nathaniel leff - industrial organization and entrepreneurship in the developing countries. the...

Industrial Organization and Entrepreneurship in the Developing Countries: The EconomicGroupsAuthor(s): Nathaniel H. LeffSource: Economic Development and Cultural Change, Vol. 26, No. 4 (Jul., 1978), pp. 661-675Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/1153538 .

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Industrial Organization and Entrepreneurship in the Developing Countries: The Economic Groups

Nathaniel H. Leff* Columbia University

I. Introduction The subject of industrial organization has not received much attention in the analysis of postwar economic development. This neglect has occurred

despite the importance of industrial organization for such questions as

efficiency in production and investment and, especially, for transmitting the external economies which are believed to play a central role in the development process.' By contrast, the topic of entrepreneurship in less- developed economies has been discussed extensively, if not always in

satisfactory theoretical terms.2 As William Baumol expressed it a decade ago, despite the entrepreneur's "acknowledged importance . . . [he is] one of the most elusive characters in the cast that constitutes the subject of economic analysis . . . [and has] virtually disappeared from the theoretical literature."3 This conceptual elusiveness is especially unfortu- nate for the analysis of the developing economies, in which entrepreneurship is likely to be more necessary for output expansion and structural change than in the more developed countries.

* I am grateful to Tuvia Blumenthal, Neil Chamberlain, Frank Edwards, Ronald Findlay, David Felix, Harvey Leibenstein, Richard Porter, Frederic Pryor, Kazuo Sato, and Julian Simon for helpful comments on an earlier version of this paper. I also thank the Faculty Research Program of the Columbia Business School for financial support; and the Department of Developing Countries of Tel-Aviv University, where the first draft of the paper was written, for the use of its research facilities. I bear sole responsibility for any deficiencies in the paper. 1 Paul N. Rosenstein-Rodan, "Problems of the Industrialization of Eastern and South Eastern Europe," Economic Journal 53 (June 1943): 202-11.

2 For an indication of the large volume of professional literature addressed to the subject of entrepreneurship and economic development, see the bibliography in Flavia Derossi, The Mexican Entrepreneur (Paris: OECD Development Centre, 1972), pp. 409-28.

3 William Baumol, "Entrepreneurship in Economic Theory," American Eco- nomic Review 58 (May 1968): 61-71; quote from p. 64.

? 1978 by The University of Chicago. 0013-0079/78/2604-0001$01.30

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Economic Development and Cultural Change

Industrial organization and entrepreneurship are of course related.4 Accordingly, this paper attempts to make some analytical progress by considering these two subjects together. We will proceed by drawing attention to and analyzing a pattern of industrial organization in the developing countries which has important effects on the functioning of these economies, particularly on the conditions which affect investment and production decisions. This pattern of industrial organization, which I shall call "the group," is distinct from other forms of capitalist organization in the less developed countries which have been more widely noted and discussed; for example, the public sector corporation, the

broadly held public company, the family owned company, and the multinational corporation. Despite its existence as a phenomenon which ap- pears in many developing countries and despite its pervasive economic effects, which we shall discuss below, the group has received surprisingly little generalized analysis. Some aspects of the group phenomenon have been noted before, usually in observations for individual less developed countries. Also, most observers have focused on one or two features of the groups, such as their monopoly power or their political connections. However, relatively little effort has been directed to conceptualizing the groups in more general analytical terms, and analyzing the implications for economic development, industrial organization, and entre-

preneurship.5

II. The Economic Groups In many of the less developed countries a significant part of the domestic and privately owned industrial sector, and particularly the activities which use relatively modern and capital-intensive techniques, is organized in a special institutional pattern. Following the Latin American term, we may call this structure the "group," although this pattern of economic

organization is also common, with different names, in Asia and Africa. Documentation on the structure and scale of group activities in many less developed countries is sparse. This is not surprising, for collection of data on a phenomenon usually requires that its existence first be noted in the professional literature and a conceptual framework be developed to analyze it. Such a general framework has previously not been

developed for the groups. Nevertheless, on the basis of presently available materials, the following generalizations can be advanced.6

4 Cf. the comment by W. A. Lewis: "We have no good theory of entrepreneurship because we have no good theory of monopoly," cited by Baumol, p. 68.

5 The present paper concentrates on the causes of the group structure and on its positive effects on the functioning of the less developed economies. Pernicious effects and their policy implications are discussed in my "Monopoly Capitalism and Public Policy in the Less-developed Economies," mimeographed (1978; available from the author).

