Executive Summary

This paper reviews the literature on firm-level upgrading in developing countries, focusing on what drives upgrading among medium-sized and larger firms in manufacturing.

The first part of the review discusses what is meant by the term upgrading, conceptually and empirically. The term encompasses innovation, but also reflects the fact that innovative activities among developing-country firms are often oriented toward catching up to the world frontier, rather than pushing it forward. Specifically, upgrading is defined as one of four types of the activities: learning (accumulating knowledge about products, techniques, or implementation of techniques); quality upgrading (increasing the average quality of goods produced); technology adoption (adopting a technique not previously used); and product innovation (widening the varieties of products produced).

Measuring upgrading can be difficult. Conceptually appealing measures such as Total Factor Productivity (TFP) can be misleading when markets are imperfectly competitive and firms produce multiple goods, differentiated by quality. Directly observable measures of upgrading, such as technology use, quality ratings, and product-level innovation, while they have yielded important insights, are often available for particular sectors only. These measures also require careful interpretation, because it may not be optimal for individual firms to increase these measures, depending on the associated costs and particular constraints they face. The review argues that it is important to improve measures of upgrading, both measures of TFP and more direct measures, and that most compelling recent studies have tended to be ones with direct measures of technology use, quality, and product innovation.

With the definitions of the key upgrading outcomes in hand, the second part of the review turns to recent work on the drivers of upgrading. The key drivers of upgrading can be classified into three broad groups: output-side drivers, input-side drivers, and drivers of firm capabilities.

Output-side drivers

There is robust evidence that selling to developed-country consumers, either directly or indirectly through value chains, leads firms to improve productivity and product quality. Compared to domestic consumers in developing counties, international consumers are on average richer and more willing to pay for product quality, and developing-country firms tend to produce higher-quality goods to appeal to them. The process of quality upgrading also can also generate learning and productivity improvements. Supplying to multinational corporations has a similar effect, as they demand higher product quality, which in turn requires domestic firms to switch to higher-quality inputs and change hiring, sourcing, and organizational practices.

The ability to establish a reputation also matters for quality upgrading. In developing countries, the issues of asymmetric information and weak enforcement of contracts are particularly severe, so firms enter into “relational contracts”, relying on repeated interactions and the threat of discontinuing a relationship to enforce an agreement. The more that firms are able to develop a reputation, for instance by developing a brand, the greater the incentive they have to improve product quality.

Input-side drivers

Increasing the supply of high-quality inputs promotes upgrading. Physical inputs available on the international market tend to be of higher quality than domestic inputs. Several studies have found that import tariff reductions, which increase the availability and variety of high-quality imported inputs, spur upgrading.

Labour is another key production input. A greater relative supply of high-skilled labour (those with a university degree) leads firms to file more domestic patents and shift towards products with higher human-capital intensity. Similarly, minimum wage regulations lower the relative cost of high-skilled workers, leading firms to increase productivity and move towards more skill- and capital-intensive production.

Drivers of firm capabilities

Conflicts of interest within organizations are a major obstacle to upgrading. Contracts that do not align employees’ and the firm’s incentives can prevent the adoption of potentially beneficial technologies. These “agency” issues can also explain why inherited control is prevalent among developing-country firms, despite strong evidence that it lowers performance. Family members are more trusted to act in the firm’s interests and have a lower tendency to move to other firms, taking clients and production knowledge with them.

Learning can drive upgrading, but much of the knowledge needed to produce successfully is tacit rather than formally written down. A number of consulting interventions have had positive effects on firm performance, with tailored, intensive interventions typically the most successful. It has become common to attribute poor firm performance to bad management, but we should be careful in drawing this conclusion. If we think of management practices as a technology like any other, then we need to think about the different constraints that developing-country firms face – in output-demand conditions, in input-supply conditions, and in investing in know-how – before attributing a lack of upgrading to poor management.

Challenges and prospects for future research

Developing-country firms appear to be constrained by a lack of know-how. A key challenge for upgrading is encouraging firms to learn. An important first step in addressing this challenge is to recognize that learning is costly and organizational dynamics are complex. Developing-country entrepreneurs may rationally decide not to adopt apparently beneficial technologies or products, because of the costs of learning. We need more research to identify the factors that influence the rate of learning.

Also, when designing interventions, policymakers face additional constraints not considered in small-scale studies, including pressures from different interest groups and the limited knowledge of government officials. Given the limited capacity of many developing-country governments, more research is needed on effective industrial policy design, particularly the wider effects these policies could have on the economy. With the growing availability of detailed data such as information on customs transactions, product-level quantities and prices, and contractual relationships, future research has the potential to address these concerns.

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