Wage Inequality in India

Wage Inequality between Skilled and Less-skilled Workers: Evidence from India (1991-2008)

By: Abid Amiri

May 2011


An empirical study by K.V. Ramaswamy (2008) illustrates how the wage gap in India has been rising since the economic reform took effect in 1991. The skilled workers share in total employment has gone up from 11 percent to 26 percent over the period of two decades continuously since the 1990s, except the year 1999 when there was a huge drop in the skilled workers share. The trend clearly shows a rise which favors skilled workers. Also, the increase in the skilled workers share in total employment in the 1990s is accompanied by an increase in relative wages of skilled labor. This suggests an aggregate demand shift in favor of skilled workers.India liberalized its trade and foreign investment policies in July of 1991. Major areas of reform were the reduction of tariffs, the elimination of the licensing regime, the abolition of other non-tariff barriers on all imports of intermediate and final goods, the removal of trade monopolies of the state, and the simplification of the trading regime. In brief, the economic liberalization of the 1990s allowed Indian industries to have greater access to the international market, capital goods, and technology. This action provided incentives for raising production, upgrading technologies, and modernizing industries. In turn the demand for skilled labor increased relatively to the demand for less-skilled workers, which led to an increase in economic activities, and skill-wage. On the other hand, less-skilled workers were adversely affected when low demand weakened their bargaining power. This has, in effect, created growing wage inequality. Not surprisingly a continuing debate has developed among economists as to what has caused the growing wage inequality in India. Therefore, the main focus of this paper is to answer the question of what has caused the growing wage inequality between skilled and less-skilled workers in post-liberalized India.

1.1    Wage Inequality

Moreover, to further understand the problem of growing wage inequality, it is important to study the Gini coefficient index of India. The Gini coefficient, a widely used measure of a country’s income inequality, ranges from 0 to 100, where 0 implies a perfect equality and 100 means aggregate income inequality.  According to the International Monetary Fund estimates based on NSSO (National Sample Survey Organization) data, India’s Gini coefficient was at one time declining steadily, but it rose during the reform period following the mid-1990s. This rise was quite significant (Kundu, 2010). In the first twenty-five years after independence income inequality in India as measured by the Gini coefficient had declined from 35 percent in 1951 to 29 percent in 1973. The decline continued in the 1980s to a record low of 24 percent until it started to rise in 1991. The last two decades of the 1990s and the 2000s have been decades of rising Gini coefficient index from 24 in 1990 to 37 percent in 2000 and onwards. Since the Gini index provides the aggregate income inequality for India, it is also an indication of wage inequality on the individual level in the country, which shows a growing trend since 1991.

Another direct but basic measure of wage inequality is the skill premium or the wage-gap between workers with different levels of skill. Table 1 shows the average weekly nominal wage rate of skilled and less skilled workers in different occupations during the post reform era. While overall nominal wage rates, or average wage per week for skilled and less skilled workers which was 52 rupees in 1993, increased to 79 rupees in 1999 and to 83 rupees in 2004, the average inflation rate increased by 4.97 percent during this time. There are substantial disparities around these averages. While Administrative and Professional workers, who had skills, meaning they went to school and completed college, were among the highest paid workers, farmers, labors, and production workers who did not have higher education skills were the lowest paid workers. The average wage per week for skilled workers increased from 126 rupees in 1993 to 188.6 rupees in 2004. This was an increase of 19.89 percent during one decade. On the other hand, the average weekly salary of less-skilled workers increased from 62.5 rupees in 1993 to 87.2 rupees in 2004. This was an increase of 19.89 percent during one decade. On the other hand, the average weekly salary of less-skilled workers increased from 62.5 rupees in 1993 to 87.2 rupees in 2004. This was an increase of 16.4 percent. Table 2 clearly illustrates the difference between the wages of skilled and less-skilled workers during the period of 1993 to 2004. The average wage gap growth was 0.15 percent per year.

