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Productivity, Wages and Employment in Indian Manufacturing Sector: An Empirical Analysis

Badri Narayan Rath and S.Madheswaran* Institute for Social and Economic Change Nagrabhavi (PO) Bangalore 560072 Email: badrirath@yahoo.com Abstract This paper investigates the relationship between labour productivity, real wages, employment and prices in Indian manufacturing sector. The empirical results derived from conventional cointegartion and error correction models provide evidence for long run relationship among these variables during 1960-61 to 2001-02. The results derived from the block exogeneity test indicate that there is uni-directional causality between real wages to labour productivity and causality runs from real wages to labour productivity. However, employment and prices are not causing the labour productivity. Similarly, labour productivity and real wages are causing prices but there is no causation from employment to prices. The speed of adjustment parameters indicates that the short run disequilibrium among these variables is adjusted through labour productivity and prices, but not by the real wages and employment. The government functioning needs to be more efficient to make Indian manufacturing globally competitive.

Keywords: Labour Productivity, Real Wages, Employment, Prices, Cointegartion, Error Correction, Block Exogeneity and Indian Manufacturing. * The authors are the Research Scholar and Associate Professor at the Institute for Social and Economic Change, Bangalore-560 072, India. The first author is grateful to Dr.M.Ramachandran, Professor University of Pondichery for his valuable comments and suggestions. However the authors are responsible for any errors.

1. Introduction Indias post-independence development plans have emphasized industrialization as a very important instrument for sustained growth. As a result, today in 2004-05, the annual growth rate of industrial production of total industry is 8.9 per cent and higher than countrys overall economy growth. Within industrial sector, manufacturing plays an important role in countries economies and its weight is 79.3 per cent out of total industrial sector in 2004-05 (Economic Survey, 2004-05). Manufacturing growth started accelerating in the 1980s and got further stimulus in the 1990s. The key reasons for increasing growth is investment in public infrastructure, gradual reduction in government controls and higher inflow in private investment in 1990s. At present, Indian manufacturing constitutes nearly one fifth of the economy. It employs nearly 1.8 million people in the organized sector and contributes more than 75 per cent Indias export.1 Despite a steady growth over the several decades, Indian manufacturing faces stiff competition from other developing economies in Asia and elsewhere both in domestic as well as global markets. The important requisite, which is needed for competitiveness is enhancement of productivity. Being a labour abundant economy, India could boost the productivity by employment generation, higher wages to the employees, innovation and technology. So, the issue of productivity and employment in manufacturing sector is the only root to make Indian manufacturing as a global manufacturing hub. Productivity studies gained prominence in India after 1950s and early 1960s, when development was basically growth oriented. In later part of 1960s, a number of studies have been conducted in the manufacturing sector in India.

Quoted from (WTI, 2003).

Several studies like Ahluwalia (1991), Goldar (1986, 2000, 2004), Upender (1996), Kumar (2002), Aggarwal and Kumar (1991), Balakrishnan and Pushpangadan (1994), Rao (1996), Gangopadhyaya and Wadhwa (1998), Unel (2003), Trivedi et.al. (2000), TSL (2003), Tendulkar (2003), Bidhe and Kalirajan (2004) have measured the productivity trends, employment trends and growth of Indian organized manufacturing sector during the post independence period. A significant number of studies have focused on the measurement of Total Factor Productivity Growth (TFPG) and found different figures within different underlying methodological framework. Recent studies like Balakrishnan and Suresh Babu (2003), find the growth rate of labour productivity and employment in the nineties has risen as compare to eighties. But at the same time, the growth rate of money wage, product wage and real wages has declined in the post-reform as compare to pre-reform period. Some of the indicators of their study do commensurate with the findings of Unel (2003) and Gangopadhyay and Wadhwa (1998). But Goldar (2004) finds a deceleration growth in Indian manufacturing during post-reform periods as compared to pre-reform period. He has compared his results with Unel (2003) and TSL (2003) and criticized their findings on the ground of measurement problems. Goldars study also finds a negative employment growth in Indian organized manufacturing sector after 1997-98. The study by Bidhe and Kalirajan (2004) also shows a slow growth rate of employment in organized manufacturing sector in post-reform period as compare to pre-reform period. Indian government policies with regards to industry, foreign investment and trade have been sprouting over the years. In 1950s and 60s, the focus of the government was on attaining self-sufficiency in all sectors of the economy, generating employment, promoting small industries and preventing private sector monopolies. Over the years, however, these policies had detrimental effect on low productivity, lack of professional management in most of the Indian firms. In state owned enterprises and government ownership, the bureaucratic system delayed in decision-making process. The compulsory licensing for all the industries, price controls and subsidies removed motivation to improve performance. After the 1991 reforms, Indian manufacturing has been opened out to competition from global players. However, the pace of reform has been slow. The government should find out proper immediate action in order to enhance the productivity, which will accelerate the