6 For some published sources which discuss aspects of the groups (often in different terms), see, e.g., W. Dean, The Industrialization of Sao Paulo (Austin:

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Nathaniel H. Leff

The group is a multicompany firm which transacts in different markets but which does so under common entrepreneurial and financial control. More generally, this pattern of industrial organization has two essential features. First, the group draws its capital and its high-level managers from sources which transcend a single family. The capital and the managers may come from a number of wealthy families, but they remain within the group as a single economic unit. The group's owner-

managers typically include some (but by no means all) members of the

family within which the group's activity originated. However, what

distinguishes this institution from the family firm and what gives it the resources for greater scope is the fact that owner-managers from other families also participate. Participants are people linked by relations of

interpersonal trust, on the basis of a similar personal, ethnic, or com- munal background.7

Second, somewhat like the zaibatsu in pre-World War II Japan, the groups invest and produce in several product markets rather than

University of Texas Press, 1969), pt. 1; A. Lauterbach, "Management Aims and Development Needs in Latin America," Business History Review 42 (Winter 1968): 558-59; Derossi, esp. pp. 97-115 and 158-93; Frangois Bourricaud, "Struc- ture and Function of the Peruvian Oligarchy," Studies in Comparative International Development 2 (1966): 1-15; Robert T. Aubey, "Entrepreneurial Formation in El Salvador," Explorations in Entrepreneurial History, vol. 6 (November 1969), esp. pp. 272-76; D. W. Stammer, "Financial Development and Economic Growth in Under- developed Countries: Comment," Economic Development and Cultural Change 20 (January 1972): 318-25; Andrew J. Brimmer, "The Setting of Entrepreneur- ship in India," Quarterly Journal of Economics 69 (1955): 553-76; G. Rosen, Some Aspects of Industrial Finance in India (Glencoe, Ill.: Free Press, 1962), chap. 1; E. K. Hazari, The Corporate Private Sector (Bombay, 1966); Gustav Papanek, Pakistan's Development (Cambridge, Mass.: Harvard University Press, 1967), pp. 67-68; Thomas A. Timberg, "Industrial Entrepreneurship among the Trading Communities of India," Harvard University Economic Development Report no. 136, mimeographed (Cambridge, Mass.: Harvard University, July 1969), pp. 1-126; Hannah Papanek, "Pakistan's Big Businessmen," Economic Development and Cultural Change 21 (October 1972): 1-32, esp. 17-32; Lawrence J. White, Industrial Concentration and Economic Power in Pakistan (Princeton, N.J.: Princeton University Press, 1974); and Harry Strachan, The Role of Family and Other Groups in Economic Development: The Case of Nicaragua (New York: Praeger Publishers, 1976). (The page references cited below to Strachan's work refer to his D.B.A. thesis, Harvard University, 1972.) I have also been informed by Steven Resnick, K. S. Lee, and Jose Buera that a similar pattern exists in the Philippines, South Korea, and the Dominican Republic, respectively. Also, on the basis of his field experience in Asia and Africa, Richard Porter has written to me that the groups are common in other countries of Asia and Africa. These materials, as well as my own interviews conducted in the course of fieldwork in less developed countries, constitute the basis for the statements advanced in the text.

7 The groups I am discussing are, for reasons of their comparative advantage and private returns, largely in the "modern" sector of the economy. Another type of group, often purely ethnic and without capabilities in modern technology, sometimes operates as an informal financial intermediary in activities where "organized" sources of finance are scarce in less developed countries (see, e.g., William Baldwin, "The Thai Rice Trade as a Vertical Market Network," Economic Development and Cultural Change 22 [January 1974]: 179-99).

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in a single product line. These product markets may be quite diverse, ranging, for example, from consumer durables to chemicals to steel rolling. These activities have sometimes been selected on the basis of forward or backward integration. In other cases, new investments have been made in product markets which are unrelated but in activities where the group's technical and managerial capabilities are applicable as inputs.8 Large groups have also established banks and other financial intermediaries to tap capital from sources outside the immediate members of the group.9 Finally, the groups usually exercise a considerable degree of market power in the activities where they operate.

In some respects the groups' diversified activities obviously resem- ble the American conglomerates. However, for microeconomic reasons discussed below, they developed indigenously and independently in the less developed countries.1' It is also important to note that in many less developed countries the assets of the larger individual groups run to tens of millions of dollars. Taken together, they comprise a significant perecentage of the modern industrial sector, particularly of that portion which is not owned by public sector firms or by multinational corporations.

