Entry Liberalization and Inequality in Industrial Performance

GAICIL Insights

Open a sector to entry and the industry average says almost nothing.¹ Entry Liberalization and Inequality in Industrial Performance, by Philippe Aghion, Robin Burgess, Stephen Redding and Fabrizio Zilibotti, studies industrial delicensing in India, which began in 1985 and marked a discrete break from a past of centrally planned industrial development. Similar liberalization episodes have occurred across the globe, making the lessons broadly relevant.

A simple growth model captures how firms respond to the entry threat liberalization creates. Firm responses, even within the same industrial sector, are likely to be heterogeneous, increasing within-industry inequality. Technologically advanced firms and those in regions with institutions favorable to business are more likely to respond to the entry threat by investing in new technologies and production processes. The same threat is a call to arms for some and a death notice for others.

The evidence confirms it. With a panel of three-digit state-industry data from India for 1980 to 1997, the authors find delicensing increased within-industry inequality in industrial performance. Entry deregulation elicited heterogeneous responses from industries in the same three-digit sector located in different Indian states. Identical industries, different states, divergent fates.

Reality is more nuanced than the usual split between supporters and opponents of liberalization. No a priori assumption can say whether an industry in a particular region will benefit or be harmed. Outcomes depend on firms' technological capabilities and the institutional environment. The liberalization debate's two camps are both partly wrong.

The implication is actionable. Firms upgrading technological capability, and policymakers improving the institutional environment, bear centrally on whether industry in a given sector and state benefits. The authors place the search for policies enabling local industry to benefit at the research frontier.

Artificial intelligence is an entry threat in all but name. AI introduces a powerful competitive threat across industries, similar in some respects to entry liberalization. Firms near the technological frontier, with strong capabilities, are likely to respond by investing in AI and improving performance. Firms further behind may struggle. Within-industry performance dispersion may widen. AI may do to every industry what delicensing did to Indian manufacturing.

Institutions shape the response. Regions with supportive institutions may see their firms respond more effectively to AI-driven competition. Labor market flexibility, finance access, skills and infrastructure all shape adaptation. Spreading AI's benefits requires strengthening the institutional foundations that let firms respond. Where a firm sits on the map may matter as much as what it makes.

Capability is the firm's best defense. Firms investing in upgrading capabilities are better placed to benefit from competitive shocks. As AI transforms markets, continuous investment in technology and skills becomes both defense and growth path. The firm that waited for the shock before upgrading has waited too long.

Within-industry inequality deserves attention. Liberalization widened performance gaps within sectors, and AI may do likewise as leaders pull ahead. Helping lagging firms adopt AI, through diffusion programs, training and technology access, can narrow gaps while preserving competition's dynamism. Diffusion policy is the complement that keeps openness from turning into a sorting machine.

Method matters. Combining theory with microeconomic data and emphasizing incentives and technology offers a fruitful route to understanding industrial development. Similar approaches can illuminate how AI affects firms with different capabilities and institutional environments.

At bottom, liberalization creates winners and losers depending on technological capability and institutions. Firms near the frontier in favorable environments respond to entry threats by innovating, while others may fall behind. As AI reshapes competition, the same principles apply: investing in capabilities and strengthening institutions can help more firms and regions benefit from the opportunities new technology and competition create.

A hard question for anyone reading AI's impact from industry averages: the average may be flat while firms inside it split apart. Measure the spread, and target help at the laggards before the gap becomes permanent.