Causes and Consequences of the "Missing Middle": Informality, Productivity, and the Size Distribution of Manufacturing Firms in India

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

Intellectual Merit The size distribution of manufacturing firms in India is highly unusual, with many small and large firms but very few in between. This "missing middle" is of concern to policy makers, who believe that it may be associated with India?s inability to expand manufacturing, increase the number of formal sector workers, and reduce the size of the informal sector. The large share of informality is associated with lower productivity, low wages, poor working conditions, and lack of security for workers. This research project seeks to understand the size distribution of firms in India, explain its causes, and identify the consequences for firm productivity in the manufacturing sector. The PI's confirm that there is a "missing middle" in comparison with other countries, with many small (informal) enterprises and few medium sized firms. They then systematically explore the possible determinants of this unusual size distribution, using a new panel dataset which they have created. In particular, they examine the effects of trade and foreign investment policies, licensing requirements, labor market policies, credit constraints and infrastructural constraints on the size distribution of manufacturing firms. The project concludes with an analysis of the determinants of productivity growth in India before and after the sweeping 1991 reforms. It analyzes the effects of changes in the trade regime, restrictions on foreign investment, credit constraints, infrastructure constraints, and labor laws on productivity growth. Rather than focus on one policy change, the PI's attempt to assign relative weights to all these different policies in driving Indian productivity changes. They link their work on productivity with research on size distributions by analyzing productivity differences between small and large enterprises, and between the formal and informal sectors. Finally, they explore the importance of policy changes for between- versus within-firm changes in productivity. This is the first study to analyze the effects of India's policy changes on the size distribution of both formal and informal manufacturing firms. This may also be the first study to systematically identify the policy determinants of India's "missing middle". Broader Impacts While the phenomenon of a "missing middle" is present in many poor countries, there has been no academic research that seeks to quantify the underlying causes of their unusual firm size distributions. More research is also urgently needed to understand why informal sector manufacturing employment in a country like India has not been absorbed by a growing formal sector. Evaluating these questions is important for poverty reduction, as many unskilled and poor workers are found in the informal sector. This project will create the most comprehensive panel dataset of Indian firms to date, as well as a linked informal-formal firm database. These two datasets, which will be made available to researchers, can be used to understand the relative importance of different policies (trade, foreign investment, licensing restrictions, exit restrictions, credit allocation) for productivity growth.