hiring and firing workers. This makes production more costly and results in lower operating profits. Lower profits would reduce innovation rates λ according to the first order condition presented in equation 4.

Indian states also show variation in access to external finance. Financial development can be an important facilitator for innovation by allowing firms to spare more resources for investments in R&D. I define a state as financially developed if the average state credit level per capita is above median. The second column of Table 7 shows the result for financial development. Licensing reform has a larger benefit on firms that are located in states that are financially under developed. This finding could be interpreted as follows. Easier access to finance helps to reduce the financial burden on firms caused by license requirements. Thus the states that did not have sufficient financial development might have underperformed in innovation activities due to license requirements. When these requirements were removed, the effect on innovation performance was higher in these states.

Aghion et al. (2008) can only show the impact of licensing reform on firm sales through its differential effect on states with varying levels of labor regulations. They show in Table 2 of their study that without the interaction terms, licensing reform does not have any impact on sales. According to the model presented here, license requirement can directly affect innovation performance and thus sales. The ASI database they use might not reveal this direct relationship as it is not appropriate to for analyzing dynamics of firm evolution. I test the direct relationship between licensing reform, Log(Sales), and sales growth using the data from Prowess. Sales growth is computed below using the formula presented in Davis and Haltiwanger (1992), Sales Growtht-1,t=(Salest-Salest-1)/(( Salest+Salest-1)/2.

Sales values vary a lot across firms and outliers can be a much serious concern than product growth and this formula is robust to outliers. I also computed sales growth as log difference of sales levels which provided quite similar results.

The results are presented in Table 8. The table shows that unlike in Aghion et al. (2008) licensing reform significantly increases both sales and sales growth. The licensing reform increases sales by 3.4 percent. Although the estimation method and the controls used in this study differs from those used in Aghion et al. (2008), magnitude of the coefficient is quite close to 3.1 percent increase obtained in their study. However the coefficient in their estimation is not significant. Licensing reform has also a significant impact on sales growth by leading to a 5 percent increase. This value is close to the impact of the reform on product growth rate which could mean that the reform mainly affected product growth rate rather than the growth in revenues generated from existing products. To further support this hypothesis, I computed total unit sale values of every product and then computed the growth rate of this value. Replacing total sales growth with the growth of unit product sales yields an insignificant coefficient on licensing reform. This supports the argument that the reform mainly contributed to product creation rate rather than a growth in sales of each product.

# **V. Conclusion**

This study investigates the impact of regulatory environment on the success of firms’ innovative efforts. Using data from Indian manufacturing sector, it focuses on a particular reform on license requirements of firms. This reform liberalized product markets in introducing new products, increasing capacities, and 16