Reliable documentation on the extent of group activities is not available for many countries; and in developing countries with a substantial stock of direct investments by multinational corporations it would be easy to underestimate the groups' quantitative importance. This is because their investment strategy involves portfolio balance through diversification in different activities; consequently, they do not concen- trate their investments in a single industry. By contrast, foreign-based multinational corporations can also diversify their portfolios interna-

8 For a similar pattern in more developed countries, see Edith T. Penrose, The Theory of the Growth of the Firm (New York: Basil Blackwell, 1959), chaps. 5 and 7. Cf. also with G. B. Richardson's distinction between expansion into activities which are "complementary" to or "similar" to a firm's initial activities (see his paper, "The Organization of Industry," Economic Journal 82 [September 1972]: 887-92).

9 In some cases, the reverse sequence has occurred: from a group's estab- lishing a bank to entry into nonfinancial activities. Derossi (p. 178, n.) remarks that in addition to the banks which belong to industrial groups in Mexico the same can be said of 41 of the country's 44 financieras (investment banks).

10 In some respects these reasons are similar. Thus the groups' pattern of diversifying to utilize slack resources is similar to the expansion path documented by Alfred D. Chandler for American firms (see, e.g., his Strategy and Structure: Chapters in the History of Industrial Enterprise [Cambridge, Mass.: M.I.T. Press, 1962], pp. 102-3, 432, 448). By contrast, the emergence of the groups in the less developed countries owes less to the conditions of tax and capital-market legislation, which were important in the United States. On the latter, see Jon Didrichsen, "The Development of Diversified and Conglomerate Firms in the United States, 1920- 70," Business History Review 46 (Summer 1972): 202-19. Didrichsen has also emphasized the importance of economies of scale to imperfectly marketed skills (see the discussion in Sec. III below).

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Nathaniel H. Leff

tionally." Because of the groups' interactivity diversification, multinational corporations are often the largest firms within specific industries. The foreigners' position as the dominant firm within individual industries may divert attention from the groups' large overall assets within the industrial sector as a whole.

Despite data limitations, some figures convey an idea of the groups' scope. In Nicaragua, Strachan reports that in the early 1970s four groups accounted for 35% of all loans and investments of the total financial sector and a much larger share of loans and investments in the private financial sector.12 In Pakistan in 1968, 10 groups controlled 33% of all assets of private, Pakistani-controlled firms in the modern manufacturing sector; and 30 groups controlled 52%.13 These assets were held in a wide range of diversified activities.14 Similarly, in India the largest four groups held 17% of the assets of public and private companies in 1958 and the largest 20 groups, 28%.'5 As regards diversification, data for 37 of the largest Indian domestically owned groups show an average of five activities per group.16 Excluding the two largest groups (Tata and Birla), the average was still four activities per group.

A more detailed picture of the size and diversification of groups in a developing economy is available from a 1962 study in Brazil." These data on the assets and diversification of Brazilian groups in 1962 are presented in table 1. Although these data convey an idea of the size of groups in Brazil, for a number of reasons table 1 tends to understate the importance of the groups. First, the study considered only the groups' own capital, excluding external resources which they could mobilize. The balance-sheet data utilized may also underreport true asset values, both to reduce tax payments and because of accounting lags during inflation. The study was also confined to the four most industrialized states of Brazil's south, thereby omitting groups located elsewhere in the economy. Finally, the data of table 1 relate to 1962, before the large economic expansion which began after 1967. An update of these data

11 In some cases where multinational corporations operating in developing countries have generated cash flow in excess of profit-remission constraints, they have also followed a pattern of interactivity investment within the local economy. This behavior reflects the same causes as those affecting the groups (see Sec. III below).

12 Strachan, pp. 80-81. 13 White, p. 65. 14 Letter from Gustav Papanek, May 6, 1969. 15 Hazari, chap. 2, as cited in White, p. 71. 16 These figures on group participation in different activities were computed

from data presented in Timberg, pp. 88-104. 17 Mauricio Vinhas de Queiroz, "Os grupos multibilionarios," Revista do

instituto de ciencias sociais (Rio de Janeiro) 2, no. 1 (January 1965): 47-77; Luciano Martins, "Os grupos bilionarios nacionais," ibid., pp. 79-115. I am grateful to Marcio Teixeira for bringing this data source to my attention.

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TABLE 1

OWN ASSETS AND DIVERSIFICATION OF PRIVATE, LOCALLY OWNED GROUPS IN FOUR STATES OF BRAZIL, 1962

ASSET CLASS ($ MILLION)

2.5-10 >10 > 25

Groups (N)................... 144 24 5 Average companies per group (N) 8* 21 N.A.

