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Firm-level technological capabilities (FTC)

The micro-level analysis of technology in developing countries has drawn inspiration from the "evolutionary theories" developed by Nelson and Winter [55], and explained in Nelson [52, 53] and Dosi [15]. The starting point of these theories is that firms cannot be taken to operate on a common production function. Technological knowledge is not shared equally among firms, nor is it easily imitated by or transferred across firms. Transfer necessarily requires learning because technologies are tacit, and their underlying principles are not always clearly understood. Therefore, simply to gain mastery of a new technology requires skills, effort, and investment by the receiving firm, and the extent of mastery achieved is uncertain and necessarily varies by firm according to these inputs. Furthermore, firms have more knowledge of their "own" technology, less about similar technologies of other firms, and very little about dissimilar alternatives, even in the same industry. They operate, in other words, not on a production function but at a point, and their technical progress, building upon their own efforts, experience, and skills, is (to varying degrees) "localized" around that point [3]. The extent to which firm-level differences in technological effort and mastery occur may vary by industry, by size of firm or market, by level of development, or by trade/industrial strategies pursued.

There is little doubt that as a description of reality, in developed or less-developed countries, the evolutionary approach is far more plausible than the production function approach. As Dosi [15] puts it, evolutionary theories can explain the "permanent existence of asymmetries among firms, in terms of their process technologies and quality of output" (p. 1155). Scale economies and vintage differences in capital goods explain part of this asymmetry, but they "are also the effect of different innovative capabilities, that is, different degrees of technological accumulation and different efficiencies in the innovative search process" (p. 1156). Once firm-level technological change is understood as a continuous process to absorb or create technical knowledge, determined partly by external inputs and partly by past accumulation of skills and knowledge, it is evident that "innovation" can be defined much more broadly to cover all types of search and improvement effort. From the firm's point of view, there is little difference in essence between efforts to improve technological mastery, to adapt technology to new conditions, to improve it slightly or to improve it very significantly - though in terms of detailed strategies, degrees of risk, and potential rewards these efforts will certainly be different.

There are various ways to categorize firm-level technological capabilities (FTC). Drawing upon Katz [36, 37], Dahlman et al. [12] and Lall [44], table l shows an illustrative matrix of the major technical functions involved. The columns set out the major FTCs by function, the rows by degree of complexity or difficulty, as measured by the sort of activity from which the capability arises. The categorization is necessarily indicative, since it may be difficult to judge a priori whether a particular function is simple or complex [76]. Nor is it meant to show a necessary sequence of learning. Though the very nature of technological learning (i.e. accumulated experience of problem-solving, aided by external inputs or formal research effort) would seem to dictate that mastery would proceed from simpler to more difficult activities, different firms and different technologies adopt different sequences. This would depend on various factors, described below.

The functions set out in table l may not be exhaustive, and not all of them have to be performed for every industrial venture. Even where they are performed, moreover, not all need be undertaken by the firm itself - several specialized services can be bought in from (domestic or foreign) contractors, consultants, or other manufacturing firms. Yet there is a basic core of functions in each major category that have to be internalized by the firm to ensure successful commercial operation. If a firm is unable by itself to decide on its investment plans or selection of equipment processes, or to reach minimum levels of operating efficiency, quality control, equipment maintenance, or cost improvement, or to adapt its product designs to changing market conditions or to establish effective linkages with reliable suppliers, it is unlikely to be able to compete effectively in open markets. Moreover, the basic core must grow over time as the firm undertakes more complex tasks. The ability to identify a firm's scope for efficient specialization in technological activities, to extend and deepen these with experience and effort, and to draw selectively on others to complement its own capabilities is the hallmark of a "technologically mature" firm. Before full "maturity" is achieved, firms will vary in their mastery of the various functions involved. While this is true of any economy, it is likely that the typical firm in developing countries, with deficiencies in skills and limited experience of manufacturing, will use the same technology less efficiently than its counterpart in developed countries. Scattered evidence confirms that this is in fact the case, and that such differences also exist between more and less advanced developing countries [61].

