Download 2. Approaches to industrial competence: The Capabilities

Module 3
Chapter 10:
Imperfect Markets and Fallible
Governments: The Role of the
State in Industrial Development
Lall
Arab Open University - Beirut
1
1. Introduction
This
chapter considers the case of government
intervention in promoting industrialization, specifically
in developing countries.
Market
imperfections in the industrial sector include:
oligopolies, uncertainty, externalities, patented
technologies…
If
such failures are associated with scale economies and
Schumpeterian technological growth, the case for
official intervention may be negligible: the costs of
market failure may be outweighed by its benefits.
Only
certain failures call for intervention: where market
failures retard industrial development, or where market
solutions fail or take too long.
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2. Approaches to industrial competence

Industrial development requires the firm to be
technically and managerially efficient.

Firms should gain competence and technological
efficiency.

This chapter focuses on the technological rather
than the managerial and organizational aspects of
efficiency.

There are two main approaches to industrial
competence: the neoclassical approach and the
capabilities approach.
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2. Approaches to industrial competence: The
Neoclassical

All firms are efficient in the use of technologies, and there is no
process of acquiring technological capabilities.

If inefficiencies happen, they are because of management
incompetence or negligence.

Even if we are to assume that in the case of developing countries
additional costs are needed to absorb new technologies, these
costs are assumed to be very trivial, predictable and similar
across industries.

Firms are assumed to acquire and use technologies as individual
units in isolation. There are no linkages, no externalities, and no
need to create information networks. No one industry is more
strategic than others.
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2. Approaches to industrial competence: The
Neoclassical

And since markets are assumed to operate with
equal degrees of efficiency there is no need to
devise different policies by the level of
development of the countries.

Policy might be recommended for developing
countries, if it is admitted that some factors may
not operate efficiently (education).

This neoclassical approach does not recommend
much intervention from government (liberal in
nature).
5
2. Approaches to industrial competence: The
Capabilities

Acquisition of new technological capabilities (TC)
is very important. To master and adapt new
technologies, firms in developing countries need
to develop new knowledge, skills, and interlinkages between enterprises.

Technological capabilities are the information
and skills that allow firms to utilize equipment
and information efficiently. Such capabilities are
firm-specific.

The growth of capabilities may be defined as
industrial technology development (ITD). This
process is evolutionary, and depends on the
efforts of every enterprise.
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2. Approaches to industrial competence: The
Capabilities
 The successful transfer of a new technology to a developing
country has to include a major element of capability building:
 simply
providing equipment and operating instructions does not ensure
that the technology will be properly used.
 Some tacit elements have to be learned (like training, engineering,
technical information, experimentation and other capabilities).
 Technological
mastery is not a passive process. In order to
successfully absorb and deploy new technical information,
prior investments have to be made in human capital and
organizational capabilities to decode the new technical
information and to incorporate it into manufacturing
processes.
 Different
firms can thus experience quite different rates of
technological development and end up with different levels of
efficiency in using the same technologies. There is no
predictable learning curve along which all firms travel.
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2. Approaches to industrial competence: The
Capabilities
 Manufacturers
develop capabilities in a network of relationships with
customers, suppliers, competitors, consultants and researchers.
 These
linkages help individual firms to deal with each other, to gain access
to expensive information and facilities and to create skills and standards
that all firms need but no individual firm will generate on its own (public
goods).
 In
industries with strong inter-linkages a firm cannot know its future cost
structure (because it cannot predict the learning process of its suppliers
and subcontractors) or take rational investment decisions in isolation.
 Efficient
resource allocation requires an external agent to coordinate
individual investments. The classic case for planning.
 Developing
countries depend on the import of technology and skills from
advanced industrial countries. Therefore, technology transfer policy should
be selective about what technology to allow into the country.
 Costs
of technology transfer are lower when the recipient has absorptive
capabilities.
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2. Approaches to industrial competence: The
Capabilities


We can have two modes: internalized modes or externalized
modes.

Internalized modes are like foreign direct investment (FDI), where the
seller of technology retains ownership and control of the utilization of
technology. This mode tends to centralize the innovation process in
developed economies. They transfer the results of their research to
affiliates.

Externalized modes are like licensing or equipment purchase, the recipient
may not get the technology as rapidly, and has to do much more
homework to absorb and build upon it. This may lead to more
technological learning and a better understanding of the technology being
transferred.
The capabilities approach warns us that you cannot always rely
on market forces, because market failures can happen. The firm
should develop technological capabilities.
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3. The case for interventions in trade

It has been empirically proven that Export Orientation (EO)
strategies are successful strategies.

