The Effects of Labor Regulation on Firms and Exports: Theory and Evidence from Indian Apparel

Abstract

Building on a detailed analysis of qualitative data collected from formal Indian apparel manufacturers and sector experts, we develop a theory to predict the effects of labor regulations on monopolistically competitive manufacturing firms’ production decisions. The theory clarifies how these decisions may differ between firms producing for domestic and export markets. We then test the model’s predictions using establishment-level data on formal Indian apparel manufacturers for 2009-10 and 2010-11 and interstate variation in labor laws. We find a close fit between the theory, the qualitative evidence and the quantitative data – a finding that survives multiple robustness checks and instrumental variables estimation. Apparel producers in states with inflexible labor regulations tend to replace labor with capital, producing more output per worker, and hiring fewer workers. This effect is smaller for exporting firms, which are more tightly bound to international norms for organizing production. Pro-labor regulations select against less productive firms, especially in the export sector. Our theory shows that labor regulations have ambiguous effects on firm capital stocks and output levels, and no empirical effect on these outcomes is detectable. Our findings allow us to comment on the likely efficacy of various types of labor reforms being advocated to spur industrial activity and employment in labor-abundant developing countries.