# **I. Introduction**

Since the seminal works of Grossman and Helpman (1991) and Aghion and Howitt (1992), many studies have found technological innovation to be the main determinant of growth. There are structural factors like human and physical capital levels that affect innovation performances of firms. The regulatory environment and investment climate in a country also play important roles for the success of technology adoption strategies and innovative efforts. This study provides an empirical analysis of how regulatory environment affects innovation. It focuses on a particular product market regulation that was reformed in India in mid 1980s and then again in early 1990s and shows how this reform affected introduction of new product varieties in formal manufacturing sector.

There are a number of papers that investigate the relationship between different aspects of regulatory environment, investment climate, and innovation. Aghion et al. (2009) focus on liberalization of foreign firm entry to U.K. market and find that technologically advanced entry by foreign firms has a positive effect on innovation in sectors that are initially close to technological frontier. In another study Aghion et al. (2005) use a sequence of competition policy reforms to investigate how product market competition level affects innovation performances. They find that an inverted U-shape relationship between product market competition and innovation outcomes. In a recent work Goldberg et al (2010b) relate international trade to innovation. They show that liberalization of tariff rates which led to imports of new intermediate goods that were not available in the market before increased the rate at which firms introduce new products to the market.

Following this literature, I analyze the effects of India’s licensing reform on firms’ innovation performances. Before the reform all firms were required to obtain a license to establish a new factory, significantly expand capacity, start a new product line, or change location. Delicensing reform meant freedom from constraints on output, inputs, technology usage, and location choice as well as easier entry into delicensed industries. Freedom from these constraints allowed firms to take advantage of economies of scale, more efficient input combinations, and newer technologies. Furthermore, greater domestic competition as a result of free entry into delicensed industries provided firms with incentives to innovate, increase productivity, and improve product quality.

Most of the existing studies on innovation use patenting activity/citations, total factor productivity (TFP), and data from innovation surveys.<sup>2</sup> R&D expenditures which are sometimes used to measure innovation intensity should be considered only as an input factor for innovation process. TFP measures have the well known problem that they are biased in the presence of imperfectly competitive product markets. Moreover there is a general problem with interpreting TFP findings as they usually use revenue data which makes it difficult to identify the effects of policy reforms on physical efficiency separately from its the effects on firm markups, product quality, and in the case of multiproduct firms the range of products produced by the firm (see Foster et al. (2008) and Katayama et al. (2009)). The patent data provides a better measure of innovation compared to TFP or innovation survey data but it usually has low data coverage. Moreover in developing countries the patenting mechanism usually does not work efficiently and thus provide a very limited picture of overall innovation activities. The innovation measure I use in this paper is introduction of new products to the market. This information is

> 2  An example of these surveys is Community Innovation Surveys (CIS) which is developed by European Commission for member countries of European Union.

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