dramatic in the case of contract labor. In contrast to labor and land, the adjustment cost for fixed capital (excluding land) has not declined over the years.

We examine how these trends vary across states and by firm attributes such as size.<sup>8</sup> Splitting states into two groups based on their manufacturing growth rates over the study period, we find that the decline in permanent and contract labor adjustment costs has been significantly faster in fast-growing states compared to slow-growing states. The decline in land and capital adjustment costs, in contrast, is not correlated with state-level growth performance.

As regards firm attributes, we show that firm size plays a role, particularly for land. The decline in permanent labor adjustment costs has been experienced by firms of all sizes, but at a significantly faster pace among ‘large’ firms (those with more than 50 workers) compared to `small’ firms (those with 10 to 50 workers). Contract labor adjustment costs, in contrast, have fallen faster among smaller firms. Strikingly, land-related adjustment costs have trended in opposite directions for large firms relative to small firms, declining for large firms and increasing for small firms.

Firm-level variation in the adjustment cost of an input is associated with a misallocation of that input across firms (Hsieh and Klenow, 2009). For instance, the variance of factor adjustment costs across firms within a state is indicative of within-state misallocation across firms. We find that the variance of permanent and contract labor adjustment costs has been falling faster in fast-growing states compared to slow-growing states, suggesting that the within-state misallocation of labor is falling faster in faster growing states. But for land, the within-state dispersion has been rising for both fast- and slow-growing states.

Discussing the potential causes of these trends, we also present a review of the institutional framework concerning labor and land in India, supported by grassroots evidence on the constraints faced by firms in the country gathered through our field interviews with small and medium enterprises in Telangana and Uttar Pradesh. Among the most interesting considerations emerging from the exercise, we document an important role of governance in shaping the effective enforcement of factor market policy, and show that broad statelevel governance measures are strongly correlated with firms’ perceptions about business environment, regulatory ease, and transparency. Using an index of governance quality to split states into a “high” and a “low” governance group, however, we puzzlingly find that adjustment costs for certain productive factors fell significantly more in the low-governance group, compared to the high-governance one. This pattern is robust to restricting the sample to neighboring districts located on opposite sides of the borders between low and high governance states, increasing our confidence that it is related to initial differences in statelevel institutions, rather than other spatially varying factors. Interestingly, a preliminary examination of available indices of governance quality over time suggests a slow convergence in governance quality across Indian states. The states that did not have robust governance structures earlier seem to have also been the most effective in improving their governance over time, which could in turn have produced a more sustained reduction in firms’ adjustment costs.

The rest of this paper is as follows. Section 2 discusses the relevant literature. Section 3 describes our empirical methodology, as well as our main data sources. Section 4 discusses our results on the main trends in factor adjustment costs, and on how they vary by firm size and across fast- and slow-growing states. Drawing on in-depth firm interviews conducted in two states, Section 5 discusses the key factor market regulations which could be relevant to explaining these results. Section 6 conducts a preliminary exploration of the role of governance, examining how the trends in adjustment costs have varied across high- and lowgovernance states. Section 7 concludes with suggestions for priority areas for future policy analysis, as suggested by the results of this paper.

> 8 The firm-level data set used for the analysis, the Annual Survey of Industries, covers factories with 10 or more workers. We are unable to measure these trends for firms with fewer than 10 workers.

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