There are disagreements among economists on what has really caused the rising wage inequality in post-liberalized India. The current literature extensively discusses the controversies among economists over causality of growing wage inequality in India. However, the contribution of this paper to the existing literature is two-fold. First, this study adds to our understanding of the wage inequality problem from a different perspective, not only pointing fingers at the trade liberalization of 1991 for the growing wage gap, but looking at the failures of the government for not providing necessary tools to the private sector that could have lessened the burden of wage inequality. Second, this study will make necessary policy recommendations that could ease the course of the rising wage gap.was an increase of 16.4 percent. Table 2 clearly illustrates the difference between the wages of skilled and less-skilled workers during the period of 1993 to 2004. The average wage gap growth was 0.15 percent per year.was an increase of 16.4 percent. Table 2 clearly illustrates the difference between the wages of skilled and less-skilled workers during the period of 1993 to 2004. The average wage gap growth was 0.15 percent per year.

This paper is structured as follows. Chapter 2 opens with exploration of the economic history of India from its independence in 1947 to 1991 when the economic reform package was introduced. To understand India’s wage inequality problem, it is important to know the country’s economic history. Chapter 3 discusses the existing literature on wage inequality between skilled and less-skilled workers in India.  The literature on this topic is very controversial. Some economists argue that economic reforms of 1991 have actually caused the wage disparity between skilled and less-skilled workers to grow due to higher international trade, import of skill-based technologies (SBTC), and increase in foreign direct investment (FDI). Others believe the economic reforms of 1991 have decreased the wage gap. Chapter 4 opens with an analysis of poor quality of higher education in India. Education has powerful effects on individual earnings and on economic growth. While the higher education system has massively expanded in post-liberalized India, the quality of tertiary education has deteriorated due to three main reasons discussed in the chapter. Chapter 5 discusses the effects of poor physical infrastructure on wage inequality in post-liberalized India. India’s current infrastructure is in a poor condition with many weaknesses that is further debated in the chapter.  Since 1991, the government has been investing in its infrastructure, but not fast enough to cope with the high demands from domestic and multinational corporations. Finally, the conclusion summarizes the paper and provides necessary recommendations to the government of India in regards to its higher education system and physical infrastructure.

1.2    Skilled vs. Less-skilled Workers

  • Definition

Skills refer to human capacities obtained by individual workers or to the specific demands that individual jobs require (Roy, 2008). It could not be solely related to educational attainments. However, educational indicators are the best representation when access to different dimensions of skill is not available. Although it is difficult to define skill in a way that captures all its full meaning, scholars agree that there is an average skill requirement associated with each job in the economy. In this paper skill is measured in terms of the level of education. Skilled workers are those who have education qualifications equivalent to tertiary level (college) and/or above. Workers who have education below tertiary level are considered as less-skilled workers.


Education plays an important role in one’s income level. According to the World Bank, the educational quality, measured by what people know, is much more important than the quantity or the number of students enrolled per year. The

World Bank study also mentions that adding educational quality to a model that includes income and years of schooling increases individual’s earnings from 25 percent to 73 percent. However, solely the quantity or the number of enrolled students in higher education is insignificant to earnings, distribution of income and economic growth. As noted in the first chapter, skill in this paper is measured in terms of the level of education. Therefore, it is important to assess the higher education system in India and its influence on growing wage inequality in the country.

2.1    Situation Assessment

  • Higher Education System in India

Apparently education in ancient India was highly advanced as evident from Buddhist learning centers of the 7th century BC to the 3rd century AD (Perkin, 2006).  The education system slowly started to deteriorate following the British invasion of India. After independence the higher education system grew rapidly. Today, in terms of enrolment, India is the third largest higher education system after China and the US. In terms of the number of institutions, India is the largest in the world with 384 universities and 17,625 colleges. The number of universities has increased from 184 in 1990 to 384 in 2006, according to the University Grants Commission (UGC). The number of colleges has increased from 5,748 in 1990 to 17,625 in 2006. The average enrolment in a higher education institution in India is only about 500 – 600 students. According to the UGC, the total enrolment increased from 4.4 million in 1990 to 10.5 in 2006. Figure 3 gives the trends in the growth of institutions and enrolment in higher education in post-liberalized India.

However, there is very limited financial support from the government for higher education. India today spends about 0.43 percent of its GDP on higher education, as said by the UGC. In order to meet the necessary needs of students they need to increase the total spending to about 1.5 percent of GDP, which amounts to around 7.82 billion dollars per year.

Academic Structure 

The higher education system in India covers all post-secondary education beyond class twelve. There are three levels of qualifications: Bachelor’s or undergraduate degree programs, Master’s or post graduate degree programs, and the pre-doctoral and doctoral programs. Normally a bachelor’s degree is three years after high school. The master’s degree is usually two years and doctoral degrees are awarded three years after the master’s degree.