SOURCES.-Mauricio Vinhas de Queiroz, "Os grupos multibilionarios," Revista do instituto de cidncias socials (Rio de Janeiro) 2, no. 1 (January 1965): 47, 50, 64; Luciano Martins, "Os grupos bilionarios nacionais," ibid., p. 86.

NOTE.-The asset figures are in 1962 dollars, converted from cruzeiros at an exchange rate of 400 cruzeiros per dollar. N.A. = not available.

* Sample estimate.

would undoubtedly show a much larger scale for the assets of groups in Brazil.

Bearing in mind the size and diversity of groups and their importance in the private, domestically owned modern sector of the economy, we will consider and discuss below the effects this feature of industrial organization has on the functioning of the developing economies. First, however, let us analyze the causes of the group structure.

III. Causes of the Group Pattern of Industrial Organization The group pattern of industrial organization is readily understood as a microeconomic response to well-known conditions of market failure in the less developed countries. In fact, the emergence of the group as an institutional mode might well have been predicted on the basis of familiar

theory and a knowledge of the environment in these countries. The group can be conceptualized as an organizational structure for

appropriating quasi rents which accrue from access to scarce and imperfectly marketed inputs. Some of these inputs, such as capital, might be marketed more efficiently, but in the conditions of the less developed countries they are not. Some of these inputs are inherently difficult to market efficiently; for example, honesty and trustworthy competence on the part of high-level managers.18 Finally, substantial private gains can accrue from not marketing some inputs, for example, information

generated in one group activity which is relevant for (actual or potential) investment and production decisions elsewhere in the economy.

The absence of markets for risk and uncertainty also helps explain another feature of the groups' pattern of expansion-their entry in diversified product lines. This pattern may appear to be due exclusively to the relatively small size of the domestic market for many manufactured

18 Harvey Leibenstein, "Entrepreneurship and Development," American Eco- nomic Review 58 (May 1968): 72-83.

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products in the less developed countries. More important, however, for reasons of portfolio balance, diversification has an obvious appeal in economies subject to the risks and uncertainties of instability and rapid structural change. The groups' practice of choosing new investments on the basis of backward and forward linkages also stems in part from an effort to alleviate risk and uncertainty. Vertical integration has been sought to avoid being dependent on a monopolist or oligopolist for materials inputs, or on an oligopsonist for the group's output. In conditions where both parties must make specific and long-lived investments, bi- lateral oligopoly involves serious risks and uncertainties concerning future quantities, qualities, and prices for inputs and for outputs. In addition, vertical integration can avoid the transactions (bargaining and enforcing) costs which intricate arm's-length negotiations would entail.19

These conditions which lead to gains from vertical integration are well known from the more developed countries.20 They are likely to be more severe, however, in the less developed countries. The probability of having to confront strong market power is greater in these economies whose domestic markets are often too small to accommodate more than a few sellers and buyers for many intermediate products.21 Also, in relatively large and open economies such as those of the more developed countries random fluctuations in the components of overall market demand for specific intermediate products may be offsetting. The less developed economies, however, are too small and often too closed to enable the law of large numbers to have this smoothing effect, and make more predictable the total market demand for individual intermediate products.

The institution of the group is thus an intrafirm mechanism for dealing with deficiencies in the markets for primary factors, risk, and intermediate products in the developing countries. In this perspective, the group pattern of industrial organization fits closely into the theory of entrepreneurship and development formulated by Harvey Leibenstein.22

Leibenstein has suggested that entrepreneurship in less developed countries involves the opening of channels for input supply and for marketing of output in situations where a routinized market mechanism does not exist. In the absence of such "intermarket operators" some input and/or output quantities, qualities, and costs would be so beclouded by risk and uncertainty that investment and production in these activities

19 Oliver E. Williamson, "The Vertical Integration of Production: Market Failure Considerations," American Economic Review 61 (May 1971): 112-23.

20 George J. Stigler, "The Division of Labor Is Limited by the Extent of the Market," reprinted in his The Organization of Industry (Homewood, Ill.: Richard D. Irwin, Inc., 1968), pp. 136-38.

21 Reliance on international trade to complement the domestic market might be another possibility. However, in addition to problems often posed by overvalued exchange rates, foreign trade often involves--or is perceived to involve-substantial risks and uncertainties of its own in the less developed countries.