Table 1 Illustrative matrix of technological capabilities




Degree of complexity   Pre-investment Project execution Process engineering Product engineering Industrial engineering Linkages within economy
Basic Simple, routine (Experience-based) Prefeasibility and feasibility studies; site selection; scheduling of investment Civil construction; ancillary services; equipment erection; commissioning Debugging; balancing; quality control preventive maintenance; assimilation of process technology Assimilation of product design; minor adaptation to market needs Work flow; scheduling; time motion studies; inventory control Local procurement of goods and services; information exchange with suppliers
Intermediate Adaptive, duplicative (Search-based) Search for technology source; negotiation of contracts; bargaining suitable terms; info. Systems Equipment procurement; detailed engineering; training and recruitment of skilled personnel Equipment stretching; process adaptation and cost saving; licensing new technology Product quality improvement; licensing and assimilating new imported product technology Monitoring productivity; improved coordination Technology transfer of local suppliers; coordinated design; S&T links
Advanced Innovative, risky (Research-based)   Basic process design; equipment design and supply In-house process innovation; basic research In-house product innovation; basic research   Turnkey capability; cooperative R&D; licensing own technology to others

Investment capabilities are the skills needed before a new facility is commissioned or existing plant is expanded: to identify needs, prepare and obtain the necessary technology, then design, construct, equip, and staff the facility. They determine the capital costs of the project, the appropriateness of the scale, product mix, technology, and equipment selected, and the understanding gained by the operating firm of the basic technologies involved (which, in turn, affect the efficiency with which it later operates the facility). Production capabilities range from basic skills like quality control, operation, and maintenance to more advanced ones like adaptation, improvement, or equipment "stretching" to the most demanding ones of research, design, and innovation. They cover both process and product technologies, as well as the monitoring and control functions included under industrial engineering. The skills involved determine not only how well given technologies are operated and improved, but also how well in-house efforts are utilized to absorb technologies bought or imitated from other firms (on the significance of R&D for assimilating external innovations see ref. 9). Linkage capabilities are the skills needed to transmit information, skills, and technology to, and receive them from, component or raw material suppliers, subcontractors, consultants, service firms, and technology institutions. Such linkages affect not only the productive efficiency of the enterprise (allowing it to specialize more fully) but also the diffusion of technology through the economy and the deepening of the industrial structure, both essential to industrial development. The significance of extra market linkages in promoting productivity increase is well recognized in the literature on developed countries (survey in ref. 8).

The emerging empirical literature of FTC in developing countries has touched on various aspects of the development of FTC (apart from the references above, see refs. 11, 82, 26, 80, 32, 63, 19). These need not be reviewed at any length here, but it is worth noting the main influences on the demand for, and supply of, FTC. On the "demand" for efforts to build FTC, the most important factors are threefold. First, there is an inherent need for the development of new skills and information simply to get a new technology into production. This operates regardless of policy regime and provides the elemental drive for firms to invest in capability building; the form that capability building takes depends on the nature of the technology (process or batch, simple or complex, large to small scale).

Second, apart from this inherent pressure for capability acquisition, external factors strongly influence the process. As with any investment decision, the macroeconomic environment, competitive pressures, and the trade regime all affect the perceived returns to FTC development efforts. A stable, high growth environment conduces to higher investments in FTC. So does competition with international competition probably the most potent inducement to skill and technology upgrading. However, competition is a double-edged sword, and, given the necessary costs of learning, can stifle capability building in newcomers when certain market failures exist. This type of "infant industry" argument is taken up in the next section. Trade orientation also affects the content and pace of FTC development. The evidence (and the present author's comparison of technological development in similar industries in India and Korea: see ref. 44; also 38, 1) suggest that inward-oriented regimes foster learning to "make do" with local materials, "stretch" available equipment for down-scale plants, while export-oriented regimes foster efforts to reduce production costs, raise quality, introduce new products for world markets, and often reduce dependence on (expensive) imported technology.

Third, technological change itself, which proceeds continuously in almost all industries in the developed world, stimulates developing country firms to try to keep up. Exposure to competition mediates this incentive, and highly protected firms can delay their upgrading for long periods. Nevertheless, the existence and potential availability of more efficient technologies can create their own incentives to invest in FTC.

On the "supply" side, the ability of firms to produce new capabilities depends on: the size of firm (where technologies are complex and call for large-scale production, large amounts of skilled manpower, or intense technological effort, and particularly where capital markets are deficient); access to skills from the market; organizational and managerial skills in the firm and its ability to change structures to absorb new methods and technologies [37, 33]; access to external technical information and support (from foreign technology sources, local firms and consultants, and the technology infrastructure of laboratories, testing facilities, standards institutions, and so on); and access to appropriate "embodied" technology, in the form of capital goods, from the best available sources, domestic or foreign.