In the aftermath of trade liberalization in 1991, there was an unprecedented demand for higher education due to rising needs of businesses and industries for skilled workers. Also, there was a substantial increase in the population in the middle and higher income people. However, the expansion of the education system was very problematic. This idea to make higher education available and affordable for all increased the numbers of institutions without a proportionate increase in material and intellectual resources. In other words, the expansion of higher education in India after liberalization was solely quantitative not qualitative. As a result, academic standards have been jeopardized (Béteille, 2005).

As the India’s Prime Minister once said:

Our university system is, in many parts, in a state of disrepair…. In almost half the districts in the country, higher education enrollments are abysmally low, almost two-thirds of our universities and 90 percent of our colleges are rated as below average on quality parameters…. I am concerned that in many states there are complaints of favoritism and corruption.

Manmohan Singh, Prime Minister of India (Sunder, 2007)

2.2    Theoretical Consideration

The consequences of poor quality of education are in fact significant for peoples’ income, distribution and economic growth when the demand for qualified individuals is high. The problem with higher education and its effect on wage inequality could be explained by one of the most fundamental concept of economics; the law of supply and demand. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price. In case of higher education in India, after liberalization domestic and International Corporations imported large numbers of machineries, computers and other technologies. This increased their demand for educated individuals to run the machineries. In this theory the demand for higher education explicitly measures the market need for educated workers.

On the other hand, supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. In case of India, higher education is supplied by institutions. As said before, the number of these institutions that supply highly educated individuals to the labor market has increased in the past two decades. However, the quality supplied has deteriorated. In this theory supply is a measure of students enrolled in tertiary education and graduated with qualified skill needed in the market.

Moreover, the Concept of Qualification comes into play when the Quality of Education is considered in the model of Supply and Demand. The term qualification means the skills required to do a job, the skills that a worker possesses (linked to his or her education) and the skills that are recognized in the labor market. According to the World Bank analysis, education could not solely be a symbol of high earnings, and economic growth unless the quality of it is taken into account.

On balance, the theory of supply and demand studies the corporate need for highly educated individuals in pre-liberalized India and compares it with the number of people attending college during this period who graduate with qualified skills. The analysis will then take the quality of the education into account to measure if the standard of skills acquired in college meets the demands of multinational corporations.

2.3    Data Analysis

The Indian economy was near autarky with a large number of industries reserved for the public sector during the 1980s whereas the 1990s was a period of integration with the global economy. The economy freed the private sector and allowed foreign investment into the country. As part of economic reforms, India took serious steps to liberalize the external sector of the economy as explained before. It affected the demand for qualified tertiary graduate workers. Figure 4 illustrates the trend of demand for skilled and less-skilled workers during the period of 1993 to 2004. While the demand for skilled workers increased from 26.45 percent in 1996 to 29.71 percent in 2004, the demand for less-skilled workers decreased by 0.82 percent during this time. According to Azam (2010), the employment share of skilled workers went up from 19 percent to 30 percent over the period of two decades, while the demand for less-skilled workers increased by 4 percentage points during the same time frame. It clearly shows that the economic reform of 1991 increased the demand for qualified college graduates relative to the supply of college graduates in post-liberalized India.

Similarly, the demand for higher education went up as well. The number of Universities went up from 184 in 1990 to almost 384 in 2006. During the same time, the percentage of high school graduates attending tertiary education went up by 6.1 percentage points. Affiliated colleges also grew to about 17,625 in 15 year time (Table 4). This massive expansion of the education system was solely done by the government. The logic behind the enormous growth was to provide affordable education to everyone. However, this growth came with a huge price. While the numbers of educational institutions went up, and the ratio of enrolment grew faster than any time before, the quality of education started to deteriorate due to lack of proficient instructors, insufficient learning materials, and poor management of the system.