growth process and competitiveness of the economy. In order to take various steps for increasing the productivity, it is more important to see the dynamic relationship between the key variables in the manufacturing sector. The present paper has a different dimension. It differs from the previous literature on the ground of specific focus on explaining the long run causal relationship between productivity, employment, real wages and price in the manufacturing sector. It is well documented that the mutually reinforcing phenomena of low productivity in manufacturing sector is the cause for low income. Low income in turn leads to low standards of living, which constitute the root cause for poverty and unemployment in the country. So, the issue of labour productivity growth, the only route to enhance labour welfare in the long run has been under examined. The paper is set out as follows. Section 2 discusses some of international literature pertaining to our study. Section 3 briefly outlines the methodological framework for causality issues and the long run equilibrium relationship among these variables. Section 3 discusses the measurement of variables and the sources of data. Section 4 presents the results of cointegration tests, error correction models and causality tests. Concluding remarks is given in section 5. 2. Review Literature In light of this, we have reviewed some of the international literature pertaining to our study. Policy-makers and financial analysts cite wage pressures and productivity gains as leading factors in explaining inflation. Mehra (2000) shows that prices explain wages, but that wages are not a causal factor in determining inflation. Studies by Hu and Terhan (1995) and Gordon (1988) report evidence indicating that wage growth has no predictive content for inflation, rejecting the cost-push view. Ghali (1999), using Granger-causality tests, finds that wage growth does help to predict inflation, supporting the cost-push view. Lindbeck (1983), Giersch and Wolter (1983) and others have examined the negative impact of inflation on labour productivity. The acceleration of inflation will push workers into higher tax brackets and it may have impaired work incentives. Since higher inflation rates can distort the price mechanism they can also reduce the economic efficiency, having negative impact on capital accumulation and technological progress. Strauss and Wohar (2001) investigate the long-run relationship between prices and wage-adjusted productivity as well as between real wages and average labour productivity at the industry level for 459

US manufacturing industries over the period 1956-96. Their panel cointegration test results strongly reject the null of no cointegration in the panel between both price and wageadjusted productivity and between labour productivity and real wages. In view of the above, the aim of this paper is to investigate the long-run relationship between labour productivity, real product wages, employment and prices of Indian manufacturing industry over the period 1960-61 to 2001-02. The justification for choosing real product wages is that employment decisions are made on the basis of real product wages not real consumption wages. The following specific questions are addressed in the paper. First, is there is a long-run equilibrium relationship between labour productivity, real wages, employment and prices? Second, what are the short-term relationships among these variables? 3. Methodology 3.1 Causality Issues On the basis of theory, a number of causal relations between labour productivity, real wages and prices may be hypothesized. These are summarized in Table 1, along with the expected signs. Table 1: Hypothesized Causal Relations among the Variables Causal Direction LP RW LP Price LP EMP RW LP RW Price RW EMP Price LP Price RW Expected Sign + + + + Rationale Performance-based pay; bargaining Productivity will hike the price level Efficiency wage theory says a rise in real wages may induce higher work effort -and hence productivity- by raising the costs of job loss. Efficiency wages Workers purchasing power will hike the price level Higher real wages causes employment negatively. Inflation will decrease productivity through output Inflationary situation suppresses the purchasing power of the workers.