In sum, FTC development is the outcome of investments undertaken by the firm in response to external and internal stimuli and in interaction with other economic agents, both private and public and local and foreign. Thus, there are factors that are firm-specific (leading to micro-level differences in FTC development and to "idiosyncratic" results) and those that are common to given countries (depending on their policy regimes, skill endowments, and institutional structures). It is these common factors to which we now turn.

National technological capabilities

Let us now consider national technological capabilities in developing countries. National capabilities are not simply the sum of thousands of individual firm-level capabilities developed in isolation. Because of externalities and interlinkages, there is likely to be synergy between individual firm-level capabilities. Despite individual idiosyncracies, there is a common element of response of firms to the policy, market, and institutional framework. It makes sense, in other words, to conceive of national differences in technological capabilities. Clearly, countries - developing or developed - differ in their ability to utilize or innovate technologies, and this difference manifests itself in their productivity, growth, or trade performance. There is little by way of theory that brings together all the factors that may influence these variables (but see refs. 21, 22, 24, 25, 57, 59). The analysis of national technological capabilities is nevertheless important because of the current dominance of some partial explanations of industrial success, which may lead to misleading policy conclusions [46, 47]. In particular, it is necessary to look again at approaches that, as mentioned in the introduction, trace success to "getting prices right" and noninterventionist strategies, treating them as both necessary and sufficient conditions. These approaches are based on particular readings of technological capability and the efficiency of markets in developing countries.

The OECD explains long-term differences in the performance of advanced industrial economies thus:

Over the longer term, economic growth arises from the interplay of incentives and capabilities. The capabilities define the best that can be achieved; while the incentives guide the use of the capabilities and, indeed stimulate their expansion, renewal or disappearance. In the advanced economies, the capabilities refer primarily to the supplies of human capital, of savings and of the existing capital stock, as well as to the technical and organizational skills required for their use; the incentives originate largely in product markets and are then more or less reflected in markets for factor supplies thereby determining the efficiency with which capabilities are used. Both incentives and capabilities operate within an institutional framework: institutions set rules of the game, as well as directly intervening in the play; they act to alter capabilities and change incentives; and they can modify behaviour by changing attitudes and expectations. [57, p. 18]

This three-pronged approach, involving the interplay of capabilities, incentives, and institutions, is a useful way of organizing the numerous factors that influence national technological capabilities in developing countries [46].


At the country level, capabilities can be grouped under three broad headings: physical investment, human capital, and technological effort. These three are strongly interlinked in ways that make it difficult to identify their separate contributions to national performance [52], but they do not always go together. If physical capital is accumulated without the skills or technology needed to operate it efficiently, national technological capabilities will not develop adequately; or if formal skills are created but not combined with technological effort, efficiency will not increase dynamically (see ref. 67 for a theoretical analysis); and so on. Physical investment is in some sense a "basic" capability, in that plant and equipment are clearly necessary for industry to exist, but it is the efficiency with which capital is utilized that is of greater interest. The ability to muster the financial resources and the embodied technology that make up physical investment (and the need for an efficient financial system to support this) need not be spelled out at any length here.

The term "human capital" is used broadly here to include not just the skills generated by formal education and training but also those created by on-the-job training and experience of technological activity, and the legacy of inherited skills, attitudes, and abilities that aid industrial development. Literacy and primary education are essential for all forms of efficient industrialization, and may be largely sufficient for early industrial efforts utilizing simple technologies [48]. However, as more sophisticated technologies are adopted, the need for more advanced, specialized skills on the part of both workforce and managers emerges [75]. Moreover, the gap between the workforce and engineers has to be reduced to facilitate skill transfer [50]. The quality of formal education, especially of technical training, and the relevance of the curriculum to changing technical needs are clearly very important. To the extent that public or private training facilities do not meet the need for such skills, firms have to invest in their own training facilities, but will do so only if mobility is low and their investments yield appropriate benefits [40]; low mobility thus has this benefit but is offset by the restraint it places on the diffusion of knowledge. Ergas [21] and the OECD [57] outline the very different systems dealing with these problems in the United States, Germany, and Japan, each with its own strengths and weaknesses.

