available for a large number of firms over a six year period. The use of such direct measure of innovation activities differentiates this study from most of the existing work with firm-level datasets.

There are several studies that analyze the effects of licensing reform in Indian economy. In one of these studies Aghion et al. (2008) analyze how the effects of this reform on firm revenues varies across states with differing restrictiveness of labor regulations. My analysis differs from their work in two main aspects. I use a firm level panel dataset whereas their data is at industry level. Hence the policy question I investigate is how the reform affects firm dynamics rather than industry dynamics. Their focus is on revenues whereas mine is on innovation and growth. In another study Chari (2010) focuses on the effects of the licensing reform on total factor productivity. Using the same dataset as Aghion et al. (2008) he focuses on the licensing reform in 1985. Lack of a panel dataset prevents to perform a firm-level productivity analysis using a production function estimation method. It also prevents to observe the heterogeneity in firms’ responses to the policy change. Using the same dataset as Aghion et al. (2008), Chamarbagwala and Sharma (2010) analyze the effect of licensing reform on skill upgrading where they measure skill upgrading as employment and wage bill shares of white-collar workers. None of these studies can analyze growth at firm level as the data they use is a repeated crosssection of firms.

Removal of the distortive regulations can have significant contribution to firm performance. The analysis of Hsieh and Klenow (2009) on within-industry dispersion in factor productivities in China and India show that the removal of plant-level distortions could result in as much as a 30% improvement in aggregate productivity. Chari (2010) shows that the licensing reform in India improved productivity by 22%. In this study, I show that the licensing reform increased innovation rate by five percentage points. The empirical analysis presented in the paper is supported by a dynamic model of innovation. The model explains the mechanism how a group of multi-product firms evolve and how licensing reform can impact innovation. The model extends a stylized model of innovation and industry evolution presented by Klette and Kortum (2004). In their model, a firm is defined as a collection of products and firms grow by introducing new products. Through the model, they explain various stylized facts that relate R&D, productivity, patenting, and firm growth. Seker (2009) extends their model by introducing exogenous heterogeneity in firms’ efficiency levels which allows him to have rich firm dynamics.

The rest of the paper is structured as follows. In the next section I present the analytical model to explain the dynamics of firm and industry evolution. Then I explain the data and the various policy reforms that were implemented in India. In section four, I present descriptive analysis of the licensing reform, the empirical model, and discuss the estimation results. I finish with some concluding remarks.

# **II. Model**

I introduce a dynamic and analytically tractable model of firm evolution to be able to explain the relationship between the licensing reform and innovation performances of firms. The model is replicated from Seker (2009) which follows from Klette and Kortum (2004). Klette and Kortum (2004) present a stylized model with a simple interpretation of innovation and industry evolution. Seker and Rodriguez (2011) extend Seker (2009) further to explain the relationship between innovation and the use of imported intermediate goods. Their model shows how trade liberalization in India contributed to introduction of new product varieties. Goldberg et al. (2010b) present another study that includes a 3