22 See n. 18 above.

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would not take place. With their access to nonmarketed inputs and with their pattern of vertical integration, however, the groups create a channel both for mobilizing and for allocating such inputs and outputs. In fact, the group can perhaps best be understood as an institutional innovation for internalizing the returns which accrue from interactivity operations in the imperfect market conditions of the less developed countries. What has happened in effect is that the groups have appropriated as gains the

quasi rents of the output which Leibenstein envisaged would otherwise be foregone due to imperfect factor markets and insufficient entrepreneurship.

Not only does the group pattern of industrial organization provide the "real life" correspondence to Leibenstein's theory of entrepreneurship, but it also suggests some analytical extensions. First, the group constitutes a pattern of industrial organization which permits structure rather than gifted individuals to perform the key interactivity function of

entrepreneurship. Another departure from earlier theoretical expectations is that with the institution of the group some factors and products flow within the firm rather than through the market.

IV. Other Explanations The preceding discussion has explained the group pattern of industrial

organization largely as an institutional innovation for overcoming-and reaping the benefits from-imperfect markets in the less developed countries. We must also consider some other interpretations of this phenomenon.

Thus it has been suggested that the group structure arises mainly because of political connections which permit special access to government dispensations of, for example, import licenses.23 Groups undoubtedly do benefit from government largesse in the form of import licenses, bank charters, and tax and investment credits; but this is hardly an "alternative" explanation. For one thing, the groups' entrepreneurship and the externalities which they internalize (see below) help explain why particular government favors may have higher present value for groups than for other firms and, consequently, why the groups can outbid others in

acquiring political favors and connections.24 More generally, I do not believe that political influence per se is a sufficient reason for the emergence of the group pattern of industrial organization.25 If the reader

23 See, e.g., White, p. 17. 24 For a more general framework on this topic, see my "Corruption and

Economic Development," American Behavioral Scientist 3 (December 1964): 8-14.

25 Cf. Hannah Papanek's comment: "Although political influence obviously played an important role in the development of the Big Houses, it was not in itself sufficient for large-scale growth of the enterprises" (p. 17).

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Nathaniel H. Leff

judges otherwise, however, political connections can readily be conceptualized as an imperfectly marketed input.

It may also be suggested that the group structure is due to no more than imperfect access to capital and that the highly skewed distribution of wealth common in less developed countries simply means that the very rich take a pervasive role in industrialization. I find this explanation insufficient on a number of grounds. First, it fails to explain why only a small percentage of individuals and families in the traditional wealthy class establish groups. Also, some groups have been founded by individuals who were initially not in the high-wealth brackets.26

The emphasis I have placed on the importance of conditions other than preferential access to capital alone as an explanation for the groups27 is supported by other features of their structure.28 The groups do not operate simply as financial trusts or holding companies; rather, they maintain active entrepreneurial participation in their manifold activities. The existence of structures similar to groups in the public sector of some less developed countries provides further evidence that more than imperfect access to capital underlies the group pattern of industrial organization. Public sector companies in the less developed countries generally face less stringent conditions of capital supply than do private firms. Nevertheless, where legislation has permitted, some public sector companies have also operated with diversified investment and production activities similar to those of private groups.29

V. The Groups and Entrepreneurship The existence of large-scale, diversified firms is a familiar phenomenon in advanced capitalist economies. What have we gained from noting that a similar phenomenon, in the special form of the groups, is also present in the developing countries?

First, the group pattern of industrial organization has helped relax entrepreneurial constraint which, in the first postwar decade, many observers expected would limit the pace of economic development in the

26 Hannah Papanek (ibid.) has also noted the "modest antecedents of some of the big businessmen in Pakistan today."

27 Cf. George Stigler's comment that the phrase "imperfections in the capital market" has too often been employed as a substitute for analysis of other relevant conditions (see his "Imperfections in the Capital Market," Journal of Political Economy 75 [June 19671: 287-92, reprinted in The Organization of Industry).

28 Strachan (p. 111) reports that in the Nicaraguan groups people who can contribute only capital but not special management skills to group activities are gradually excluded from participation. He has also noted another piece of information which reduces the importance of preferential access to capital as a sufficient condition for the group structure. He points out that Costa Rica, where the banking system has been nationalized since the late 1940s, has groups which operate in modes similar to those of Nicaragua, with its privately owned banking system.