Changes in labour productivity may cause changes in wages for at least two reasons: (i) if individuals pay is performance-based; and (ii) if labour unions bargain for real wage increase on the basis of past improvements in productivity (Wakeford, 2003). Higher productivity means that more goods and services can be derived from the same factor 5

inputs. An increase in labour productivity is always a ground for workers to press their claims for higher wages. If the increase in productivity is due to the efforts of labour or their improved efficiency, then it will positively cause real wages. The increase in productivity will lead to higher income and higher standard of living of the workers. Thus, higher standard of living will lead to economic growth in the long run. According to efficiency wage theory, a rise in real wages may induce higher worker productivity by raising the costs of job loss. Productivity of an industry may be rising, but if it suffers a fall in the prices of its product it would not be possible for it to adequate rise in money wage rates. So, increase in product wages brings the wage burden on the industry. The effect of an increase in average labour productivity on employment is unclear. It could reduce the demand for labour, as workers are more efficient. Alternatively, a rise in productivity could have a positive impact on employment through an output effect, which shifts the demand for labour curve outwards (Wakeford, 2004). The Granger causality tests2 are performed to establish the direction of dynamic (shortrun) relationships among these four variables. Granger causality says if X causes Y, then changes in X should precede changes in Y. In particular, to say that X causes Y, two conditions should be met. First, X should help to predict Y; i.e. in a regression of Y against past values of Y, the addition of past values of X as independent variables should contribute significantly to the explanatory power of the regression. Second, Y should not helps to predict X, it is likely that one or more other variables are in fact causing the observed changes in both X and Y.3 3.2.The Cointegration Test In the literature, it has been established that most of the macro economic time series data exhibit nonstationary and the conventional wisdom is that difference all the nonstationary variables before putting them into regression analysis. Alternatively, regression on nonstationary variables is permitted if their linear combination is stationary. It has been recognized in recent literature that if a linear combination of integrated variables is stationary then such variables are said to be cointegrated. Although Engle and Granger (1987) was the first to introduce the cointegration test, the tests propounded by
2 3

See C.W.J. Granger, 1969. See Pindyck and Rubinfeld, 1998, pp. 243.

Stock and Watson (1988), Johanson, 1991 and

Johansen and Juselius (1990) are more

useful in testing the long run equilibrium relationships in multivariate setting. The estimation part of Johansen and Juselius method involves the following steps. Let Xt be an (n1) vector of variables with a sample of T. Assuming Xt follows I(1) process, identifying the number of cointegrating vector involves estimation of the vector error correction representation: X t = A0 + X t p + Ai X t i + t
i =1 p 1

(1)

In the above equation, the vectors Xt and Xt-i are I(0) while the vector Xt-i are I(1) variables. Therefore, the long run equilibrium relationship among Xt is determined by the rank of matrix. If the rank of , say r, is zero, then Eq. (1) reduces to a VAR model of pth order and the variables in level do not have any cointegrating relationship. Instead, if 0 < r < n then there are n r matrices of and such that = (2)
/

where is cointegrating vector; hence, Xt is I(0) although Xt are I(1) and the strength of cointegration relationship is measured by s. In this framework, we have to estimate (A0, A1, . . ., Ap-1, , ) through maximum likelihood procedures, such that can be written as in (2). To estimate all these parameters, we have to follow two-step procedures. In the first step, regress Xt on Xt-1, . . ., Xt-p+1 and obtain the residuals ut . In the second step, regress Xt-1 on Xt-1, Xt-2, . . ., Xt-p+1 and obtain the residuals e t . From the obtained residuals u t and e t , find the variancecovariance matrices. 1 uu = u t u t T t =1
T

(3) (4) (5)

1 T ee = et et T t =1 1 ue = u t et T t =1
T

The maximum likelihood estimator of can be obtained by solving: | ee eu INV ( uu ) ue |= 0 (6)

With the eigenvalues 1 > 2 >.. > n . The normalized cointegrating vectors are: = ( 1 , 2 ,.... n ), such that ee = I Now we can test the null hypothesis that r = h, 0 h < n against the alternative of r = n by obtaining the following statistics: trace = LA LO Where Tn Tn T T h LO = log( 2 ) log | uu | log(1 i ) 2 2 2 2 i =1 and Tn Tn T T n L A = log( 2 ) log | uu | log(1 i ) 2 2 2 2 i =1 Hence, LA LO = - (T/2) 2(LA LO) = - T (8) (7)

i = h +1

log(1 i ) (9)

