noise error term

3. Empirical Specification

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Drawing from the recent theoretical literature, we considered: labour laws, priority sector lending, price of power supply and firm size

as the variables that determine the benefits and costs of formalization in Indian manufacturing

Choice of these variables also exploit the fact that there are important differences in institutions relating to labour regulation, access to credit and the provision of

infrastructure across Indian states and over time

3. Empirical Specification

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Second stage analysis We modelled the production behaviour of formal and informal sector

firms using a simple Cobb-Douglas function as follows:

ln(QiT) = 0 + 1ln(KiT) + 2ln(LiT) + (viT - uiT)

Where T=1989-90, 1994-95, 2000-01 & 2005-06 and i is the firm. Q is output, K is capital, L is labour, and s are parameters to be

estimated

viT captures the random shocks that are beyond the control of firms

uiT represents technical inefficiency which is the combined outcome of non-price and organizational factors that constrains a firm from achieving their maximum possible output

3. Empirical Specification

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3. Testing for Impact of Reforms on Duality

Effect of reforms on duality

an interaction term for our reform variable with that of the formal firms is introduced

TEijt = α + β1*FORMALijt + β2*REFORMSjt + β3*FORMALxREFORMSijt + δj +γt + εijt

If δTE/δFORMAL = β1 + β3*REFORMS < 0

reforms have reduced duality

We used estimates of absolute and relative technical efficiency alternately as our dependent variable

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4. Data and Variables

ASI data for the formal sector and NSSO data - surveys on the unorganized manufacturing sector

for the informal sector

Unit level data for four years, 1989-90, 1994-95, 2000-01 and 2005-06; repeated cross-sections, and not in panel form

Confined the analysis to those informal firms that employ at

least one hired worker (i) serious limitations of the data on output and capital stock for firms that

employ only family labour(ii) interest is in firms that are likely to modify their behaviour in response to

policy changes as family firms in informal sector are often in business to bring in additional income with little additional effort and are unlikely to expand or invest in their businesses

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4. Data and Variables –Reform Variables Tariff: trade and industrial output data of the World Bank Trade Data-base (World Bank 2006)

Delicensing : Data on number of industries delicensed is obtained from Aghion et al (2006) and different notifications of GoI. constructed as the total number of four-digit industries delicensed in a year to that of total number of four-digit industries in the sector

Dereservation: list of number of products dereserved is obtained from different notifications of the GoI constructed as the cumulative number of products dereserved in respective two-digit industries to that of total reserved products

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4. Trend of Reform Variables

(a)most of the delicensing reforms were over by 1995

(b)dereservation reforms started after 1995

(c)by 2005-06, only 4% of industries required delicensing, nearly one-third products needed to be dereserved and average tariff was 29% (ranging between 24% to 37%), much below 100% tariff around 1991

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5. Impact of Reforms on Duality

VARIABLES Absolute Technical Efficiency Relative Technical Efficiency

(1) (2) (3) (4) (5) (6) (7) (8)

Formal -0.223*(0.004)

-0.220*(0.00469)

-0.00277(0.00199)

0.205*(0.00455)

17.977*(0.310)

39.41*(0.297)

3.972*(0.111)

-2.318*(0.285)

REFORMS 0.009*(0.000)

-0.166*(0.007)

Formal*REFORMS 0.005*(0.000)

-0.240*(0.006)

Delicense 0.00415*(4.84e-05)

-0.0724*(0.00247)

Formal*delicense 0.00317*(5.37e-05)

-0.409*(0.00328)

Dereserv 0.00208*(9.49e-05)

-0.102*(0.00618)

Formal*dereserv 0.00205*(6.73e-05)

0.109*(0.00439)

Tariff 0.000885*(0.000110)

-0.105*(0.00683)

Formal*tariff -0.00338*(8.64e-05)

0.158*(0.00569)

Constant 0.247*(0.004)

0.269*(0.00362)

0.357*(0.00304)

0.333*(0.00901)

36.937*(0.240)

29.55*(0.194)

40.18*(0.194)

43.79*(0.620)

Ind. dmy Y Y Y Y Y Y Y YYr dmy Y Y Y Y Y Y Y YN 173108 173108 173108 173108 173108 173108 173108 173108R-squared 0.19 0.179 0.139 0.119 0.23 0.314 0.215 0.215

Impact of reforms on duality of Indian manufacturing industry

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5. Results

For the average values of REFORM variable, the efficiency difference between formal and informal firms is 0.04 for absolute efficiency and 5.35 for RTE. At the mean value of absolute technical efficiency (0.44), this suggests that reforms have increased the efficiency of formal firms by 9 per cent vis-à-vis informal firms. Similarly, relative to a mean RTE of 24.5%, the efficiency gap between the representative formal firm and the MEF in a particular industry has increased by 21.9% as compared to the efficiency gap between the representative informal firm and the MEF in the same industry.

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5. Results – TE vs. Reforms

REFORM vs efficiency

relationship - stronger in the

formal sector as compared to the informal sector

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5. Results – RTE vs. Reforms

REFORM vs efficiency

relationship - stronger in the

formal sector as compared to the informal sector

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6. Conclusions

Do economic reforms reduce or exacerbate manufacturing dualism?

Our regression results suggest that these reforms have had an unambiguous positive effect on the

absolute efficiency levels of formal firms relative to informal firms, and a negative effect on the relative efficiency levels

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Economic reforms (as measured by individual reform variable or composite index) had an unequalising effect on the manufacturing sector, as it exacerbated the productivity differentials between average firm in the informal & formal sectors, and at the same time, it reduced the gap in efficiency levels between formal firms as compared to informal firms

Dualism has increased in Indian mfrg. after the reforms, both between formal and informal firms and within the informal sector

6. Conclusions