29 An example is the Pertamina company in Indonesia.

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underdeveloped countries. Thus, this institution has permitted "pure" Schumpeterian entrepreneurship to become effective. This is because the group provides the capital and the technical and managerial resources which are necessary to transform "innovativeness and alertness to opportunities"30 into actual investment and production decisions. The institution of the group also facilitates economies in the use of scarce entrepreneurial resources. Economies of scale to entrepreneurship can be appropriated as able individuals are utilized to their full potential in the group's large and diversified activities. In addition to such "central office" effects, the groups increase entrepreneurial mobility, for they can deploy entrepreneurial resources to specific intragroup companies as opportunities arise.

Perhaps even more importantly, the group structure itself reduces the amount of enterepreneurial capacity which is required per unit of innovative decision making. Thus the groups' partcipation in many different activities increases information flows and reduces uncertainty sur- rounding investment and production decisions.31 More generally, the

groups embody in their structure and expansion path a number of sug- gestions which have been advanced on theoretical grounds for economiz- ing on entrepreneurship in developing countries. As noted earlier, the group performs the Leibenstein entrepreneurial function of overcoming deficiencies in important factor and product markets. In addition, as we have seen, the groups expand along a path of backward and forward linkages, with investment decisions taken in function of economic and

technological complementarities. Thus the groups have in effect implemented at the micro level the development pattern which Albert Hirsch- man proposed as an optimizing macro strategy for economies where

entrepreneurship is scarce.32 Note finally a subjective, motivational feature which also increases

the groups' orientation toward the investment and economic expansion aspects of entrepreneurship. The groups' top managers are often aggres- sive "empire builders." However, these managers lack some standard criteria for evaluating their performance, either for purposes of their own self-assessment or, perhaps even more important subjectively, for com-

30 For a discussion of these aspects of entrepreneurship, see I. M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), pp. 39-57.

31 In terms of John Harris's decision-theory conceptualization of entrepreneurship, the reduced uncertainty caused by the group pattern of industrial organization leads to a shift of the action set toward the origin and a rise in the probability that a given profitable investment will be implemented. For Harris's model of entrepreneurship, see his paper, "Entrepreneurship and Economic Development," in Business Enterprise and Economic Change: Essays in Honor of Harold F. Williamson, ed. Louis Cain and Paul Uselding (Kent, Ohio: Kent State University Press, 1973).

32 Albert O. Hirschman, The Strategy of Economic Development (New Haven, Conn.: Yale University Press, 1958), pp. 42-43.

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parison with rival groups. Thus, the deficiencies of formal capital markets in the developing countries prevent the use of share-prices in the stock market as an evaluative mechanism. And problems of accounting in these inflationary environments also preclude utilizing the group's overall rate of return on capital as a yardstick. In this context, two figures which are more readily available take on a special appeal as a performance measure: the size of a group's turnover and, relatedly, the rate of sales growth over time. This approach leads to a bias toward sales maximization, subject to a profit constraint, in the group's operations. The inefficiencies associated with such a management orientation are well known.33 In the present context, however, this orientation also reinforces a group's propensity for entrepreneurial expansionism.

VI. Other Beneficial Effects on the Developing Economies In addition to entrepreneurship, the group pattern of industrial organization also makes a difference in terms of other positive effects on the functioning of the developing economies. Not only does the group provide an institution for mobilizing capital from a pool which extends beyond the resources of a single family, but it performs a similar function for higher-management personnel as well. Such an enlargement of the base from which human resources can be recruited is especially important in the less developed countries. This is because mobilization and utiliza- tion of these human resources is in any case severely limited, due to the fact that top management is often selected only from within the circle of people who have at least some participation in ownership. The separation of ownership from control has not occurred on a large scale in the indigenous private sector of these economies.34

Furthermore, the group's internal relations of interpersonal trust permit the formation of larger top management teams than would otherwise be possible.35 This facilitates effective communication and delega- tion of authority and enables firms to overcome organizational constraints

33William J. Baumol, Business Behavior, Value and Growth (New York: Harcourt, Brace & World, 1959), pp. 49-50.

34 As discussed below, the groups' activities may suffer from some forms of inefficiency. It would be easy to attribute this to nepotism and to the lack of separation of ownership from control. Many of the groups' top managers are, however, professionally trained. In addition, the keener motivation and vested interest of owner-managers may increase the pressures for superior performance. In the United States, there is some evidence of better performance in firms which are owner controlled rather than management controlled (see R. J. Monsen, J. S. Chiu, and D. E. Cooley, "The Effect of Separation of Ownership and Control on the Performance of the Large Firm," Quarterly Journal of Economics 82 [August 1968]: 435-51; and Harvey Leibenstein, "Organization or Frictional Equilibria, X-Efficiency, and The Rate of Innovation," Quarterly Journal of Economics 83 [November 1969]: 614-15).

