PART II

THE CENTRAL RESEARCH QUESTIONS

BASED ON LITERATURE SURVEY AND INDUSTRY OVERVIEW

The objective of this part is to raise our central research questions pertaining to the technological development of the Indian Pharmaceutical Industry.

We begin with a survey of the theoretical and empirical literature on the economics of R&D and technology generation, in chapter 2 and chapter 3 respectively. Although the literature in this area has a distinct bias in favour of developed industrialised economies, which operate at the frontiers of global innovation, there is a considerable amount conceptual and empirical analyses to suggest that minor and adaptive R&D activities in less developed economies have resulted in major economic gains and have positively contributed to their technological capabilities.

Next in chapter 4, we present a brief holistic overview of the growth path of the Indian pharmaceutical industry to set the stage for raising our central research questions, to be addressed in this thesis.

9 I

Chapter 2

REVIEW OF THEORETICAL LITERATURE

2.1 INTRODUCTION

The theoretical foundations of technological progress can be traced back to the

writings of the classical economists like Adam Smith and Karl Marx as early as the 181h

and 191h centuries. However, the classical perspectives on technology were formalised

only in the writings of Schumpeter, who incorporated the concept of technological

progress into a more formal structure of economic analysis in the context of a market

driven capitalist production system.

The Schumpeterian theory constitutes the centrepiece of later theoretical

developments on technology. However, one main cornerstone of this theory is its reliance

on technological breakthroughs and major innovations as the main source of economic

gains through technological progress. The importance of diffusion and minor innovations

has been recognised and incorporated in the economic literature much later, particularly

after the emerg~nce of Japan as an economic superpower. 1 We divide this chapter in two

broad groups, one discussing the theories of major innovations and the other presenting a

conceptual and theoretical framework for diffusion and minor innovations. In this context

we also discuss the development of an economic literature particularly addressing the

problems of technology generation in less developed economies. At the outset, however,

we present an overview of the concept of research and development, which lies at the

core of the entire process of technology generation in any economy.

The chapter is organised in the following way. Section 2.2 gives an introductory

note to research and development. Section 2.3 discusses the various strands of economic

literature on major innovations. Section 2.4 presents a theoretical framework for diffusion

1 See Rosenberg and Steinmuller ( 1988).

10

and minor innovation. Section 2.5 summarises the literature on R&D and technology

generation literature in less developed countries. The final section 2.6 is for an overall

summary and conclusion.

2.2 RESEARCH & DEVELOPMENT (R&D): An Introduction

R&D led technology generation should ideally be viewed as a production process,

where R&D effort coupled with other research inputs are transformed into research

outputs, like invention, innovation or diffusion. However, it is important to note that the

production process of knowledge through R&D is distinct from the process of commodity

production because of three unique and inherent characteristics of the former. We would

like to highlight on these three unique characteristics of R&D process at the very outset.

Appropriability:

The outcome of an R&D process can be described as invention, innovation,

diffusion or imitation depending on the field of use and the nature of the output' itself. 2

These outputs of R&D may, however, be broadly defined as generation of new

knowledge. To understand the problems of appropriability, we make a distinction

between two forms of R&D output: (I) output with no physical element (i.e. new

information) and (2) output with physically visible element (i.e. new machines). In case

of the former, one encounters serious problems of appropriability.

Traditionally "knowledge" was treated as a pure public good because of its non­

exhaustible nature- knowledge acquired by an individual is not reduced by sharing it with

others. But unlike a pure public good, a large amount of private investment is visible in

the field of research and development. Thus it must bear some private good

2 These concepts will be elaborated later.

11

characteristics .as well. Therefore, the usual appropriability conditions must hold for

effective marketing of knowledge.

The sale of new knowledge becomes problematic because of asymmetric

information. While the buyer of new information is not ready to pay the price without

knowing what is he buying, the seller can not completely reveal this information as the

buyer then will have no incentive to pay for it. The seller, therefore, has to give some

signals about the nature of the new knowledge.

IPR Regime and Appropriability:

Patents are often regarded as a mechanism through which the ownership of the

new knowledge can be procured only by partially disclosing the features of the R&D

output thereby overcoming the problems of appropriability. But it has several nontrivial

limitations. It is applicable only for a fraction of all possible R&D activities. For

disembodied process innovation and for some product innovations, the scope of inventing

around is very high (automobile components, for instance). Firms in such cases do not

apply for patents as they apprehend that even the slightest disclosure of specification

required to be submitted with the patent application, would make the output vulnerable to

imitation. There are certain other kinds of innovation where patent application is not

feasible (McDonald's burger, for instance).3 Accordingly the effectiveness of intellectual

property right (IPR) regime will vary from industry to industry. Taylor and Silbertson

(1973), for instance, found that the impact of the British patent system on inventive

activities was negligible except for the chemical and pharmaceutical industries.