Table . Growth of higher education institutions and enrolment in India

Year Universities Colleges Enrolment in Million
1990-91 184 5,748 4.4
2000-01 266 11,146 8.8
2005-06 348 17,625 10.5

Source: University Grants Commission

Also, despite massive expansion in higher education and high enrollment rates in post-liberalized India, the gross enrolment ratio (GER) remained very low compared to the world standards. GER is a statistical measure used in the education system that gives a rough indication of how many people enroll in higher education amongst residents in a given jurisdiction. While the GER in the developing countries is 10.3 percent, in India the ratio is 7 percent. In other words, higher education is still not readily available for almost half of the total population. See Figure 5

2.4    Poor Quality of Education 

Poor quality of education throughout the higher education sector, be it engineering, medicine, business administration or in science, commerce, humanities, liberal arts and law institutes, failed to produce qualified workers as the knowledge economy started dominating after 1991. The National Assessment and Accreditation Council (NAAC), which is an independent body established to assess and accredit institutions of higher education in India, ranked only 9 percent of colleges and universities in the country as high quality in 2006. The rest, 91 percent of the institutions were considered to be low quality. NAAC uses the following parameters to assess the standing of an institution: curricular aspects, teaching-learning and evaluation, research, consultancy, infrastructure and learning resources, students support and progress, governance and leadership, and innovative practices. In addition, by global ranking of universities there is no Indian university featuring in the top 50. In a London Times Higher Education Supplement ranking of the top 200 universities, only 1 Indian institution was listed, while Shanghai University ranking of 500 world-class universities featured only 3 Indian Universities. (See Figure 6) Therefore, according to Bhatia and Dash (2010), there is annual outflow of more than 150,000 students to institutes in the west every year, taking out nearly 2 to 3 billion dollars in foreign exchange annually.

Jhunjhunwala (2009) believes the rapidly expanding Indian industry found the graduates of these institutes lacking in simple skills required for employability. The newly flourishing Indian industry did not find enough people to employ, spiraling up the salaries and its wage bill for those available with skills. The number of higher education seats in India was available for around 3 million students per year, but those with high quality may not have numbered more than 30,000 students. Large stock of graduates with only English language skills started to feed the economic growth. However, there were concerns that many sectors of the economy were not getting trained manpower. There was a greater need for manpower with diverse skills. The country’s higher education system was perceived to be inadequately prepared to face this challenge. Thus, poor quality of higher education lowered the supply of qualified skilled workers, which resulted in higher salaries for those available with some sort of skills.

2.5    Lack of Facilities

The primary problem in expanding quality of education in the country is the great shortage of talented teachers. In India academia is not attractive to talented youth. Although data on the quality of talent entering the teaching profession is hard to come by, there is plenty of anecdotal evidence. The compensation for highly trained college teachers is far below that of pay in private industry. Teachers are barely considered lower middle class in the social ladder. They do not hold a social status, which could give them an extra reward. The social status often goes for engineers, MBAs, green card holders, etc., but hardly ever for teachers (Sunder, 2010). Most people are discouraged to take the professorial route.  In such a situation, only a small fraction of the best minds would look for teaching as their profession. This is exactly what was happening in India in the 1990s when the economic reform took effect, according to Jhunjhunwala (2009). As a result, there was a huge shortage of quality teachers in higher education. In many places, “fresh graduates who failed to get any other job,” became teachers. As soon as they acquired some experience they would drift away to the industrial sector where they could earn higher salaries.

The economic reform packages that were introduced in India in the beginning of 1991 imposed a heavy compression on the public spending on the education sector, specifically on higher education. Cuts in public budget for higher education have been very steep (Figure 7), whichseverely impaired the quality of education. While the government was spending 0.42 percent of its total GDP on higher education in the late 1980s, the percentage share of GDP dropped to 0.37 percent in the 1990s after trade liberalization. Recently, in 2006 the number lowered to about 0.30 percent of the GDP, which is still very small compared to the growing need for higher education in the country. Therefore, students are dealing with problems such as lack of necessary learning materials, unreliable buildings, poor facilities and overcrowded classes. Classrooms are often unattractive and laboratories inadequately stocked, leading to poor teaching. It is estimated that barely 20 percent of the institutions have the basic minimum laboratory equipments. The alternative solutions to the problem have been to either raise student fees, give student loans, increase graduate tax, or encourage the private sector to help.

Private institutions have been growing in the country. According to Kaul (2006), in 2000-01, of the total higher education institutions, 42 percent were privately owned and run catering to 37 percent of students enrolled in higher education; this is approximately 3.1 million out of total 8.8 million. There were genuine concerns about many of them being substandard and exploitative. Corruption and entry barriers for private institutions have increased tuition fees (Rani, 2006). They are charging eight to ten times more than a public institution.

