Firms, Markets, and the State: Institutional Change and Manufacturing Sector Profitability Variances in India

We assess absolute magnitudes, relative importance, and intertemporal differences in firm, industry, and business group effects in explaining the variance of Indian manufacturing firms’ profitability over the 26-year period between 1980–1981 and 2005–2006. We stratify the data by institutional phases to place emphasis on the role of changing institutional factors in an emerging economy: first as a regime of command and control transits to partial liberalization (between 1985 and 1991) and then to an open competitive market economy (after 1991); thereafter, financial reforms occur, followed by legal reforms. We find that liberalization significantly affects and alters the relative importance of firm, industry, and group effects. Firm effects are always important, whether in a command and control regime, with benefits accruing from protectionism and political rent seeking, or in liberalized periods where firm-specific capabilities and dynamic efficiencies are valued. Industry effects are significant in the command and control regime, when mandatory sector placement benefits firms in industries with superior profits, and in the liberalized period, when the choice of the industry segment in which to operate is open to firms. Thereafter, industry effects dissipate. Business group effects matter in explaining profitability variances. Group effects’ magnitudes, however, do not change significantly over time.