Firms and Farms: The Local Effects of Farm Income on Firms’ Demand

How do changes in agricultural productivity affect firms? Using the predictions of a simple multi-sector general equilibrium model of the local economy and exploiting weather-induced agricultural volatility across India, I estimate the response of manufacturing firms to changes in agricultural productivity. I show that negative agricultural productivity shocks lower the cost of labor but that this does not cause firms to hire more. Firms’ production and employment in fact decrease because the shocks also reduce local income and hence the demand that firms face. My estimates provide evidence for a significant local demand effect. I then use my framework to show that this has key policy implications. I examine the introduction of a rural workfare program and assess how it affects firms. I show that the program attenuates the impact of negative agricultural shocks on firms because of its counter-cyclical effects on local wage and demand for manufacturing goods. The results highlight how policies that target households and increase their income can affect local market size and therefore the industrial sector through their general equilibrium effects.