2.6    Highly Regulated Education Sector 

A complex education regulatory system has contributed to low quality of higher education in India. While India introduced massive economic reforms in 1991, the country’s education system remained highly regulated. The regulatory arrangement of higher education in India is very complex and dysfunctional. This is due to highly detailed, time-consuming and nontransparent regulations that do not allow higher education institutions to respond to changing needs of society. There is standardization in higher education but there is no maintenance of standard (Kapur and Mehta, 2004). Most of the countries in the world are working towards loosening statutory control over their higher education system such as China, but India is moving towards more tightening of government control in higher education institutions (Rani, 2006).

India has multiple agencies and complex web of rules and regulations that govern the higher education system in the country with the University Grants Commissions (UGC) that was set up under UGC act of 1956 as the main body. The state governments, the thirteen professional councils at the national level, and five professional councils at the state level, the state councils, and affiliate universities are the key regulatory institutions in the country (Agarwal, 2006). These entities are responsible for coordination, determination and maintenance of standards and release of grants to Universities and research organizations.

As per constitutional mandate, all education including university education had been made responsibility of the states. However, the role of coordination and determination of standards has been assumed by the central government. They have a key role in defining policy for higher education in the country. In fact, the central government and its various entities have come to occupy the center-stage of higher education in the country.

All regulatory bodies are maintained and funded by the central government. Key appointments are made by them and they have a final say on major issues. In addition, the central government has a decisive role in matters of pay scales and the career progression of teachers in universities and colleges in the country. The establishment of universities is authorized by both the national parliament and the state legislatures. Moreover, “deem-university” status is authorized by the central government to an institution initially as a public college. This bureaucratic oversight creates a system that is unresponsive to the developing needs of society and labor markets (Bhushan, 2008).

Academic institutions lack the autonomy to offer new programs, change curriculum and evaluation or even to change policies. They are constantly subjected to governmental pressures and intrusion of political processes. Decisions are often made on the basis of non-academic considerations. With so many affiliated colleges and universities the educational system becomes a bulky structure, all intertwined and difficult to manage. According to Pratap Bhanu Mehta, the image of private institutions is charged with exorbitant fees, poor quality, financial barriers to the entry of deserving students, etc. There are certain regulations that prevent private investment in the education sector. University Grant Commission Act section 3.1.2(a) suggests that additional institutions will be permitted only if the Commission is convinced that the existing institutions are not adequate to serve the needs of the state or country. This provision prohibits free entry of private investors into the education sector, which prevents competition. The government still seeks to regulate the entry of private institutions. Ultimately, no quality competition has taken place between institutions. Private schools don’t compete for good students, but attract those students who could afford to pay the tuition. Thus, due to this centralized and complex education system, the quality of the higher education has deteriorated in recent years.

On balance, education has dominant effects on earnings, on the share of income and on economic growth. The educational quality, measured by what people know, is much more important than only the number of students enrolled per year. In India after the trade reform package was introduced in 1991, the demand for higher educated, skilled workers increased from multinational corporations. The diagram below illustrates this phenomenon. The demand increased from Dto D2. However, despite massive expansion in higher education system of India, the supply of qualified tertiary educated workers ceased to grow for three main reasons declared in this chapter: first, lack of proficient teachers; second, limited facilities and third, highly regulated, and finally, complex education system. The supply of qualified skilled workers remained inelastic to the high market demand for skills. As a result the premium for skilled workers grew from W1 to W2 in the aftermath of trade liberalization.  Normally, we would expect S1 to shift right to bring the premium back to its long run equilibrium. However, in this case the diagram could reach to its long run equilibrium, if the education system is reformed and the quality of education is improved which would satisfy the needs of employers.


Infrastructure plays an indispensable role in a country’s economic prosperity, especially for a developing country. It shows credibility, confidence, low cost of production, and market competitiveness. Since 1991, when India introduced a massive trade reform, the government has been investing in its infrastructure,

but not fast enough to cope with the high demands from domestic and international corporations. Opening its economy to the world led to the acceleration in economic activities. The proportion of total trade (export plus imports of goods and services) to the GDP rose from 15.9 percent in 1990-91 to 43.1 percent in 2005-06. Total foreign direct investment inflow reached to $3.3 billion during the period of 1991 – 2006. Increasing forces of economic reform and acceptance of a greater role of the market in the growth process contributed positively to the economy. However, potential benefit from this open system was unattainable when the physical infrastructure fell short of requirement. Thus, large amounts of FDI was funneled to other sectors of the Indian economy, specifically the service sector, while not as much entered export-oriented industries that were characterized by low-skilled labor (Banga, 2003).