i = r +1

log(1 )
i

Equation (9) follows 2 distribution and called as trace statistics. Further, the null hypothesis that there are r against r + 1 cointegrating vectors can be tested by obtaining the following statistic: max = - T log (1- r +1 ) 4. Data Sources and Defining the Variables The present study uses annual data from 1960-61 to 2001-02. The variables considered in the above model are labour productivity (LP), Real product wages (PW), Employment (EMP) and Wholesale Price Index. The data are collected from Annual Survey of Industries (ASI published by the Central Statistical Organization). The data on wholesale price index has been collected from Handbook of Statistics on Indian Economy. In order to measure the variables, we have used the following data: gross value added, employment, emoluments and Wholesale Price Index for all commodities. The labour productivity is defined as real output per employee. Following Goldar (1986), we have preferred gross value added as an index of output in place of net value added because depreciation charges in the Indian industries are known to be highly arbitrary, fixed by income tax authorities and seldom represent actual consumption. However, it is 8 (10)

extremely difficult to arrive at proper estimate of capital consumption from the available data. To make correction for nominal value added to real one, the yearly current value has been deflated by wholesale price index of manufacturing products base 1993-94 = 100. In order to obtain the general price level, the wholesale price index of the manufacturing products base 1993-94=100 has been taken. Employment is defined as the total employees of an industry. Real wages are defined in different ways in the literature. Following (Wakeford, 2003), this study chooses a variant of real product wages, where the gross domestic product of manufacturing sector deflator is used to deflate nominal wage rate. This makes it fit most closely with measure of labour productivity used, which is based on real value added. A final point to note is that nominal wage is defined as average emoluments (i.e. per employee). 5. Empirical Results 5.1. Preliminary Data Analysis A visual examination of time plots of the variables provides a useful orientation to the data (see Figure 1). Labour productivity of the manufacturing sector has shown an upward trend during the period 1960-61 to 2001-02, although there was decline in the year 1982-83. The real wages in the manufacturing sector have also shown an upward trend, but fairly high degree of volatility over the past four decades. The employment series shows most volatility during 1960-61 to 2000-02. Finally, the wholesale price index for manufacturing series has demonstrated an upward smooth curve. Figure 1: Labour productivity, Real product wages and Price, 1960-61 to 2001-02
Labour Productivity 12.5 ln Wages in rupees 12 11.5 ln Lp 11 10.5 10 9.5
1960 1969 1978 1987 1996

Real Wages 8.5 8 7.5 7 6.5


1960 1968 1976 1984 1992 2000

Year

ln LP

Year

ln Wage

Em ployment 9.2 9 8.8 8.6 8.4 8.2 8 7.8 7.6


1960 1969 1978 1987 1996

Price 6 5 4 3 2 1 0
1960 1967 1974 1981 1988 1995

ln EMP in number

ln WPI

Year

ln EMP

Year

ln Price

A scrutiny of Table 1 allows us to make the following observations. First, the comparative analysis of the trend growth pattern between labour productivity and wages highlights that labour productivity growth is higher than the real wage growth except the sub period 1981-82 to 1991-92.4 The Table shows that there is a constant relationship between labour productivity and real wages. During 1960 to 1980, the growth rate of real wages and labour productivity are very low. The main reason for the low growth is due to the deceleration process of Indian industry and other factors like drought, war, oil crisis etc. From 1981-82 to 1991-92 the growth of labour productivity and real wages have increased. During this period the real wages of the workers have increased. So, the rise in real wages was the main factor for increase in labour productivity in the 1980s. But during the postreform, again labour productivity growth and real wages growth have declined. The labour productivity of the employees in aggregate manufacturing sector grew at the rate of 4.54 per cent during 1960-61 to 2001-02, while the wage rate of the employees grew only at the rate of 2.51 per cent. Similarly, the price level shows an increase of 8.14 per cent during the overall period, whereas, a negative of 4.06 per cent during post-reform period.

Table1: Growth rates of Labour productivity, Real wages and Price level (%)
4

The growth rates have been estimated through semi-log model.