Neoclassical economics assumed that EO is equivalent to free
trade. Under perfect competition and efficient markets free
trade generates welfare benefits arising from comparative
advantage.

If we are to include the technological learning process, welfare
implications do not hold.

Free market prices cannot guide resource allocation correctly
as far as investments in activities with difficult technologies are
concerned.

Infant industries might need protection until they are strong
enough.
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3. The case for interventions in trade

The essential feature of industrial investment in
developing countries is that they have to create new
capabilities to utilize the technologies they import.

This implies higher costs during the learning period
relative to firms that have already gone through the
learning process.

In a completely free market regime firms in developing
countries may under invest in activities that have costly
learning periods.

The case for protection rests on the existence of a number
of market failures in a free market that could distort
resource allocation. These may create a case for
intervention.
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3. The case for interventions in trade
 Sources of market failures in trade:

Trained workers might leave the firm after its investment on
technology, or knowledge may leak out of the firm.

They may find that their own lack of experience and of supporting
suppliers and institutions makes the learning process highly risky and
unpredictable.

Firms may not realize the need for investment in capabilities to raise
efficiency. Or firms may not know how to raise capabilities (they have
to ‘learn how to learn’).

They may be unable to anticipate learning in vertically linked suppliers.

They may not be able to raise the finances to cover their losses during
the learning period (capital market failures).
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3. The case for interventions in trade

John Stuart Mill (1848) attacked protection policies.
Mill is a believer in free trade. Protection in his view should be temporary and
for a short time.
 The superiority of one country over another in a branch of production arises
only from having begun it sooner; thus acquiring skill & experience
 Protection should be lifted once the necessary skills and experience are
acquired.


Different technologies have different learning costs and periods. Complex,
skill-intensive technologies require greater protection than those which
have simple processes. Some industries need longer time of protection.

Note: A country has certain sectors that are very important (strategic
sectors).

Protection allows industries to have the necessary resources to develop
capabilities, but the absence of competitive pressures during protectionist
policy might make the firm unwilling to invest in expensive capability
acquisition (disincentive effect).
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3. The case for interventions in trade
 It is possible to offset this disincentive effect by forcing protected
industries to enter export markets at early stages even while
maintaining protection. This is the secret of the success of export
orientation in East Asia.

While learning costs always exist, complex technology may be more
readily implemented by MNCs than by local firms. Because they
have the knowledge, skills and financial resources to take capability
development.

Even for countries that wish to depend on MNCs to drive their
industrial development, there are many activities where the
learning period may be too long and costly to finance in free trade
conditions.

Multi-national companies generally don’t transfer their R&D
activities to their subsidiaries in developing countries. Trade
strategy and foreign investment is therefore necessary for
developing countries, to encourage local firms to invest in research
and in ‘know-why’ capabilities (not just know-how).
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3. The case for interventions in trade

There are many countries that have technological
ambitions they do not wish to depend on foreign
firms to transfer all the technologies they need or
to conduct all sophisticated technological activity
in their countries.

For example Japan and South Korea vs. Saudi
Arabia and other Arab countries.

In the case of Japan trade strategy becomes
necessary not only to allow difficult activities to
be started but also along with technology strategy,
to encourage local firms to invest in developing
know-why capabilities.
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4. Interventions in factor markets: Skills
 Industrialization
needs education, experience, training on-the-job,
supervisory & other skills.
 Companies
countries.
sponsor some of the formal training of employees in developed
 In
developing countries, firms don’t usually sponsor training, because
managers:
are not aware of the needs, and are also not educated enough.
 there are no suitable trainers locally.
 the fear that employees may leave to work for competitors.

 Many
forms of educational investments are non-selective, providing a general
base of skills for all activities, like schooling.
 However,
more specialized forms of training are highly industry specific, and
policies to address these needs have necessarily to be selective.
 If
the government has an active industrial strategy, pushing the economy into
a selected complex areas of activity, it has to ensure that the necessary skills
are created by the education system.
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4. Interventions in factor markets: Technical Effort

Most of the technological activity that firms undertake to cope
with production problems, cost reduction… is an in-house affair.

However such effort may suffer from market failure:
 Firms
in developing countries may not know that they have to undertake
deliberate technological effort to resolve those problems.
 They may not have well functioning information and technical support
services to draw upon.
 They may not possess the necessary means and facilities in the country.
 They may loose the knowledge to competitors.

