True to form, the a priori expectations are a mixed bag: Economic theory in a world of imperfect competition allows for both a decrease and increase in market power measured by the price-marginal cost ratio with trade liberalisation. Domestic prices may be driven lower due to removal of quantitative restrictions or lowering of tariffs. As costs remain unchanged, this compresses the price-marginal cost ratio or decreases market power.
The flip side is that an increase in market power is likely as trade liberalisation reduces the number of firms in an industry. According to theory, the mark-up is inversely related to elasticity of demand or number of firms in an industry. Trade reforms increase competition or rivalries which rationalise industry structures, resulting in far fewer firms. The latter, in turn, exercise greater market power.
In sharp contrast, the effects on scale efficiencies due to trade reform largely remains an empirical question rather than a straightforward prediction from theory. In the Indian context, in 1998 two researchers using an identical methodology (as the study in review) focused on five industries between 1985-93 and observed across-the-board reduction in market power and worsening of scale efficiencies.
However, Balakrishnan, Pushpangadan and Babus work is more robust as it covers a broader period, 1987-88 to 1997-98 and studies the entire manufacturing sector of the country. Their sample of 3,596 firms, which accounts for nearly 73 per cent of the value of output of the manufacturing sector, is simply the largest assembled so far for the purposes of studying such questions in the economic literature.
What do they find With trade reforms in 1991, there is no evidence of across-the-board moves towards a more competitive market structure in terms of a reduction in market power or improvement in scale efficiencies in Indian industry. As there is no overall pattern, the evidence is obviously non-uniform across various industries with respect to these two variables in the countrys manufacturing sector.
Estimating a group-wise production function allowing for firm-specific effects, their results indicate a mixed picture on market power. In only eight industries (out of 15 at a two-digit level of classification) is there statistically significant change the ratio of price to marginal costs increases in five cases and declines in three cases. On balance, our results point to a move to a less competitive one, argue the authors.
As for scale efficiencies, in 9 out of 15 industries there is no evidence of change. Out of the six instances of a recorded change, there is an improvement in scale efficiency in four, with two others showing a worsening. Of the four industries where there is an improvement in scale efficiencies, a move to increasing returns to scale post-1991 is indicated for basic metals. This finding warrants closer research.
With trade reforms, such a move to increasing returns can set in when domestic firms have access to world-class inputs at lower prices. When this increased competitiveness is translated into greater market access worldwide or an expanded production opportunity, an improvement in scale efficiency is clearly to be expected. But while the results on scale efficiencies will be considered empirical matters, further research will have to explain increasing market power with Indias trade reforms post 1991.
*Pulapre Balakrishnan, K Pushpangadan, M Suresh Babu Trade liberalisation, market power and scale efficiency in Indian Industry, Working Paper 336, August 2002, Centre for Development Studies, Thiruvanthapuram, Kerala.