In developing countries, capital is usually trapped in extremely large and small firms, which is inefficient. The challenge developing countries face is encouraging the small firms to scale up so that more capital in the economy is embedded in mid-sized firms.

There is an active literature on what is called the “Capital Misallocation Hypothesis.” The idea is simple. If somehow (magically) capital was reallocated amongst firms, will the GDP of an economy increase? Put another way, are the institutions of a country misallocating capital? The empirical evidence shows us that developed economies have a normal distribution of form size, that is, most firms are mid-sized and very few firms are very large or very small. Conversely, in developing economies the capital is trapped in very large and very small firms. There is a hollow in the middle.

The argument is that lack of mid-sized firms is the obstacle for developing economies when it comes to development. The key challenge for India is that it still lacks mid-sized firms. Or at least, that is what the data is telling us.

Here is the thought experiment. Rough calculations show that if capital is somehow allocated to mid-sized firms, then India per-capita income will increase by 30-40%. Further, it will change the growth dynamics for India.

Incidentally, we have evidence from research papers that this is what was happening across India in 1980s when the licence raj was being dismantled. While it created some change, there have been no reforms since then and we are stuck with an inefficient size distribution of firms in India. It follows that if India needs to progress, it needs to solve two problems.

  1. Create an environment of entrepreneurship when efficient firms can easily scale up. That requires removing bureaucractic hurdles for scaling up.
  2. Level playing field in access to capital through debt and equity. That is by ensuring that everyone (irrespective of their economic status) has fair access to capital through stock markets and bank loans. Wealthy industrialists in India have easy access to capital through debt, while other entrepreneurs struggle to raise capital. That needs to change.
  3. Creating an effective Competition policy that ensures that levels the playing fields for all firms, irrespective of their size. This would engendered entprenuership and innovation and growth and development in the long-run.