Government interventions in information and technology
markets may be needed to correct such failures.

Many forms of technical info are available free to firms (journals,
conferences…) more complex info is available commercially
from consultants. There is little need for policy intervention
here, except to guide firms to the right sources of info.
17
4. Interventions in factor markets: Technical Effort
 There
are essential technological functions that have public
goods features, thus suffer from market failure. These include
the encouragement of technological activity in general (the
development of special research skills, setting of industrial
standards, contract research…) the provision of these services
has to be undertaken as an infrastructural service, or as a
cooperative activity.
 The
public infrastructure for science and technology (S&T)
may comprise a variety of institutions, from universities to
standards institutes and R&D institutions.
 From
the viewpoint of industrial policy, intervention in
technology markets have to be integrated with interventions in
product markets. Industries being promoted cannot become
efficient unless matching measures are undertaken to provide
info and technical support.
18
4. Interventions in factor markets: Finance

The development of technological capabilities (TC) is an
investment in time and money. Failures in capital market
can therefore be a barrier to capability development, and
resources for technology development can be reduced.

Capital market failures are widespread in developing
countries because of weak economic structures. There is
also inadequate information, lack of knowledge, along
with the usual risks inherent in technological activities.

Some countries like Korea and Japan have an industrial
policy that involves the direct participation of government
in the allocation of investments (by owning banks or
industrial enterprises).
19
5. Some country experiences: Hong Kong
 Hong Kong followed a laissez faire policy, it did not intervene
in product markets.

The Hong Kong government provided






education and training,
subsidized land to manufacturers,
It set up the Hong Kong productivity centre to perform various
technological services to help producers improve their technologies.
Its interventions were predominantly non-selective.
Thus the level of intervention was fairly low and trade was always free.
Two features of the Honk Kong experience have to be noted:
1.
First, It started with several unique advantages for industrialization.
Hong Kong had more than a century and half of intermediate trading
experience.
 The presence of several British business and finance houses provided a
constant supply of foreign skills and training.
 After the communist takeover Chinese entrepreneurs, engineers and
technicians came from Shanghai.

20
5. Some country experiences: Hong Kong
2. Second.
The colony started and stayed with light labor-intensive manufacturing industry.
 Its success was based on the development of operational and marketing
capabilities.
 There was little diversification (textile and toy)
 There was little natural progression up the ladder of industrial complexity into
more difficult and demanding technologies.
 As wage and land pressures increased the colony had to relocate its
manufacturing.

 Because
of the size, location and history of the colony, this
industrialization strategy is not one that may be open to other
developing countries.
 But
it should be noted that the laissez faire policy prevented the
colony from adopting strategies that have generated the
computer and telecom products of Singapore, Korea and Taiwan.
 Today
the government has toned down the laissez faire policy to
permit a new applied research and development scheme.
21
5. Some country experiences: South Korea
 Its
record of industrial development is the most impressive in
modern economic history, even more than Japan’s.
 Its
government intervened extensively in both product and factor
markets.
 It
offered high and prolonged periods of protection to selected
activities, while forcing those that approached competitiveness to
export significant parts of their output.
 It
directed domestic resources to infant industries, subsidized
credit, and encouraged the emergence of giant private
conglomerates (chaebol).
 It
invested heavily in education, especially technical, and forced
firms to train their employees. It also invested in R&D and
technology institutions, while encouraging local firms to open
their own research.
22
5. Some country experiences: South Korea
 The
most important aspect of Korea’s industrial success is that it
was largely based on innate enterprises that imported and
integrated complex technologies rather than on technology
transfer via direct investment.
 The
Korean government was and still is very selective concerning
foreign direct investment.
 Korea’s
investments in education and R&D, and the
encouragement of the giant chaebol, were a necessary part of its
nationalist strategy, driven by the objective of being efficient in
world markets.
A
strategy of nationalism with inward orientation (India) would
have led to less efficiency.
A
strategy of outward orientation with reliance on foreign
investors (Singapore) would have led to lower domestic
innovative capabilities.
23
5. Some country experiences: Singapore

The government has been very interventionist, The economy
started with a base of trading, ship servicing and petroleum
refining.

After a brief period of import substitution, it moved into
export oriented industrialization based on foreign
investment and technology transfer by MNCs.

The government upgraded the industrial structure by
intervening in the entry of foreign investors to guide them to
higher value-added activities, and in education to create
specific high-level technical skills.