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Variable 1960-2001 1960-80 1981-91 LP 4.54* 1.88* 7.09* RW 2.51* 0.71 7.75** EMP 1.56* 2.49* 1.02 Price 8.14* 8.83* 7.03* * significant at 1% level, ** significant at 5% level

1992-2001 5.55* 3.51* -1.48 -4.06*

The correlation coefficients presented in Table 2 provide an initial indication of the relationships among the three variables. During pre-reform period i.e. 1960-61 to 1991-92 all the three variables exhibited upward trends and so their correlations all are positive. In the post-reform period (1992-93 to 2001-02) most of the pairwise correlation coefficients are positive but declining, which is probably due to volatility of political factors and marked business cycle movements. In the entire period, 1960-61 to 2001-02, the pairwise correlations are all positive. Table 2: Pairwise Correlation Coefficients Variables Pair LP RW LP EMP LP-Price RW-EMP RW-Price EMP-Price 1960-61 to 1991-92 0.98 0.77 0.93 0.80 0.92 0.93 1992-93 to 2001-02 0.96 0.51 0.98 0.54 0.98 0.56 1960-61 to 2001-02 0.99 0.86 0.97 0.90 0.97 0.96

5.2. The Cointegartion Results We now turn to an analysis of the stationarity properties of the series (in logged form). The visible evidence of upward trends (see Figure 1) suggests, a priori, that all the series are non-stationary. We use both ADF and PP test for examining the order of integration of the variables. The results in Table 3 show that all the three variables are stationary at their first differences confirming the presence of stochastic trends. As the variables follow the same order of integration, we can test for cointegration to examine the long run equilibrium among the four variables. 5 Table 3: Unit Root Tests ADF PP

While estimating Equation (1) the choice of lag length (p) is very crucial, since the results are highly sensitive to alternative lag specifications. We have chosen an optimal lag length of 1 as suggested by Final Prediction Error, Hannan Quinn information criteria and Sims (1980) Likelihood Ratio test.

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Variables Level LP RW EMP 0.3963 0.0482 -1.75 1st Difference -4.78* -3.96* -3.57** Level 0.4606 -0.2281 -1.70 1st Difference -5.86* -6.617* -5.58*

Price

0.0179

-4.77*

0.5919

-4.1658*

Note: The McKinnon critical values for ADF and PP tests at 1%, 5%, and 10% levels are -4.04,

-3.45, and 3.15 respectively. The two test statistics defined in Eq. (9) and (10) are presented in Table 4. The results show that trace statistics confirm the presence of one cointegrating vector at both 5% and 1% significance level whereas the maximum eigenvalue test indicates the presence of two cointegrating vector at 5 percent level of significance. If we select r = 1 and normalize the cointegrating vector with respect to log(LP) then the cointegrating relation is log (LP) = 4.197log(RW) + 3.535log (EMP) 1.60log(Price) (7.05) (4.88) (4.98) (11)

Note that the normalized cointegration parameters bear theoretically predicted sign and tstatistics in parentheses indicate that they are significantly different from zero at 1 percent level. Equation 11 implies that 1 percent increase in real wage is associated with a 4.2 percent rise in growth of labour productivity in manufacturing sector in the long run. It is also found that an increase in the average price level, say 1 percent, ceteris paribus, can decline labour productivity growth by 1.6 percent. Table 4: Unrestricted Cointegration Rank Test Null hypothesis r=0 r 1 r 2 r 3 Null hypothesis Trace statistics 5% Critical Value 56.8815** 47.21 26.53349 29.68 4.89485 15.41 0.16456 3.76 Max-Eigen 5% Critical Statistics Value 1% Critical Value 54.46 35.65 20.04 6.65 1% Critical Value

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r=0 30.34801* 27.07 32.24 r=1 21.6386* 20.97 25.52 r=2 4.73028 14.07 18.63 r=2 0.16456 3.76 6.65 *and ** indicate 5% and 1% level of significance, respectively. 5.3. Error Correction Models and Granger Causality Table 5: Pair wise Granger causality/block exogeneity Wald tests Dependent Variable D(LP) Exclude Chi-Square
D(RW) D(EMP) D(PRICE) All D(LP) D(EMP) D(PRICE) All D(LP) D(RW) D(PRICE) All D(LP) D(RW) D(EMP) All 3.452680 0.147532 0.025528 5.010177 1.90E-05 0.242185 0.012645 0.477990 1.134943 0.439010 0.775680 2.162234 3.230993 2.705046 1.947743 4.767730

df
1 1 1 3 1 1 1 3 1 1 1 3 1 1 1 3

Probability
0.0631 0.7009 0.8731 0.0711 0.9965 0.6226 0.9105 0.9237 0.2867 0.5076 0.3785 0.5394 0.0723 0.1000 0.1628 0.0896

