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Ajay Shah returns to explore why firms are the fundamental unit of economic growth and what conditions allow them to thrive
Rahul Ahluwalia is the Founding Director of the Foundation for Economic Development and host of the Growth is Good podcast, where he explores ideas at the intersection of economics, policy, and development. Ajay Shah is an economist with experience across government and academic institutions, known for his work on the Indian financial system, public policy and institutional reform. He is the co-founder of XKDR Forum.
Economic growth isn't an abstract macroeconomic phenomenon—it's the arithmetic sum of value added by every firm in a country. This simple accounting fact forms the foundation of Ajay Shah's firm-centric view of development, where understanding growth means understanding what makes companies more productive and what allows the best firms to capture more of the economy's resources.
Shah explores the conditions that enable firms to emerge and flourish: protection from expropriation by both private actors and the state, deep integration with global markets that forces competitive excellence, creative destruction that allows weak firms to die while strong ones grow, and sophisticated financial systems that allocate capital efficiently. He argues that India's growth challenges stem largely from failures in these areas—excessive regulatory interference, limited globalization, poor bankruptcy processes, and underdeveloped finance.
The conversation reveals how firm productivity varies enormously within countries, why most successful Indian companies should focus on management excellence and incremental R&D rather than Bell Labs-style research, and how the entrepreneurial process of building companies requires constant problem-solving against an unpredictable world that "throws demonetization at you" or "a war in Iran."
GDP growth isn't an abstract concept—it's the direct result of firms producing more value. Shah begins with what he calls a "technically true" foundation: GDP equals the sum of value added by all firms in a country. This isn't economic theory but accounting fact.
Value added means the difference between what a firm buys as inputs and what it sells as output. If a retailer buys vegetables for 90 rupees and sells them for 100 rupees, their value added is 10 rupees—representing the packaging, distribution, and other services they provide. When you sum this across every productive unit in the country, from individual farmers to massive corporations, you get GDP.
This mathematical reality leads to a crucial insight about growth. Shah explains:
"The macro journey of a country in a doubling of GDP is millions of firm journeys where the firms got better."
The implication is profound: to understand economic growth, you must understand what happens inside firms and what conditions allow them to improve.
Building and maintaining a firm requires constant problem-solving against an unpredictable world. Shah emphasizes how difficult it is even to maintain the status quo, let alone grow.
The statistics are sobering. Large Indian non-financial firms average only 6% profit after tax relative to revenue. A company generating 1000 crore in revenue typically earns just 60 crore in profit after tax. And there's no guarantee that profit will continue.
Shah paints the challenge vividly:
"The universe will throw demonetization at you. The universe will throw a war in Iran at you. There are United States tariffs, GST, the world will just keep throwing stuff at you."
Every firm must constantly answer the question: "What is your right to win?" If a firm can't identify the economic source of its profit, competitors will eliminate that profit. This creates what Shah calls the "daily MIS" reality—firms are evaluated every day through sales figures, monthly through profit statements, quarterly through earnings reports, and daily through stock prices for listed companies.
The entrepreneurial stories Shah tells—Dhirubhai Ambani starting as a petrol pump attendant and building a petrochemicals empire, or Narayan Murthy and colleagues creating Infosys with minimal capital—illustrate how entrepreneurs must "pull all the other pieces together" through energy and creative problem-solving rather than just capital.
Not all firms are equally productive. There's enormous variation in value added per worker, from the mom-and-pop shop generating minimal value to world-class companies producing many times more per employee.
This productivity dispersion creates two pathways to growth. First, moving workers from less productive to more productive firms instantly increases GDP without requiring any firm to improve. Second, helping the most productive firms become even better pushes the entire economy forward.
Shah uses a thought experiment of India's "five thousand best firms" to illustrate this. These companies represent India's productivity frontier, but they're still far behind global standards given India's per capita GDP is about one-tenth of the United States.
For firms outside this frontier—including casual workers earning around 10,000 rupees per month—the opportunity is massive. Moving these workers into firms generating ten or twenty times that value added per employee could multiply GDP growth.
But Shah also emphasizes that even India's best firms have room for improvement:
"For all the watchers of this show who are in a fancy pants corporate job working for one of the great firms of India, I would like to wag my finger at you and say that you guys ain't good enough."
Shah identifies four conditions necessary for firms to emerge and thrive, starting with the most fundamental.
Protection from expropriation forms the foundation. Entrepreneurs must feel safe investing their "energy, passion, time, money, children" in building firms. This means protection from both private gangsters and state overreach. Shah recalls Jaswant Singh's policy of ending income tax raids, calling them "an uncivilized thing." When word spread that the state would no longer wake people with pre-dawn raids, it created confidence throughout India's business community.
