Microeconomic Flexibility in India and Pakistan: Employment Adjustment at the Firm Level

By Chaudhry, Theresa | The Lahore Journal of Economics, September 2009 | Go to article overview

Microeconomic Flexibility in India and Pakistan: Employment Adjustment at the Firm Level


Chaudhry, Theresa, The Lahore Journal of Economics


Abstract

In this paper, we look at the pace at which firms adjust their employment levels as a measure of "microeconomic flexibility." Flexibility aids in creative destruction processes, where less efficient establishments recede and dynamic firms can rapidly expand. Following the techniques used by Caballero, Engel, and Micco (2004), we use firm-level data from India and Pakistan to estimate the proportion of the gap closed in a year between desired and actual employment. The results for the proportion of the gap closed for India were 0.46 in 2001 and 0.45 in 2000. For Pakistan, we estimated the proportion of the gap closed as 0.2 in 2001 and 0.53 in 2000. The results for 2001 were much lower than expected (and lower than previous estimates for both countries), possibly due to the events of 9/11. Pakistan compared favorably to India in various key sectors, including chemicals, food processing, and garments. Exporters did not seem to have a quicker speed of adjustment.

JEL Classification: E2, J2, J6.

Keywords: Costs, efficiency, flexibility, inputs, labor.

(ProQuest: ... denotes formulae omitted.)

Introduction and Literature Review

There are many ways of looking at allocative efficiency at the microeconomic level, particularly in a static model. However, in this paper, we examine one aspect of dynamic allocative efficiency, referred to as "microeconomic flexibility" by Caballero, Engel, and Micco (2004), henceforth CEM (2004). In order to examine microeconomic flexibility, we are going to look at how quickly firms adjust to economic changes.

In the short run, firms can change output by adjusting variable inputs, most importantly labor. However, due to adjustment costs, firms are not usually able to shift immediately to the new optimal (i.e., profit maximizing) level of labor. In this paper, we look at the speed of adjustment in employment as a measure of microeconomic flexibility.

Flexibility within firms is deemed important, most significantly for economic growth. Flexibility aids in "creative destruction" processes, where less efficient establishments recede and dynamic firms can rapidly expand. An additional benefit is that more flexible economies can quickly take advantage of new opportunities when opening up to trading partners, possibly leading to a first mover advantage. Without flexibility, there is a less efficient allocation of resources, which leads to lower total output. For an example at the industry level, one can see the impact of the lack of flexibility on the part of US automakers in recent years; inflexibility with regard to supply chains and labor contracts compounded the economic difficulties the industry was already facing.

In this paper, we measure economy-level microeconomic flexibility by calculating the speed of adjustment in labor in India and Pakistan. Auxiliary issues that can be addressed include comparing the relative flexibility in India versus Pakistan in key industries, and whether exporters are generally more flexible.

The basis for such research on the microanalysis of employment dynamics was initiated by Caballero and Engel (1993) and extended by Caballero, Engel, and Haltiwanger (CEH) (1997). CEH 1997 used quarterly plant-level data from the US, finding that, from 1972-1980, 90% of an employment gap (between desired and actual employment levels) was adjusted for in a 1-year period.

Caballero, Cowan, Engel, and Micco (2004), henceforth CCEM (2004), used sector-level data from 1963-2000 and calculated the annual speed of labor force adjustment, controlling for labor regulation. The adjustment coefficient (measured as the percentage of the gap between desired and actual employment closed in 1 year) was calculated for 60 countries, including India and Pakistan, the focus of our paper. They found similar rates for India and Pakistan, with firms on average closing 74.6% and 77.1% of the gap between desired and actual employment respectively. …

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