35 Interpersonal trust among the top owner-managers of the group is so important in these environments that Strachan (pp. 4, 22-25) considers it one of the central features of this pattern of industrial organization.

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on size and efficiency.36 As a result, group firms can achieve economies of scale which might otherwise be foregone and can attain output levels and rates of growth within individual activities which would be beyond the scope of family-owned firms."3

The group pattern of industrial organization also affects rates of return to capital and the rate of capital formation in the less developed countries. The groups' capacity to marshall the managerial and technical resources necessary for entry into new activities mitigates downward pressures on rates of return to capital which would otherwise occur if firms were restricted to their existing activities. The groups' power in product markets probably also leads to a higher rate of return.38 In addition, the diversification in the groups' activities reduces portfolio risk. Both individually and a fortiori, in interaction, these risk and rate-of- return conditions caused by the group pattern of industrial organization probably lead to a higher rate of investment than would otherwise prevail.

Further, investments made along lines of vertical integration permit the group to internalize economies which would otherwise be external to the firm and its individual activity. Thus, in addition to increasing the volume of capital formation, the group pattern also leads in this respect to a (socially) more optimal allocation of investment."9 With their interactivity investment allocations, the groups provide a previously unsus- pected mechanism for capital mobility between activities. In fact, to some extent the groups approximate the functioning of a capital market in the less developed countries.40 The pattern of investment and production

36 See Penrose, pp. 28-29. On the special aspects of this managerial problem in developing countries, see Peter Kilby, Entrepreneurship and Economic Develop- ment (New York: Free Press, 1971), pp. 26-29.

37 This has also been noted by White (p. 33). His data for Pakistan (pp. 150-51) indicate that group firms there experienced faster growth than nongroup firms. This result obtained even when the size of original equity investment, which was also larger for group firms, is held constant.

38 Studies with U.S. data, for example, have indicated a strong positive relation between a firm's rate of return and its market power, as measured by its market share within an industry (see, e.g., W. G. Shephard, "The Elements of Market Structure," Review of Economics and Statistics 54 [February 1972]: 25-37. This relation holds even when barriers to entry are low [p. 31]). For a less developed country, Pakistan, White (pp. 145-46) has presented evidence showing a positive relation between industry concentration ratios and industry rates of return. William J. House reports similar results for Kenya (see his paper, "Market Struc- ture and Industry Performance: The Case of Kenya," Oxford Economic Papers 25 [November 1973]: 405-19).

39 In discussing their investment decisions, group firms usually express them- selves in terms of the need to provide input and output quantities for complementary group activities rather than in terms of prices and rates of return. This need not be as irrational as might first appear. In effect, such decisions involve using the primal rather than the dual solution of an implicit linear programming optimizing model.

40 White (p. 33) has also noted aspects of the groups' capital market activities. An extended analysis is presented in my "Capital Markets in the Less- developed Countries: The Group Principle," in Money and Finance in Economic

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Nathaniel H. Leff

decisions taken in cognizance of backward and forward linkage effects

helps explain the speed of the adjustment process with which interrelated investment opportunities have been taken up in less developed countries.41 Finally, the coordination of investment and production decisions by the groups has both reduced the need for, and lessened the burden on, government planning of the modern sector in developing countries.

The preceding discussion has noted some of the ways in which the group pattern of industrial organization improves the efficiency of the less developed economies. However, the groups also create some serious distortions. These involve inefficiency within the group, interfirm and intersectoral distortions, and finally, political-economic effects on overall development patterns. In effect, the groups have taken factor-market imperfections in the less developed countries and transmuted them into product-market imperfections. In the process, rapid industrial growth has often occurred, but the groups have also created a special form of monopoly capitalism in the less developed countries. The associated distortions raise important problems for public policy in the less developed countries. However, that subject is so large that it requires another paper.42

VII. Conclusions This paper has drawn attention to and analyzed a neglected feature of industrial organization which has far-reaching effects on the economies of many less developed countries, the group. As noted, the groups have their origin in well-known market imperfections of the less developed countries. Mobilizing imperfectly marketed inputs, and reducing uncer-

tainty and risk with their diversified and vertically integrated activities, the groups in fact constitute the "intermarket operators" on which Lei- benstein's theory of entrepreneurship has focused. Further, in addition to its effects on entrepreneurship, the group pattern of industrial organization also permits less developed economies to relax institutional constraints in the allocation of capital and of managerial resources. Conse- quently, domestic, privately owned firms can enter and can attain efficient scale in activities which might be beyond the scope of a private, locally owned firm. And because of the groups, the modern sector in many less developed countries is far less "fragmented"-both in a static and a dy- namic sense-than might be expected from accounts which have not been

Growth and Development, ed. Ronald I. McKinnon (New York: Marcel Dekker, Inc., 1976).

