This is our 5th blog post for our Job Market Paper Series blog for 2025-2026.
Kamalesh Pahurkar is a Ph.D. student in the Department of Economics at the Indian Institute of Technology Bombay, India. His research interests lie in the field of applied microeconomics with a focus on Industrial Policy and Firm Performance.
Product quality is an important source of heterogeneity among firms. Improving quality is a key form of innovation that can foster growth (Garcia-Macia et al., 2019; Grossman and Helpman, 1991). What policies promote or encourage quality improvement, and which ones contribute to maintaining lower quality levels? For example, can encouraging competition spur quality upgradation among firms? In this study, we focus on size-based policies that promote micro, small, and medium enterprises by protecting them from competing with large firms. A large body of evidence suggests that dismantling size-based favouritism promotes competition and enhances output, employment, and productivity (Martin et al., 2017; García-Santana and Pijoan-Mas, 2014). However, we know little about their impact on product quality. Given that product quality plays a crucial role in driving growth, it is crucial to rigorously explore this relationship.
In my job market paper, co-authored with Vidhya Soundararajan, I study the staggered dismantling of a domestic, size-based, product-specific industrial policy in India. We find that removing small-scale industries (SSI) product reservation leads to an increase in the quality of products produced by these firms.
Small-Scale Industry Reservation in India
The 1967 Small-Scale Industry (SSI) policy reserved certain products exclusively for production by small-scale firms, aiming to promote employment and protect these firms from competition with large-scale firms. Small Scale Industries (SSIs) were initially defined as industrial undertakings with fixed assets not exceeding Rs 500,000 and employing fewer than 50 employees. The employment restriction was dropped in 1960, and by 1999, industrial enterprises with up to Rs 10 million in plant and machinery (based on historical cost) were designated as Small-Scale Industries (SSIs). Some large firms were allowed capacity expansion under the condition of exporting at least 75 per cent of their production (Mohan, 2002). In 1967, the reservation policy started with 47 products, but over time, the number of products increased considerably. In 1997, 1045 reserved products were on the list. A major criticism of the policy was its failure to account for quality differentiation within products and its lack of incentives for technological upgrading (Mohan, 2002). On the recommendation of the expert committee (Hussain committee, 1997), the government started the gradual de-reservation of the products, which began in 1997 and continued until the end of 2015.
Identifying the Impact of De-reservation on Product Quality
We quantify product quality for Indian manufacturing firms based on Khandelwal et al. (2013). This is based on a demand-residual approach, whereby the residual demand after controlling for prices helps measure quality. The underlying intuition is that, conditional on price, products with higher demand are inferred to be of higher quality. We estimate quality at the firm-product level, where each firm-product combination is considered as a distinct variety of that product.
Firm–product-level information is obtained from the Annual Survey of Industries (ASI) data spanning 2000 to 2007. We first obtained a list of products dereserved from the Indian government portal (https://msme.gov.in/). We then mapped these official product codes to the ASI commodity classification (ASICC) because the ASI reports products based on the latter codification. For the crosswalk between the official product list and ASICC codes, we used the concordance by Martin et al. (2017).
In the de-reservation reform, most of these products were “dereserved” between 2000-2007, allowing any firm (small or large) to manufacture these products. We exploit the plausibly exogenous timing of the dereservation of these products and employ a difference-in-differences (DiD) approach based on treatment firms that produced dereserved products and control firms that did not produce any dereserved products, and estimate the effect of dereservation on the quality of dereserved products.
De-reservation results in product quality upgrading
Figure 1 shows the event study plot of the impact of dereservation on product quality. The event study plot (Figure 1) shows a positive and statistically significant change in quality following the de-reservation event, while the absence of any discernible pre-trends provides confidence in the validity of our identification strategy. Furthermore, the heterogeneity analysis indicates that this quality effect is monotonically increasing with firm size and productivity, suggesting that larger and more productive firms benefited more strongly from the relaxation of reservation constraints. When estimating effects by quartiles of firm size and productivity, where firm size is measured using employment and plant and machinery value, we find that quality improvements are mainly driven by large, high-productivity firms in the top three quartiles. The large and productive firms are more capable of facing competition from new entrants and generally possess the ability to invest in high-quality inputs, capital, and skilled labour to improve quality.
We also distinguish our results into entrants and incumbents. Incumbents are those producing a dereserved product before it got dereserved, whereas entrants started producing a dereserved product only after its de-reservation. The findings suggest that the results are completely driven by the large size incumbent firms. These findings reiterate the importance of firm size as a key determinant of a firm`s capacity to improve product quality (Kugler and Verhoogen, 2012).
Next, we categorize firms into six groups based on their level of investment in plant and machinery. Our objective is to examine whether previously constrained firms—those operating within the SSI investment limit—improved product quality following the reform. The results indicate that quality upgrading occurred not only among large firms (those above the SSI threshold, with plant and machinery investment exceeding ₹10 million), but also among constrained incumbent firms within the upper range of the SSI limit (₹5–10 million). This pattern suggests that quality improvements were driven not merely by increased competition but also by firm expansion enabled through the removal of investment restrictions.
Mechanism behind quality upgrading
Consistent with the above results, we find that large firms increased their skill intensity following de-reservation. Skill intensity is measured as the share of real wages paid to regular workers. We also observe an increase in capital intensity, defined as the ratio of capital to total workers. These patterns suggest that higher capital and skill intensities contributed to firms’ ability to upgrade product quality. This finding aligns with Martin et al. (2017), who document increases in employment and investment in plant and machinery following de-reservation. Since producing higher-quality goods is costlier, we further find that firms paid higher input prices after de-reservation, consistent with the adoption of higher-quality inputs.
Do consumer benefits? The Price Effect
We find that firms operating in markets with a large scope for quality differentiation (long quality ladder measured by the difference in the highest and the lowest quality in that industry) improved their product quality and pursued quality-based competition, whereas firms in markets with limited scope for quality differentiation significantly reduced their prices in response to competition. On average, there is a decline in quality-adjusted prices, indicating that consumers are getting higher quality at a lower price or at the same price as before dereservation.
Key Takeaways
This study highlights the critical role of competition and firm size in driving the production of high-quality products. The earlier size-based industrial policy, which restricted firm entry and limited expansion, proved detrimental to economic growth. In contrast, allowing firms to expand and enabling free entry fosters quality upgrading, which in turn benefits consumers through access to higher-quality products at lower quality-adjusted prices.
Note – The featured image is generated using Gemini AI by the author.
