Is Small Beautiful? Size-Productivity Relationship in Indian Manufacturing

We study the size-productivity relationship of manufacturing firms in India. Like other developing countries, India has been characterized by large size heterogeneity of firms within the same industry. In the context of growing liberalization of trade, licensing and monopoly policies since 1991 and growing incentives to small and medium scale firms, productivity implications of size heterogeneity has become more important. We find that smaller firms that are in the lowest quintile of the asset distribution are more productive than their larger counterparts. For identification, we exploit the panel nature of the data and use production-function estimation technique as developed by Levinsohn and Petrin (2003) to estimate the total factor productivity and Arellano and Bond (1991) type of dynamic estimation to control for potential endogeneity arising out of the persistence of productivity. INTRODUCTION Growth literature has long documented the importance of productivity enhancement in raising income, particularly in developing economies. Historically, manufacturing sector has been the principal component of income growth and has been subject to intense research in the past decade in search of explanations of productivity variation. One among many peculiar characteristics of manufacturing sectors in developing countries is the size-heterogeneity of firms. Industries within the manufacturing sectors in developing countries have been characterized by coexistence of firms of such heterogeneous sizes that Tybout (2000) calls this phenomenon a form of ̳dualism‘. However, productivity implications of such heterogeneity are not clear. While big firms have scale advantage and often have better access to capital and other resources through political and economic channels, small firms are likely to have leaner management and more flexibility in resource allocation. This polemic has become particularly important in the last decade or so for at least two reasons. A number of economies have liberalized their trade and licensing regimes to allow easy entry of firms and to reduce monopolies of either big state enterprises, or big private firms. Second, much richer micro-datasets are increasingly being available to empirically assess the dynamic changes in productivity. In this paper we investigate whether small firms are likely to be more productive. Size-productivity relationship in the manufacturing sectors of developing countries is an important question in its own right for the following reasons: First, theoretical literature has not been conclusive. Therefore, there is value in estimating a reduced form relationship rather than estimating some specific structural model. Second, * City College, City University of New York. pde@ccny.cuny. edu † The Graduate Center, City University of New York. PNagaraj@gc.cuny. edu We are grateful to the seminar participants at CCNY and the New York State Economic Association Annual Meeting for helpful comments. 63rd Annual Meeting NYSEA Proceedings, Volume 3 29 empirical evidence of size-productivity relationship is scant, particularly for developing countries. Finally, as discussed in the next section, India has been pursuing a policy of providing incentives to small firms over the last decade or so. Similar trends in policy can also be found in the other parts of the developing world also. Without empirical evidence, we cannot evaluate such a policy. SMALL SCALE SECTOR IN INDIA Being labor intensive, small enterprises promote employment, especially of unskilled labor. They play an important role in economic growth by contributing to the GDP (Beck et al, 2005). Among the Asian countries, India has been unique in terms of its focus on the development of small and medium enterprises since Independence. Over the decades, the policies governing the small scale industries changed from promotion to protection. Financial incentives and reservations for the small scale sector emerged as the policy instruments in the 1960‘s. By 2003-2004, the Small Scale Industry units accounted for more than 40 percent of gross value of output in manufacturing sector and about 34 percent of total exports of the country. It is the highest employment-providing sector after agricultural sector. Though 87 percent of the SSI units are unregistered, the registered units account for 72 percent of the total SSI production and 87 percent of total SSI exports. (Source: Development Commission (SSI), Third Census). There are a number of ways in which the ministry helps the small firms from directing credit, easing collateral requirement for loans, providing easy credit for technology improvement, providing training for entrepreneurs and providing technical training to tax concessions. Though the Government has now undertaken a number of policy initiatives in this direction, promoting SMEs might not be in the best interest of the economy if the SMEs are not more productive than their larger counterparts. Therefore, empirical findings on size-productivity relation will have bearing on the impact of policies promoting small and medium scale enterprises. This is true for not only India, but other countries too. THEORETICAL PRIORS AND RELATED LITERATURE While one would expect big firms to reap the traditional benefits of economies of scale, and in case of developing countries, where institutions are typically weak, other benefits such as access to license, finance and government contracts, we have not found a theoretical approach that succinctly models it. Idson and Oi (1999) argue that workers in large firms reap the benefits of increasing returns (brought in by big volumes) by having less idled time and producing more. This provides an explanation for higher productivity in larger firms. Tybout (2000) also attributes the (potential) higher productivity of large firms in developing countries to variables like increasing returns and lobbying power. One of the earliest of such attempts was made by Williamson (1967). In a model of hierarchical control, he showed that benefits of increasing returns from growing in size are countervailed by the increasing cost of managerial complexity. The models that followed, built on this advantage of small firms – leaner and more flexible management. Further, small firms can be more receptive and adaptive to the new technology. One advantage of having a smaller scale is that the production process is less deeply entrenched in existing technology. Finally, 63rd Annual Meeting NYSEA Proceedings, Volume 3 30 analyzing manufacturing firms in nine African countries, Van Biesebroeck (2005) found that large firms are more productive and have higher growth rates. However, Bigsten and Gebreeyesus (2007) find in Ethiopia that small firms actually grow faster than the larger ones. In the United States, Dhawan (2001) finds that smaller firms are more productive. DATA AND SIZE DISTRIBUTION OF FIRMS IN INDIAN MANUFACTURING The data used is taken from Centre for Monitoring Indian Economy (henceforth, CMIIE)‘s PROWESS database. CMIE compiles this data from the audited financial results of listed and unlisted firms. The firms in Prowess accounts for almost 75 per cent of all corporate taxes and over 95 per cent of excise duty collected by the government of India. We use an unbalanced panel data of manufacturing firms for the period 1994 to 2008. The choice of time period has been dictated by the intention to keep the most recent data and avoid having a lopsided sample. Number of firms covered in the PROWESS database has jumped steeply in 1994. The effects of the economic reform of 1991 were evinced gradually by 1993. The data has detailed information on financial variables including break up of assets, liabilities, income and expenses. All variables have been deflated by the wholesale price index. Since the database contains information on only the wage bill and not on employment, we infer the amount of labor by deflating the wage bill by average industry wages. The data on wage per worker has been taken from Central Statistical Organization‘s (CSO)‘s Annual Survey of Industries (ASI) database. The PROWESS data has firms from 22 NIC-2 digit industries. Table 1 shows the distribution of assets in terms of mean and median over five quintiles. We can make several key observations from this table. First, there is substantial heterogeneity in terms of firm size. The mean size in the highest quintile is more than 100 times bigger than the mean size in the lowest quintile. Second, the average size in the highest quintile has been steadily rising over the years, signifying an increasing concentration at the top. Third, as the higher up we go in quintiles, more skewed the size distribution becomes, as reflected by the wedge between mean and median. 1 63rd Annual Meeting NYSEA Proceedings, Volume 3 31 Table 1: Distribution of Assets among Indian Manufacturing Firms (in INR Million) year Quintile1 Quintile2 Quintile3 Quintile4 Quintile5 Mean Median Mean Median Mean Median Mean Median Mean Median 1994 34 34 93 92 179 175 404 381 421