The final capability relates to national technological effort. Trained labour and physical capital are fully productive only when combined with efforts by productive enterprises to assimilate and improve upon the relevant technology. As discussed earlier, such effort comprises a broad spectrum of production, design, and research work with firms, backed up by a technological infrastructure that provides information, standards, basic scientific knowledge, and various facilities too large to be owned by private firms. It is impossible to measure properly such technological effort, but rough proxies are available in the form of technical manpower available for technical tasks, or expenditures on formal R&D (input measures), or innovations, patents, and other indicators of technological success (output measures). The interpretation of all such measures is fraught with difficulties [8], since not all effort is equally efficiently made, and no measure captures fully routine engineering work devoted to minor innovation or mastery. Nevertheless, it is evident that different countries devote different levels of effort to technology (see refs. 21, 57, 13, 59 on developed countries, and 78, 35, 46 on developing countries), and even a crude measure is of some use.

Apart from domestic technological effort, the extent and nature of a country's reliance on foreign technology is also directly relevant to national technological capabilities. All countries need to import technology, but different modes of import have different impacts on local technological development. In semi-industrialized countries, for instance, a heavy reliance on foreign direct investment (FDI) may become a substitute for domestic effort at the "advanced" levels shown in table 1 above, because FDI is an efficient means to transfer the results of innovation rather than the innovative process itself. The alternative strategy, following the example of Japan, of building a strong domestic technological base, may therefore entail a selective curtailment of FDI entry, at least at certain stages of the development process (see below).


While both physical and human capital are necessary for industrial development, they will not be utilized effectively if the structure of incentives for investment and production is inappropriate. Incentives, arising from market forces, institutional functioning, and government policies, affect the pace of accumulation of capital and skills; the types of capital purchased and the kinds of skills learnt; and the extent to which existing endowments are exploited in production. In most developing countries, the role of policies assumes great importance, in positive as well as negative ways: positive because structural and market failures call for remedial action, negative because interventions can be excessive or misjudged, and even justifiable interventions can be poorly administered.

Three broad sets of incentives affect the development of national technological capabilities:

1. MACROECONOMIC INCENTIVES. Under this heading, I include signals that emanate from GNP growth (rate and stability), price changes, interest rates, exchange rates, credit and foreign exchange availability, and similar economic variables, as well as political stability or exogenous shocks (e.g. terms of trade). The impact of growth, stability, sensible balance of payments, monetary or fiscal policies, favourable external circumstances, etc., on investment and capability building are obvious and need not be discussed in detail here.

2. INCENTIVES FROM COMPETITION. Competition is, as discussed earlier, the most basic of incentives affecting capability development. Domestic competition is influenced by the size of the industrial sector, its level of development and diversification, and government policies on firm entry, exit, expansion, prices, ownership, small-scale industry, and so on. Most developing countries impose constraints on internal competition to prevent excessive entry (and so fragmentation) in protected markets, to preserve employment, to promote small firms or public enterprises, to hold down prices, to force industry to locate in backward areas, or to prevent the growth of large-size firms or the concentration of economic power. Some industrial regulation is clearly necessary in every economy, but high levels of intervention can frustrate or dissipate the development of healthy capabilities and prop up non-viable enterprises that should die out (see ref. 88 for a brief review of the most common types of competition-retarding policies).

International competition - from imports, entry of foreign investors, or export activity - can be an even greater stimulant to healthy technological development than domestic competition, in small or large countries (size of economy does not affect whether or not enterprises in the country are exposed to such competition). Yet governments place many barriers to such competition, often in a sweeping, irrational, and prolonged way that retards technological development, efficiency, export growth, and structural change. The recent development literature has analysed the costs of inward-oriented trade strategies at great length (for a useful review, see ref. 87). Most of the conventional arguments are not couched in terms of the impact of trade strategies on technological capabilities, but the implicit assumptions made about technological capability development are relevant to the issue.

The debate over intervention in trade flows is of long standing (review in ref. 5). While acknowledging the benefits of market competition, economic theory accepts that interventions in the incentive framework of free trade, in the form of infant industry protection or promotion, are needed to overcome many (but not all) market failures affecting resource allocation [82, 83, 62, 46]. It is important to be clear about the correct case for such intervention. Some arguments for protection are misplaced: if the source of market failure lies outside the firm (e.g. lack of skills, infrastructure, institutions), intervention to protect the firm will do nothing to ensure that costs come down over time. However, to the extent that failures arise from the firm's own lack of investment in capability building, due to externalities (loss of skills or technology or interdependencies between firms [62]), risk aversion, or lack of information (due to missing information markets or "learning to learn" phenomena [71]), intervention may have a justifiable role to play in restoring efficient resource allocation.