41 This has also been noted, in different terms, by Albert Hirschman, "The Political Economy of Import-substituting Industrialization in Latin America," Quarterly Journal of Economics 82 (February 1968): 1-32.

2 See my "Monopoly Capitalism and Public Policy in the Less-developed Countries."

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aware of this pattern of industrial organization.43 Having described the costs of factor-market imperfections in the less developed countries, economists should hardly be surprised that an institution like the group emerged to appropriate the gains to overcoming these distortions.

This paper has also provided an example of the now well-documented point that economic theory can be relevant beyond the more advanced countries where it was first developed. Thus, standard microeconomic concepts help explain the emergence of the group institutional

pattern, a phenomenon which might easily be attributed exclusively to sociocultural or political conditions. Understanding the economic basis of the group is not equivalent to justifying the institution, however, and indeed is a necessary step for reforming it. Our focus in this paper on the

groups' effects in mitigating factor-market imperfections should not divert attention from the product-market distortions and serious problems for

public policy which this pattern of industrial organization also creates. The group institutional form clearly resembles some features of in-

dustrial and corporate organization in the more developed countries. The similarities to the conglomerate and to the large-scale multidivisional

company are evident. Moreover, some of the causes of the group pattern also overlap with those which Oliver Williamson has discussed in his work on the theory of the firm in the more advanced economies.44 Fur- ther, as we have seen, some aspects of the microeconomic and managerial reality in the advanced sector of the less developed economies are fairly similar to those of the more developed economies. Consequently, if

adapted to recognize differences such as the absence of a formal capital market, the economics of the modern firm may be more applicable to the advanced sector of the developing countries than might have been assumed. And because of the similarity in patterns of industrial organization, oligopoly theory can clearly be helpful in modeling some features of price, output, and capacity decisions in the modern sector of the de-

veloping economies.

Finally, although we have discussed some aspects of the groups in the developing countries, many important questions obviously remain unanswered. One wonders, for example, why groups or a similar pattern of industrial organization has not emerged with equal frequency in all development contexts, both contemporary and historical. Similarly, it

43 See, for example, Ronald McKinnon's description of "the fragmented economy," in chap. 2 of his Money and Capital in Economic Development (Wash- ington, D.C.: Brookings Institution, 1972).

44 See Oliver E. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press, 1975), and particularly his emphasis on the importance of small numbers, bounded rationality (uncertainty), informational asymmetry, and opportunism (and hence the need for trust).

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Nathaniel H. Leff

would be useful to have much more quantitative information on the scale and diversification of group activities and on the size distribution of groups in individual countries and its change over time. These may clearly be related to particular phases of development and government development strategies. Provision of answers to these questions and fill- ing in our picture of the groups must await the collection of detailed statistical data. As noted earlier, however, collection of data requires that attention be drawn to a phenomenon and that a conceptual framework be elaborated to analyze it. Hopefully, the present paper will help serve this prior need.

LAND ECONOMICS CONTENTS, Land Economics, Volume 54, No. 3, August 1978

ARTICLES Spatially Differentiated Air Pollutant Emission Charges: Economic and Legal Analysis T.H. Tietenberg Some Evidence on the Distribution of Air Quality

P. Asch, I.]. Seneca Externalities from Urban Growth: Increased Storm Runoff and Flooding j.R. Barnard Allocation of U.S. Coal Production to Meet Future Energy Needs

M.R. LeBlanc, R.]. Kalter, R.N. Boisvert Federal Price Regulation and the Supply of Natural Gas in a Segmented Field Market H.G. Huntington Alternative Cost-of-Capital Concepts in Regulation

B.L. Copeland Jr. Estimating Impacts of a Property Tax Reform j. Cuddington

REVIEWS CONSERVATION AND ECONOMIC EFFICIENCY by Talbot Page

Reviewers: C. W. Howe, G. Schramm

SHORT PAPERS Alternative Measures of School Desegregation: A Methodological Note C. T. Clotfelter

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nathaniel leff - industrial organization and entrepreneurship in the developing countries. the...

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