3.1    What is Infrastructure?

There is no single definition for the term “infrastructure”. Instead of describing the concept through a single definition, it ought to be more helpful to describe it through a set of characteristic that are attributed to it. Infrastructure helps deliver essential services for the functioning of an organization or society. It helps achieve economic and social objectives. In addition, infrastructure facilities are available for common use to large groups of people. It could be viewed as the backbone of an economy.

There are several types of infrastructure. However, for the purpose of this paper, the term is restricted to Physical Infrastructure of the following types: Transportation, Energy, Telecommunication, and Water. The importance of infrastructure is two-fold. First, it is instrumental in promoting economic growth, because with reliable infrastructure transactions cost of doing business is low. Therefore, it leads to more economic activities.  Second, infrastructure plays a role in alleviating poverty when economic activities provide the needy portion of the population with jobs, and benefits.

3.2    Situation Assessment

Indian’s current infrastructure is in poor condition with many weaknesses, and it is below international standards. It is marked by a weak transport network, energy, limited telecommunication and inefficient water supply system that do not cope with rising demand in the economy.

3.2.1        Transportation Infrastructure

  • Roads

When a business depends on moving packages and products quickly from one point to another, good roads are important. However, in India, Chris Callen, manager for DHL Express says that his company is deploying bigger, faster trucks because they have to share the road with carts pulled by camels, rickshaws and cows. The average speed of DHL’s express trucks in India is less than 7 miles per hour, compared with 22 miles per hour in China and the international norm of 22 to 25 miles per hour. DHL drivers also have to stop between India’s 28 states’ borders to pay taxes and duties and have trucks inspected. According to the manager, it takes a DHL truck 10 days to hit 600 miles. Roads are an example of the startling infrastructure of India. According to statistics compiled by APL (Shipment company), India’s containerized trade has grown an average of 16 percent a year over the last five years – inbound and outbound. However, it could do better than that if the government could speed up the infrastructure projects such as ports, roads, and airports, said Michael Andres (chief economist for PIERS, a sister company of The Journal of Commerce).

  • Railways

India has one of the largest railway systems in the world with more than 67,730 miles of track. It is believed to have played an integral part in India’s transport system for more than 150 years. However, the infrastructure is very weak. Picture an overcrowded train in India in which the passengers cling to the outside walls of the railway cars or travel on top are in some ways symbolic of the condition of rail transport in India today. The railway infrastructure has reached its full limits in terms of quantity and quality; in some instances it has already exceeded them. Investment in maintenance and expansion of the infrastructure has been insufficient in recent decades. Therefore, it is not surprising that railway traffic has been losing market share to freight and passengers.

  • Airports

There are roughly 125 airports in India today, out of which 16 offer international services (Heymann, 2007). However, despite rapid growth in this sector, the Indian airports are relatively small by international standards. In terms of passenger traffic there was no Indian airport among the world’s top 50 in 2006, but four were in China. In cargo traffic, the airports of Mumbai and Delhi are among the top 50, but still the size differences are striking. The freight volume at Frankfurt Airport surpassed the combined reading for all 125 Indian airports by more than one-third.

3.2.2        Energy Infrastructure

According to Heymann (2007), coal is the main source of electricity in India with a share of 53 percent. Hydropower ranks second with a share of 25 percent. Nuclear energy accounts for 3 percent of the total energy consumption. 86 percent of power supply is mainly in hands of the central government and the states.

Besides the poor traffic infrastructure, the poor and unreliable supply of energy is one other main impediment hindering a more rapid industrialization of the Indian economy, which could alleviate the wage disparity between the skilled and less-skilled workers. Power outages occur regularly even in the big metropolitan areas. In urban India, the Indian Ministry of Power claims that, 50 percent of the households do not have access to electric power. The problem lies in lack of investment in power stations and grids. In response to frequent blackouts many private companies have built their own electricity generating stations which results in high operation costs.