Dependent Variable D(RW)

Dependent Variable D(EMP)

Dependent Variable D(Price)

As cointegartion found between labour productivity, real wages, employment and price level for the period 1960-61 to 2001-02, ECM may be estimated and used to test for a long run causal relationship between the variables. The results in Table 5 provide evidence of pair wise Granger causality and block exogeneity tests.6 The first and second rows of each case refer to bi-variable Granger causality test whereas the third row refers to the Wald block exogeneity test. The results show that there is uni-directional causality from real wages to labour productivity and from real wages to price. Similarly, labour

Testing for Granger causality and block exogeneity in an error correction specification involves imposing zero restriction on parameter matrix Ai. The pair wise Granger causality test between X1 and X2 can be conducted by restricting the coefficients of lagged values of one variable to be zero in the equation of the other variable.

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productivity causes price level while employment neither Granger causes labour productivity, real wages and price level nor Granger caused by these three variables. The Wald test indicates that real wages, employment and price level are to be included in the labour productivity equation and labour productivity, employment and real wages are to be included in price equation. However, the block exogeneity test rejects the inclusion of lags of labour productivity, real wages and price in the labour employment equation. Similarly, the block exogeneity test also rejects the inclusion of lags labour productivity, employment and price in the real wage equation. The results in Table 5 are not the final one as the speed of adjustment parameters (s) provides additional base for inferring the causal link among these variables. For the cointegrating vector presented above, the speed of adjustment parameters are =

-0.06

0.04

0.10 -0.07
(0.02)

(12)

(0.04) (0.03) (0.02)

The coefficients in Eq. (12) show the change in labour productivity, real wage, employment and price, respectively, in response to a positive deviation of labour productivity from its long run equilibrium relationship. The speed of adjustment parameters is found to be significant in labour productivity equation, confirming the Granger representation theorem that error correction model for I(1) variables necessarily implies cointegration.

6. Conclusions Manufacturing sector plays a significant role in our country since it has been growing steadily over the years. India is currently exporting more labour intensive products like textiles and leather. Its comparative advantage also lies primarily in the availability of raw material and low cost of labour. A number of studies have attempted to evaluate the strength and weakness of the Indian manufacturing sector. A brief review of empirical studies since independence showed growth rate of productivity, output, employment and

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wage rate both at aggregate and disaggregate level of manufacturing. But, less attention has been paid to assess the dynamic relationship between these variables. In light of this, our paper estimates the empirical relationship between labour productivity, real wages, employment and prices in Indian manufacturing sector, using cointegration test. The cointegration test produced evidence in favour of a long run equilibrium relationship among labour productivity, real wages, employment and prices, confirming the existence of causal link among these variables. The results derived from the error variance forecast decomposition indicate that there is bi-directional causality between real wages to labour productivity; however, employment and prices are not causing the labour productivity. Similarly, labour productivity and real wages are causing employment but there is no causation from employment to labour productivity and real wages. The speed of adjustment parameters indicates that the short run disequilibrium among these variables is adjusted through labour productivity and prices, but not by the real wages and employment. Coming to the policy recommendation, the manufacturing sector should improve the labour productivity growth by improving wages and other benefits of the workers. The value added per worker in our country is very low as compare to Thailand, Philippines, Malaysia and South Korea (Academic Foundation, 2003). The main reason for low labour productivity is innovation, product design and lack of infrastructure facility. So, higher the productivity will enhance the economic growth and standard of living of the workers. From our results, we also find that labour productivity, real wages and employment are moving in same direction. Our conclusion implies that the upward movement of labour productivity may increase wage rates and employment generation. The productivity can increase only through employment generation and higher wages. The government should give priorities to more export-intensive industries like textiles, leather, Gems and Jewellery, which have considerable potential to generate employment. So, without increasing the productivity, our government should not expect more employment generation and better standard of living of the workers in manufacturing sector because our conclusion shows that these four variables cannot move independently. The government functioning needs to be more efficient to make Indian manufacturing globally competitive.

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