Upgrading within firms in developing countries is driven by increased know-how and certain buyer types
In principle, firms in developing countries benefit from the fact that advanced products and technologies have already been invented in developed countries and are available for adoption ‘off the shelf’. Sixty years ago, the economic historian Alexander Gerschenkron famously (if somewhat undiplomatically) referred to this as one of the key “advantages of backwardness” (Gerschenkron 1962). In subsequent decades, several countries – particularly in Asia – have indeed developed quickly, powered by firms catching up to the world technological frontier. But the supposed advantages of backwardness have remained elusive for many firms in developing countries. Something seems to be getting in the way of the adoption of advanced technologies and products. What are these barriers?
Innovation versus upgrading
This question was at the heart of the field in development economics in the 1950s and 1960s but had fallen out of fashion in mainstream development research until quite recently. There are many reasons for this. Firstly, micro-level data on firms have historically been hard to come by. Secondly, the reaction against interventionist policy enshrined in the ‘Washington Consensus’ led researchers to pull back from topics related to industrial policy. It also severed many of the links to the natural policy audience. Policymakers continued doing industrial policy under different names, but often unencumbered by evidence-based insights from academic research. A third reason is that experiments are hard (though not impossible) to run in firms.
This situation has been changing in recent years. We have seen a surge of research on technology adoption and other innovative activities by firms in developing countries. Such activities can be classified under the general heading of ‘upgrading’. In rich countries, innovation is often taken to refer only to things that are new to the world, but in developing countries – where firms are mainly trying to catch up to the world frontier rather than push it forward – the broader concept of upgrading is arguably more useful. Using this terminology, the question above about barriers can be restated in a positive way: what are the drivers of upgrading at the firm-level in developing countries? In a recent review paper, I provide an overview of recent micro-empirical research on this question (Verhoogen, forthcoming). The review focuses on larger non-agricultural firms and on the determinants of upgrading within firms rather than the allocation of resources across firms (which also clearly matters for the industrial development process).
Measuring upgrading within firms
Measuring upgrading is an issue that arises immediately. The empirical literature on innovation in developed countries relies heavily on patents and R&D expenditures. But such measures are less informative in a catch-up context. In research on developing countries, the most commonly used indicator of upgrading has been total factor productivity (TFP). TFP is estimated as the residual in a regression of output (typically sales) on inputs (typically labour, materials, capital) – that is, it is the part of output that cannot be explained by inputs. While in principle it aims to capture firms’ capabilities (something we would very much like to know), in practice there are a number of technical difficulties. State-of-the-art methods require strong assumptions that are particularly unlikely to hold in developing countries. For instance, a commonly used method developed by Olley and Pakes (1996) requires that there be no differences in the degree of credit constraints across firms. This assumption is inconsistent with a large development literature on credit-market failures. My reading of the literature is that studies using direct measures of upgrading (direct observations of technology adoption, product innovation, or quality improvements) have generally been more convincing than studies using residual-based measures such as TFP.
Buyer-driven upgrading
Beyond the measurement issues, several lessons have emerged from the recent research. One is that selling to richer consumers, either directly (e.g. by exporting to richer countries) or indirectly (e.g. by selling into production chains that sell eventually to richer countries), appears to have a robust positive effect on upgrading. Perhaps the cleanest evidence for this effect comes from an experiment with Egyptian rug producers, conducted by Atkin et al. (2017). Working with a US-based NGO and an Egyptian intermediary, the authors randomly distributed initial export contracts with buyers from rich countries. They found that treated firms improved quality on a variety of directly observable dimensions and saw increased profits. Weaving rugs with identical specifications in a laboratory setting, treated producers made higher-quality rugs in no less time than control producers. Previous quasi-experimental work on quality upgrading had hypothesised (partially for convenience) that selling to richer consumers would affect the average quality of firms’ product mixes but would not necessarily generate gains in know-how (Verhoogen 2008). This paper shows that learning is involved.