3.2.3        Telecommunication Infrastructure

The telecommunication infrastructure has grown faster over the past few years. In 2007 alone over 30 million new phone subscribers were registered in the first six months. See Figure 8 for more details. The Indian cell phone industry has expanded faster than that of the Chinese counterpart over the past five years. If we look back at the history, between 1960 and 1992 the number of subscriber lines in India increased by almost 6 million in 32 years. As mentioned, in the first six months of 2007 alone there were 6 million new phone subscribers. This shows the scale of growth in telecommunication industry of India.

3.2.4        Water Infrastructure

However, there is room to improve the telecommunication infrastructure as well. There are problems associated with this massive expansion of the industry. First, over the past years the number of landline telephones has actually declined. It is cheaper for companies, firms and foreign industries to use landline phones than cell phones. This caveat could increase the cost of running a business in the country.  Second, the scale of growth in telecommunication sector has been uneven across the country. While the telecommunication density surpasses 50 percent in cities, the figures come down to 2 percent in rural areas. Considering the large population of India, nearly 800 million people living outside the cities, the problem is far from over. This problem also adds to the difficulties of investing in rural areas where facilities are not available.

India’s public water supply system suffers from inefficiencies. Besides natural peculiarity of water supply, water infrastructure is deeply troubled by financial bottlenecks resulting in a shortage of investment in the maintenance and modernization of the supply infrastructure. The World Bank describes how the country has been caught up in a vicious circle of low water charges. This results in a decline in water supply and poor-quality drinking water, which in turn triggers a drop in foreign investment in the country.

Given the huge water crisis, and inefficient water system, more and more businesses and households have secured their own water supply by drilling wells. Some of the users have tapped into non-renewable water channels; therefore the water table is falling. Drilling water out of wells is costly and it increases variable expenses of running a company in a region with insecure water supply. Thus, foreign investors are less likely to put their money in export-oriented sector of the Indian economy.

3.3    Theoretical Consideration

  • Transaction Cost Theory:

The consequences of weak physical infrastructure are indeed substantial for any business in India. Poor quality of highways, railroads, airports, as well as blackouts, and insufficient supply of water add to the cost of doing business. The role of transaction cost comes into play when businesses deal with externalities of such kinds. Thus, fewer foreign investors would enter a market with high transaction costs.

The purpose of this paper is to examine if the poor quality of infrastructure has anything to do with rising wage inequality between skilled and less-skilled workers in the post-trade liberalization era. Theoretical concept of transaction cost would help analyze the relationship. Keeping in mind that so far foreign firms have only led to export diversification in the Indian industry and they have not yet entered export-oriented industries that are highly characterized by less-skilled workers in developing countries.

Transaction cost theory explains why companies expand or source out activities to other countries. The theory assumes that companies try to minimize their fixed costs, the costs of exchanging resources, external costs and bureaucratic costs. This list is not exhaustive. However, many other costs could be included.  Companies, therefore, weight the costs of doing business at home and abroad. Firm level decisions are made in terms of their transaction cost and traditional direct costs. According to Ronald Coase (1937), wherever it seems less costly, more efficient and more viable to run a business, companies would choose to go there.

In addition, Williamson (1981) argues that a transaction cost occur “when a good or a service is transferred across a technologically separable interface”. In other words, transaction costs arise every time new sets of technological capabilities are needed to make the product or service. For example, in case of India due to poor water supply system companies dig their own wells to provide water.  In absence of an effective infrastructure this extra measure of digging a private well incurs costs, which is a transaction cost.

The transaction cost theory sees institutions and markets as two different forms of organization while evaluating the costs. Some institutional arrangements are better suited than others for achieving economic and other desired efficiency criteria. In this case, Indian infrastructure arrangements are not well suited for desired efficiency criteria. The government has failed to invest sufficient funds in its infrastructure. Electricity blackouts, hampered highways, logistical problems and inefficient water supply system are good examples of such failure.

On balance, the theory supports the argument that foreign investors, as well as domestic investors would be less likely to invest in a country such as India where transaction costs are high. Therefore, poor quality of infrastructure has discouraged FDI to enter export-oriented industries that are known for their low-skilled workers.

3.4    Data Analysis

Infrastructure has historically been financed, built and operated by the Government of India due to the large costs and also monopolistic characteristics of these assets. This section provides important data about India’s investment on infrastructure, and looks at the trends since 1991 when the economic reform took effect.

