Digitalization as a double-edged sword: Winning services and losing manufacturing in India

Digitalization can increase firm productivity, but in developing countries with labor market frictions, not all firms are able to capitalize on digitalization opportunities. This study uses data from India – where a demonetization policy led to a large increase in digital payments – to examine the impacts of digitalization on firms across sectors in a developing country in the short run. I find that service firms experienced growth in income and productivity while manufacturing firms witnessed a decline. I then explore the mechanisms driving this divergence. The results show that service firms invested more in information and communications technology (ICT) capital and hired more complementary skilled ICT labor, whereas manufacturing firms did not. Notably, this influx of skilled ICT workers into the service sector was drawn from the manufacturing sector due to limited spatial labor mobility. During this period, wages for ICT labor were driven up while remaining stagnant for other workers. These findings underscore how digitalization, in the presence of labor market constraints, can exacerbate short-term sectoral divergence in productivity growth and shed light on its impacts on the growth trajectories of developing countries.