Another nice example of what might be called buyer-driven upgrading is provided by a recent paper by Alfaro-Urena et al. (2022), who take advantage of firm-to-firm sales data from the Costa Rican tax system (a type of data that has only recently become available but is spurring a wave of research). When domestic Costa Rican firms start selling to a local branch of a multinational corporation (MNC) (Intel, for instance, has had a presence in the country since 1997), their performance improves on a number of dimensions. The other (non-MNC) buyers they sell to tend to be larger, more likely to export and import, and to have longer relationships with their suppliers – consistent with the idea that supplying to an MNC tends to spur upgrading.
A lack of know-how constrains upgrading
A second lesson from the recent literature is that firms from developing countries are often constrained by a lack of know-how. Much of the knowledge required to adopt a new technology or produce a product – even ones that exist elsewhere – is tacit, not written down anywhere and not downloadable from the internet. Firms gain capabilities slowly, often by trial and error. As Gibbons (2010) puts it, capabilities need to be homegrown. These are not new ideas, but recent work has documented the learning process in a particularly credible way. For example, two influential experiments have shown that ‘high-touch’, tailored consulting can have important effects on firm performance. In Bloom et al. (2013), a random subset of Indian textile firms received five months of intensive attention from a multinational consulting firm, compared to one month for control firms. The treated firms increased output and TFP, reduced quality defects, and adopted a number of management practices associated with high firm performance in other contexts. In Bruhn et al. (2018), treated small and medium-sized enterprises met one-on-one with consultants for four hours per week for one year and saw large increases in employment after five years.
Another notable study by Cai and Szeidl (2018) shows that firms can learn not only from consultants but also from other firms. The authors randomised 2820 Chinese entrepreneurs into groups, some of whom met monthly for one year. Revenues of treated firms increased by 8% relative to control firms. To further probe information flows, the authors revealed information about two types of business opportunities in some groups but not others. Information spread within the groups and was more likely to do so if the information was non-rival (i.e. if the firms were not direct competitors in taking advantage of the business opportunity).
It is worth emphasising that the idea that firms in developing countries are constrained by a lack of know-how is distinct from the notion that they fail to maximise profits. The latter view appears to be increasingly popular, and has two variants. One is that managers hold objectives besides profits, and another is that managers would like to maximise profits but make mistakes. While both variants are plausible, my reading of the literature is that the evidence is largely consistent with the view that entrepreneurs do profit-maximise, but subject to constraints. These may be contracting problems and other organisational difficulties, or the fact that know-how is costly to acquire. Years ago, Schulz (1964) argued in an agricultural context that we should not think of peasants as making mistakes; we should instead think of them as “poor but rational” and seek to understand the constraints that poverty imposes. In the context of larger firms, I would argue that we should think of them as “lacking know-how but rational” and focus research on barriers to learning.
The micro-empirical literature on firm-level upgrading in developing countries is still at an early stage. But the motivating questions remain crucial, and the data frontier is expanding quickly. It’s an exciting time for the field and there is reason for optimism that more valuable insights will be coming soon.
Editors' note: This column is published in collaboration with Ideas for India. This article is based on this PEDL research.
References
Alfaro-Ureña, A, I Manelici and J P Vasquez (2022), “The Effects of Joining Multinational Supply Chains: New Evidence from Firm-to-Firm Linkages”, Quarterly Journal of Economics 137 (3): 1495-1552.
Bruhn, M, D Karlan and A Schoar (2018), “The Impact of Consulting Services on Small and Medium Enterprises: Evidence from a Randomized Trial in Mexico”, Journal of Political Economy 126 (2): 635-687.
Cai, J and A Szeidl (2018), “Interfirm Relationships and Business Performance”, Quarterly Journal of Economics 133 (3): 1229-1282.
Gerschenkron, A (1962), Economic Backwardness in Historical Perspective: A Book of Essays, Harvard University Press.
Olley, G S and AriAel Pakes (1996), “The Dynamics of Productivity in the Telecommunications Industry”, Econometrica 64(6): 1263-1297.
Schultz, T P (1964), Transforming Traditional Agriculture, Yale University Press.
Verhoogen, E (2008), “Trade, Quality Upgrading, and Wage Inequality in the Mexican Manufacturing Sector”, Quarterly Journal of Economics 123 (2): 489-530.
Verhoogen, E (forthcoming), “Firm-Level Upgrading in Developing Countries”, Journal of Economic Literature.