Tariff Liberalization and Firm-Level Markups in Indian Manufacturing: Prof. Rupa Chanda

Journal: Economic Modelling ( IF 3.127 ) 

Tariff liberalization has a significant bearing on firm performance. One important aspect of firm performance is markups, which refer to the margin between the selling price of a firm’s product and the unit cost of producing that product. It reflects the firm’s pricing and market power. Existing theoretical studies predict that input tariff liberalization, by lowering input costs, would raise firm-level markups, while final goods tariff liberalization by increasing product market competition, would lower product prices and thus firms’ markups. 

This paper examines whether this two-sided effect holds for Indian manufacturing firms and the role of firm size and the policy framework in shaping this impact. It empirically examines the impact of input and final goods tariff liberalization in the context of India’s Export-Import Policy of 1997-2003 and 2004-09, for large versus Micro, Small and Medium Enterprise (MSME) firms. It confirms that there is indeed a two-sided effect of tariff liberalization on firm-level markups with input tariff reductions increasing markups of Indian manufacturing firms and final goods tariff reductions lowering firms’ markups, and that the input channel is stronger for all firms. The findings confirm the importance of imported intermediate inputs in determining firm markups and their potential role in helping to offset product market competition effects of final goods tariff liberalization.

The paper extends the analysis to assess if there is a differential impact of tariff liberalization on the markups of large versus MSME manufacturing firms, given the significance of  MSMEs in India’s GDP, employment, and exports. It finds that large rather than MSME firms experienced higher markups following input tariff reduction, thus indicating that large Indian manufacturing firms have been able to realize the scale, variety, and cost related benefits from input tariff liberalization while MSMEs have remained constrained by technological, financial, and other factors. The paper also examines if the impact on markups for large versus MSME firms has been influenced by a change in the MSME definition in India, following the Micro, Small, and Medium Enterprises Development (MSMED) Act, 2006 which raised the ceiling on investment in plant and machinery to qualify as an MSME. This focus on the MSME policy framework is motivated by ongoing discussions about the importance of MSME classification as it determines their eligibility for various government support mechanisms and incentives and their ability to expand capacity, import, invest in technology, etc. The results show that importing MSMEs experienced higher markups following the upward revision in investment limits in 2006, indicating that the legislative framework for MSME classification has a bearing on their efficiency as it influences their operating environment. 

Overall, this paper highlights the importance of firm size, the liberalization channel, and the role of the domestic policy framework in determining firm-level markups and enabling efficiency gains following trade liberalization. 

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