The intervention may not necessarily take the form of import protection. Theory suggests that subsidies are preferable because they involve lower consumption costs than import restrictions. But protection is easier (and cheaper) for the government to administer, and historical evidence suggests that tariffs have been used by every developed country in critical stages of industrialization [80]. While protection has often been misused, as the trade strategy debate shows, it has also accompanied entry into difficult and complex activities with high learning costs In fact, the existence of such costs in developing countries (with imperfect capital and information markets and strong linkages and externalities) suggests that protection is a necessary condition for development beyond technologically simple activities. However, it may not usually be sufficient, because market failures in factor markets and institutions (see below) can hold back full gains in efficiency.

Such interventions have to be selective, requiring that policy makers identify specific sectors, activities, or even firms for promotion over others to exploit their superior growth potential, linkages, or externalities. There are two basic requirements for such intervention to be effective. First, since protection itself reduces incentives to invest in FTC, it should not be too widespread, indiscriminate, or prolonged, and should be offset by other incentives for increased efficiency. The best combination may be the selective and temporary protection of domestic markets, together with strong incentives for export activity and domestic competition. Second, policy makers should be able to identify suitable activities for protection and have the authority to correct mistakes and modify choices over time (i.e. shut down inefficient operations). This requires considerable informational and organizational resources, as well as political strength, on the part of the government. Some countries can provide such resources, but many cannot; I return to this below.

3. INCENTIVES FROM FACTOR MARKETS. Theory suggests that well-functioning, flexible factor markets and correct relative factor prices are necessary to achieve efficient production and resource allocation. Efficiency in capital markets requires that long-term financing be available, especially for risky projects involving new technologies, and that price signals achieve proper inter-firm and inter-industry resource allocation. Efficient labour markets should be responsive to changing needs, not hampered by restrictive practices, and be equipped with requisite skills. Similarly, efficient technology markets should provide adequate flows of information to enterprises as well as of "public goods" such as standards, testing facilities, and basic research. In general, incentives should be sufficient to ensure that private firms do not under-invest in their own technological development. Where market failures occur and firms invest less than is socially desirable, governments must be able to step in to enable firms to internalize markets (e.g. provide self-financing or subsidize training of workers) and to remedy the failures directly by providing finance (loans, venture capital financing, R&D subsidies, and so on) to firms or activities where social returns exceed private returns. Such interventions are often regarded as functional rather than selective, and so are considered with greater favour by those who mistrust selectivity ("picking winners") by governments. However, the distinction is often spurious. Interventions in finance, education, research, information, or retraining are generally selective above a certain (fairly low) level: for instance, after providing for general levels of secondary education, the training of university level engineers may need to be guided towards specific industrial needs. Given resource limitations, selectivity in industrial support is inevitable. But there is a stronger case for selectivity in factor market interventions: some activities have greater linkages and externalities than others. As Grossman [30] argues, "When market activity is too low relative to an efficient outcome, it is because the active and potentially-active firms fail to appropriate all the benefits from some aspect of their operation. Corrective government policy should be targeted to the particular activity that generates positive spillovers, and not merely encourage firms to produce more output" (p. 118).


The development of capabilities and the play of incentives express themselves only through specific market and non-market institutions. If markets throw up the necessary institutions naturally, there is no need to consider them separately. If they do not, however, the development of a proper institutional framework becomes an area of concern. Since development is almost definable by the deficiency of institutions, clearly the subject requires consideration. Of the vast array of institutions that affect economic life, I note only those that are external to firms and that most directly affect industrial capabilities. In addition to the legal framework supporting industrial activity and property rights, these are: industrial institutions (those that promote inter-firm linkages in production, technology, or training, or provide support to smaller enterprises, or help firms to restructure and upgrade); training institutions (where firms under-invest in training or fail to provide the right kind or quality of training); and technology institutions (on the US, see refs. 72, 73, 54; on Japan, 28, 51, 59; and 21, 57, on developed countries in general).

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