The broader issue is political settlement—the relationship between different elite groups. When there's hostility between political elites and business elites, it destroys the willingness to invest and build. Shah connects this to India's investment collapse after 2011, arguing it resulted from too many "arbitrary state power" mechanisms hitting firms unpredictably.
Globalization serves as the most powerful engine for firm improvement. Shah advocates for freely bringing in foreign workers, companies, capital, goods, and services while freely exporting Indian products globally. This creates a "beautiful mix" where access to global inputs makes Indian firms more competitive internationally, while foreign competition forces domestic firms to either improve dramatically or exit their industries.
The key insight is that competing in foreign markets creates pure meritocracy. As Shah puts it:
"When you are operating in Nigeria, you are likely to be politically weak. So you can't go pound the corridors, meet a joint secretary, get a favor from the government. You just have to win fair and square. The only way to win is to become good."
Creative destruction requires accepting that firm death is "normal and healthy." Countries need swift, frictionless bankruptcy processes that quickly dissolve failing firms and reallocate their resources. Shah draws on Hindu philosophy to make this point:
"As a good Hindu, I will always say that you need creation and preservation and destruction. A country that does not do destruction is missing something fundamental in the great trinity of existence."
By demanding stability, societies doom themselves to poverty. The world keeps changing, and healthy economies require constant churning of firms, jobs, and technologies.
Finance serves as the "brain of the economy" by allocating capital to its most productive uses. In Shah's ideal system, firms pay out most profits to shareholders, then face market tests whenever they want to invest. Investment bankers and financial markets should constantly evaluate which firms and industries deserve capital.
This creates what Shah calls the proper venue for industrial policy—the financial system rather than government bureaucrats. If electric vehicles represent the future, their P/E ratios should be 100. If not, they should be 10. Financial speculators with skin in the game make these judgments better than any bureaucrat can.
The question of why Indian firms don't invest heavily in R&D has a more nuanced answer than simple regulatory capture. Shah proposes a "house with three rooms" to understand different types of innovation.
Room one involves labor arbitrage with technology adoption. Companies like those in Indian textiles buy the best available machines from global trade fairs but don't develop new technology. The key challenges are accessing cheap global capital to buy sophisticated European machines rather than settling for cheaper Chinese equipment due to capital controls.
Room two represents India's greatest R&D success story—the two-wheeler industry. Companies like Hero, Honda, and Bajaj started with Japanese technology but realized those designs had "basic problems in India." They invested in modest R&D to solve ruggedization challenges and adapt to Indian road conditions. Because India provided a large market for their innovations, they achieved global competitiveness and successfully competed against Chinese motorcycles worldwide.
Room three involves cutting-edge R&D like Bell Labs, with corporate research centers publishing in global journals and earning US patents. Shah sees this as appropriate for only a small number of Indian companies like Dr. Reddy's or InMobi.
Given India's development stage, Shah argues the "vast amount of firm activity needs to be in room one and room two" for the next twenty-five years. He emphasizes that management itself should be considered research:
"I think of management as research. Management is complex. How do we invent a new kind of firm? How do we change processes? How do we reimagine how something will be done?"
This perspective explains why companies like Infosys, which don't do traditional R&D, can still create "lakhs of happy middle class families" and represent tremendous success stories for India.
Government hostility toward "shell companies" misunderstands their economic function. Shah argues that complex legal structures often solve real business problems, particularly in environments where courts don't reliably enforce contracts.
The simplest example is securitization, where a pool of home loans gets divided into different cash flow streams going to separate legal entities. This isn't fraud but "legal engineering"—as legitimate as mechanical engineering.
In India's context, where court enforcement is unreliable, companies create "self-enforcing agreements by turning them into a group of shell companies." Complex ownership structures can specify that certain cash flows go automatically to different entities, removing the need for judicial enforcement.
Shah frames this as a fundamental question of economic freedom:
"It is the birthright of private people to create these organizational structures because they think it's optimal."
When the state demands "simple and legible" firm structures for bureaucratic convenience, it conflicts with the private sector's pursuit of high productivity. Shah argues the latter must always triumph, because:
"Growth is a process of discovery, not design. And the people will discover, and I will always respect the people."
The conversation concludes with Shah's hope for 2027—that India will have moved beyond hysteria about corruption and tax collection to focus on the real prize. Rather than obsessing over the tax-to-GDP ratio, India should create conditions for firms to double GDP, which would automatically double government revenues while leaving everyone better off.
The complete transcript file is available to download below.
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by Sane Difference