Figure 9 illustrates India’s investment in infrastructure as a percentage of GDP for the period pre-liberalization of 1979 to post-liberalization 2009. Three main points that worth mentioning regarding this schedule are: First, the biggest expansion in infrastructure took effect before liberalization in 1990 when the government spent total of 6 percent of the GDP. Second, the lowest investment was in 2003, when 3.3 percent of total GDP was channeled for infrastructure development. Last, it is worth noticing that while investment on infrastructure fluctuated from year to year, it never increased to more than 5 percent of GDP and never decreased less than 3 percent of GDP after liberalization. In other words, if the graph is stretched thin, it would look like a straight line. The main point is that the Indian Government did not invest enough on the infrastructure when the economic demand for it was rising.

While poor quality of infrastructure bears huge barriers for the industrial sector, the service sector known for hiring large numbers of skilled workers faces no challenges, because it is not dependent on infrastructure. In 2008, more than 50 percent of India’s GDP was comprised of services, specifically Information Technology (IT) and software services, according to Gordon and Gupta (2003). Only 30 percent of the total GDP came from goods produced. See Figure 11On a similar note, in 2006 Business Environment, a non-profit organization conducted a survey of companies in India. They concluded by ranking electricity the biggest constraint to firm investment in India. This indicates the severity of the infrastructure problem for foreign companies who are willing to invest in manufacturing, specifically export-oriented industries.

In addition, service sector has been the most attractive industry for FDI. Since 1991, this sector has attracted 24 percent of the total FDI inflow, while manufacturing industry accounted for only 10 – 13 percent (Figure 12). As a result of poor infrastructure, there is a massive disparity between the two sectors which is adding to the crisis of wage inequality, because service industry is highly skill based.

On balance, while trade liberalization of 1991 encouraged FDI to India, infrastructure failure discouraged foreign and domestic investors from entering into export-oriented industries that hire large numbers of less-skilled workers. Instead the service sector, intensive in skilled labor, attracted most of the investment. Therefore, the government did not provide the platform for the open market system to alleviate the wage inequality problem. Instead, due to poor quality infrastructure, and rising transaction costs for industries, the wage inequality between skilled and less skilled workers grew in post-trade liberalization era.


The paper studies the impact of two major components of government failure, i.e., lack of investment in higher education and infrastructure on wage inequality between skilled and less-skilled workers in the Indian labor market in the post reform period. The analysis shows that while the demand for skilled workers increased in post liberalized period, the supply of qualified higher educated skilled workers ceased to grow due to lack of proficient teachers, low investment on higher education and highly complex schooling system. Moreover, the study indicates that lack of government spending on infrastructure helps attract large portions of domestic and foreign investment to the service sector, which is known for hiring skilled workers. For example, software engineers have high qualifications, as well as workers with English Language skill have the opportunity to work at calling centers in the country. However, lack of investment on infrastructure disadvantage less-skilled workers, because domestic as well as foreign investors pour very little money in the export-oriented sector due to high transaction cost they incur from poor infrastructure facilities in the country. Export-oriented sector is characterized by low-skilled labor.

One of the most direct implications for policy that can be derived from the above results is that it is important to attract FDI in the export-oriented sector in India. Entry of foreign firms in export-oriented industries will capture the adverse effects of FDI on wage inequality, as foreign firms will drive up the demand for less-skilled workers in these industries. It is a bottom up approach which will help improve the condition of low-skilled workers over time. Eventually these less-skilled workers will get training and become skilled workers, as Figini, et al. (1991) argue that wage inequality is an inverted-U shaped schedule, rising in the short term and then declining in the long term.

One of the ways of encouraging FDI in export-oriented sector is by reducing the cost of production and operation of foreign firms in this sector. The government needs to invest on the infrastructure, further relax labor laws, and improve higher education system and training of labor in India. In that case FDI is expected to flow into the export sector of the economy. On the whole, it can be said it is vital for the Indian government to maximize the benefit of trade liberalization, FDI, and technological progress in their economy. Reduction in wage inequality between skilled and less-skilled workers is possible only if benefits from FDI, in terms of improving labor productivity, are funneled towards the less-skilled sector and efforts are undertaken to make technological progress less skill-biased through continuous research and development.


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