SMU SOE Seminar (June 20, 2018): Swimming Upstream: Input Capabilities and the Direction of Product Adoption in India

What determines the production structure of firms, and how does policy influence it? Product-level export data show countries' product mix explains cross-country income differences, and theories of the product space suggest that policy can raise incomes by building the capabilities needed to move into high return products.

However, less is known about the channels through which policies determine production capabilities and the resulting production structure. This paper shows that policy influences the market structure in input supply, which in turn determines the input capabilities and production structure of plants.

Building on the theory of the firm, we take a microeconomic view and look at production patterns within plants. Previous work examines how many products firms choose to produce, but not which. We provide a theory of input-based comparative advantage of plants, and show that pro-competitive input supply policies raises input-based comparative advantage of plants. In our model, plants have input-specific productivities. Products differ in their intensity of various inputs needed in production. Plants specialize in products that use their input capabilities more intensively, and entry liberalization in input markets reinforces the comparative advantage and production specialization of plants.

Applying the theory to manufacturing plants in India, we show that removal of size-based entry barriers in input supply raised the input-based comparative advantage of plants. Plants that had higher initial shares of liberalized inputs were more likely to move into industries that used these inputs more intensively. To fix ideas, a cotton apparel producer became more likely to start producing cotton hosiery (rather than silk hosiery) after entry liberalization in cotton, compared to a silk apparel producer. Quantifying the role of economic policy on industry specialization, we show that removal of entry barriers in input markets was on average equivalent to a 45 per cent reduction in input tariffs.