They set up institutes jointly with industry to give
specialized instruction to employees rather than preemployment education.
24
5. Some country experiences: Singapore

The heavy reliance on FDI for technology and
skill transfer led the industry into sophisticated
producer and consumer electronics… but the
technological depth was low.

The lesson of Singapore:

First, FDI can take a small economy a long way if it is
carefully selected and guided, supplied with excellent
infrastructure and a trained workforce and given a
stable and competitive environment.
25
5. Some country experiences: Taiwan

Like Hong Kong, Taiwan has influx of capital, skills, and entrepreneurship
from China.

Like Korea, The state selects and promotes specific industries by protection
and credit allocations. FDI is allowed on a selective basis.

Heavy industry is led by the public sector. Taiwan has a very large public
sector.

Most private enterprises are small or medium size, meeting specific market
niches rather than mass production, they are labour intensive.

There isn’t much R&D conducted, and there is not much emphasis on
creating international brand names.

Taiwan and South Korea intervened heavily to direct domestic credit to
chosen activities. They also invested heavily in creating a Science &
Technology (S&T) infrastructure.
26
5. Some country experiences: India

India had a strong manufacturing base including
several industries like steel, paper, chemicals,
cement, machinery and consumer products.

There is an indigenous entrepreneurial class in
India, and good infrastructure and administrative
system. Macroeconomic policies have been
sound.

Investments in human capital and the presence of
a science & technology plan have been helpful.

Policy interventions by the government to
promote industrial development had mixed
results
27
5. Some country experiences: India
The pros of Indian policy interventions have been:



a diverse industrial structure able of producing all industrial
products, a wide range of manufactured exports,
and a wide base of domestic capabilities to design complex
products.
The cons of Indian policy interventions:







low industrial growth rates,
rigid investment licensing and controls on output and technology
acquisition resulted in product shortages that inhibited
competitive behaviour
high import barriers isolated enterprises from foreign
technological developments,
rigid regulatory system, constrained firm’s ability to enter new
markets and expand and their ability to restructure and close
down
Continued production by financially weak firms via subsidies,
undermined the viability of the remaining more efficient units.
Heavy indirect taxes raised domestic prices constraining firms
ability to expand markets and achieve economies of scale.
28
5. Some country experiences: India

India did not have good export performance, and its products
had high prices and variable quality. India did not have enough
technology and efficiency.

India have always had high tariffs, a complex licensing system
with enormous delays, and export disincentives. There were
corrupt processes and many restrictions.

International competitiveness was not considered by the
government, and many resources had non-economic uses.

There has been no productivity growth, no real competitiveness,
and very slow upgrading of capabilities in most industries. The
imported technology was usually of low quality.

Foreign direct investment was restricted. There were also
restrictions on entry and exit, and on growth of large
(monopoly) firms.
29
5. Some country experiences: India
A
variety of activities were reserved to the Indian
government. The public sector had privileged access to
factors of production like finance and infrastructure, as
well as to the science & technology system.
There
was low investment in India in skill generation,
and there was widespread illiteracy.
R&D
scientists and engineers were 150 people per
million in India (versus 1283 in South Korea).
R&D
in India accounts for 1% of GDP (versus 2.1% in
Korea). There are few linkages between technology
institutions and industry.
30
6. Implications

The analysis of technological capabilities is essential
to understanding industrial development and
industrial policy.

The promotion of capability development is a vital
part of the strategy of industrial development.

In the presence of market failures, active government
involvement is required to ensure capability
development.

There should be selective and functional
interventions in both product and factor markets.
31
6. Implications

The removal of irrational and inefficient
interventions is necessary.

The determinants of capability development are:
the incentive framework, the supply of human
capital, the supporting technology infrastructure,
finance for technological activity, and access to
foreign technologies.

A rational industrial policy in product markets
should provide constant competition to
enterprises. A new entrant has to incur the costs
and risks of gaining technological mastery.
32
6. Implications

There should be selective and variable infant industry
protection. Protection should also encourage efficiency
and capability building of local firms. There should be a
strong commitment to be export-oriented.

Factor markets also need policy and intervention.
Human capital, technical support, technology,
information and finance usually suffer from deficiencies
in developing countries.

Activities being promoted should not be penalized by lack
of factors and information. Selectivity and coherence are
needed. The supply side of capability building is very
important.

Given imperfect markets, the costs of non-intervention
may be very high.
33