Dipak Dasgupta, James Hanson,andEdison Hulu
Theoretically, deregulation can improve the productivity of an economy through a number of channels. First, deregulation encourages resources to shift into more productive and internationally competitive sectors and out of protected and inefficient sectors. This “stock” effect is often missed in discussions of productivity gains focused on firms and “competitive” advantage, yet it remains at the heart of the matrix of gains from comparative advantage and international trade. Second, deregulation allows easier access to higher quality inputs, an effect which was an important source of productivity growth in Korea, for example (Feenstra et al. 1992). Third, deregulation encourages greater competition, by making it profitable to sell in the export market and necessary to face imports, rather that stagnate in a domestic, protected market. This forces firms to innovate to keep pace with the competition. Fourth, deregulation encourages foreign direct investment, which brings new techniques and management capacities. Fifth, financial deregulation, in particular, provides increased funds for smaller and more labor-intensive firms (see Harris et al. 1994), which allows them to expand and modernize.
All of these channels were evident in Indonesia during the deregulation of the mid-1980s. Therefore, it is reasonable to hypothesize that the total factor productivity (TFP) of the newly deregulated Indonesian economy would also increase. The rest of the paper examines the strength of this hypothesis. We find that TFP did indeed increase during the 1986–1992 deregulation period.