Market Reforms and Industrial Productivity
An Explanation
Patibandla, Murali; Phani, B. V.
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Publication date:
2001
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Citation for published version (APA):
Patibandla, M., & Phani, B. V. (2001). Market Reforms and Industrial Productivity: An Explanation. Department
of International Economics and Management, Copenhagen Business School. Working Paper / Department of
International Economics and Management, Copenhagen Business School No. 2-2001
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Market Reforms and Industrial Productivity: An Explanation
Murali Patibandla
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B.V. Phani
Department of International Economics and Management
Copenhagen Business School, Copenhagen, Denmark
Abstract:
The recent developments in the new growth theory shows the theoretical link between industrial
productivity and market mechanism in terms of private agents’ incentives for investing in research and
development and human capital accumulation. Several developing economies, such as India, that had
implemented policy reforms towards market mechanism have been experiencing high economic growth.
This paper brings out the factors that determine micro level firm level productivity in the context of a
developing economy that had undertaken the policy reforms towards a freer market. It econometrically tests
a few hypotheses on the basis of firm level panel data for a set of Indian industries. One of the strong
results of the paper is that firm level outward orientation of exports and imports contributes significantly
and positively to firm level productivity. This finding supports one of the propositions of the new growth
theory that developing economies benefit significantly with free trade with developed economies through
free flow of new ideas and technologies and externalities.
First Draft: June, 2001
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The corresponding author, e-mail: mp.int@cbs.dk; Fax: 45 3815 2500; Tel: 45 3815 2532.
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Market Reforms and Industrial Productivity: An Explanation
Murali Patibandla
B.V. Phani
Department of International Economics and Management
Copenhagen Business School, Copenhagen, Denmark
1. Introduction
The 1980s and 1990s have seen several developing economies make a radical shift towards a market
economy after years of pursuing import substituting policy regimes. Several of them have experienced
higher economic growth after implementing the market reforms. In the case of India, the reforms on the
internal front were initiated in the mid-80s and larger scale reforms on the internal and external fronts were
initiated in the early-90s (The Economist, 2001). India’s annual average growth of GDP was at 6.2 per cent
and GDP per capita at 4.4 percent for the decade of 1990-2000 and at 5.9 percent and 3.8 percent for the
decade of 1980-1990 and 3.7 percent and 1.5 percent for the period of 1950 to 1980 respectively (IMF).
The neo-classical growth theory postulates that GDP grows as a consequence of capital accumulation,
population growth and technological change. The growth rate in GDP per capita can be attributed to higher
growth in capital accumulation and technological progress than population growth. Capital accumulation
and technological progress make workers more productive- which leads to increase in marginal
productivity of labor and wage rate and a decline in product prices and consequent increase in real incomes.
This implies that in the nineties there was higher level of capital accumulation and technological progress
than the previous four decades in the Indian economy. As is well known, India’s policy reforms towards
freer markets were initiated in the mid-80s and the early-90s (Ahluwalia 1999). At a qualitative level, one
could put together the policy reforms and higher growth of GDP per capita, and attribute the higher growth
rates to the market reforms.
The key issue concerns why a free market mechanism should contribute to capital accumulation
and technological progress at a higher degree than under state interventionist policy regime. The neo-
classical growth theory of Solow (1956) does not make a theoretical link between economic growth and
market mechanism. In a production function framework, output is a function of capital and labor and any
residual in the output, that is not explained by the inputs, is attributed to technological change.
Technological change is assumed to be exogenous. There is no theoretical basis to explain why capital
accumulation should be higher in a free market than in a socialist economy unless one shows that there are
higher incentives for saving and its mobilization in a free market than in a socialist economy. The recent
theoretical developments in the new (endogenous) growth theory shed light on the link between economic
growth and market mechanism (Romer 1986, Lucas, 1988). The link can be seen in terms of incentives to
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private agents for investing in research and development and human capital accumulation in a free market
mechanism in which technological change is not purely a public good. Partial excludability of
technological innovations gives them private good properties. At the same time, technological change is
partially a public good causing spillover effects, which increase aggregate and cumulative stock of
knowledge. The non-rivalrious nature (use of a blueprint of a technology or new idea by one agent does
not preclude use by other agents) of technological change is a source of increasing returns to scale and
sustained long run growth (Romer 1990).
The incentive mechanism that causes private agents’ investment in improving economic efficiency
and subsequent economic growth can also be seen from the theoretical developments in the new
institutional economics (Coase, 1937; Williamson,1985; North,1990). Well-defined and secure private
property rights provide incentives for efficient production and allocation of resources. Market institutions
that reduce market transaction costs of economic exchange improve efficiency in mobilizing resources for
more productive use. Coase (1960) in his paper on the problem of social cost has shown that only in the
absence of transaction costs did the neo-classical paradigm yield the implied allocative results. With
positive transaction costs resource allocation is altered by the property rights structure. Well-defined and
enforced property rights provide a certain degree of predictability to economic activity and the rules
constrain and mould behavior in ways that rule out actions that are economically inefficient. To illustrate
this, private property rights require both ownership and also control rights (Hart and Moore,1990). For
example, the investors in the stock market should have the rights to ownership and control of their
investment in terms having information about how the managers use their capital. In the presence of high
market transaction costs of information, the investors lose control rights, which in turn cause high moral
hazard behavior on the part of the managers. This in turn causes misutilization of accumulated capital
(savings) in an economy. The widespread transfer of public savings into the public sector and private
monopoly before the reforms in India could be an example. Despite a high annual savings rate (about 20
per cent) in the past; India could not achieve rapid growth because of inappropriate utilization of the
accumulated capital by both the public and private sector monopolies. This can be viewed as an
institutional failure that causes low economic growth.
The market institutions that provided right incentives to private agents with appropriate
government institutional role appear to have generated an institutional framework for the Western style
capitalism to succeed better than socialist economies in achieving sustained long run economic growth. For
example, Russia’s achievement in space technology and also India’s success in certain high-technology
areas such as the satellite technology were made possible by the public sector investment. However poor
incentives for the private agents to make use of the stock of technology and knowledge created by the
public sector investment led to drag down on the growth. Government investment in the defense industry in
the US led to generation of new technologies. Combining this investment with private incentives for using
the stock of knowledge led to effective commercialization and use of the technology for the public good-
the example is the Information Technology industry in the US. In India’s case, government investment in