There are studies, which address the welfare aspects of patents and IPR regime.

Helpman (1993) analysed the issue of IPR in a dynamic general equilibrium model with

two regions, North (industrialised countries) and South (less developed countries).

12

·.,.., ...

Innovation takes place in North but is imitated in South. If the global IPR is strengthened,

imitation possibilities are lowered and South loses out. Glass and Saggi ( 1995) developed

a similar model, but assumed that adaptation to the condition of South is costly for an

innovating firm in North. In this framework, a weak IPR of South is welfare improving

for both countries if adaptation of the technology is easy. Maskus (1997) pointed out that

countries adopt stronger patent regime as their technological capability increases in order

to facilitate horizontal transfer of technology. Mansfield (1994) found IPR regime of host \

countries to have a significant impact on the kind of technology transfer, especially in

chemical industries. Absence of adequate protection may lead to transfer of older vintages

of technologies.

The benefit~, of a weak IPR derived from widespread domestic diffusion of

technology are unambiguous. But, a weak IPR is not always costless, since it restricts

access to the latest technologies, assuming that the latest technology is important for the

country concerned. 4

Risk and uncertainty:

Though R&D is often treated as investment, it differs from the investment on

commodity production because of its riskiness and uncertainty. This uncertainty can be

thought ofhaving two dimensions: external and internal. By internal uncertainty, we refer

to the firm's inability to predict its next period's technology level, i.e., the riskiness of the

R&D process itself. External uncertainty is associated with generating funds for research

activities. For obvious reasons, firms can not reveal detailed information about its R&D

programme to a lender. The lender may not have prior knowledge of the proficiency level

of the firm and therefore refuses to lend. As a result, firms may have to depend on

3 As a consequence, many other forms of appropriation, like diversification, complementary sales and service promotion have been resorted to. These mechanisms put emphasis on the internal use of the new knowledge by the innovator himself. We will discus some of these mechanisms in due course.

13

internal liquidity to finance R&D activities or it may divert loans for production purposes

to facilitate R&D. In both cases, the total funds available for production purposes would

reduce as a result of which production may suffer. If loans available for production

purposes are diverted to other channels of riskier activities like R&D then the firm's

creditworthiness may also go down, especially if the success rate in R&D is low.

Scale of operation:

Another distinctive feature of R&D activities pertains to its scale effect. Unlike

capital and labour, R&D is likely to display increasing returns to scale. This perhaps

reflects the importance of accumulation of knowledge as an efficiency building parameter

in carrying out R&D activities. The argument of increasing returns to scale has been

refined by Nelson and Winter (1977) by categorizing it into two different sub-issues. In

the first case, research output is characterised by indivisibility. Here a minimum input

level is necessary to get any output at all. Secondly, in some cases, R&D inputs come in

indivisible units e.g. scientists with particular specialization. Thus a large research team

has the scope of finer division of labour.

2.3 THE THEORIES OF MAJOR INNOVATION

2.3.1 The Schumpeterian Hypothesis

Schumpeterian theory starts from the definition of innovation. Whereas an

invention may be defined as the first technological breakthrough in the field of basic

science, innovation is defined as the first commercial use of invention. 5 In other words,

invention may be identified with basic research (aimed at deriving fundamental

knowledge), while innovation is closely linked to applied research and development

4 Often the host country may not be interested to bring in the latest technology. The loss in these cases may not be significant. See Ray et a! ( 1999) for details.

14

(associated with engineering and commercial application) as commonly distinguished in

the literature.6 Broadly speaking, an innovation is associated with an invention with a

lag.7 According to Rosenberg (1976), Schumpeter also recognised the importance of

another form of R&D output, namely diffusion and imitation that are the subsequent

stages of the technological cycle. As opposed to invention and innovation, diffusion or

imitation do not constitute any major technological breakthrough, but their role is still

important in economics for their ability to generate substantial economic value. As

Rosenberg (1976) puts it "though it (diffusion) needs little creativity, but it adds

considerable economic value to the society". Surprisingly, however, subsequent theories

have added little to relate diffusion with R&D efforts. We shall focus on this issue later in

details.

Schumpeter explained technological progress as a disequilibriating force that

causes the economy to deviate from the circular flow model. The circular flow model

depicts the economy in a stationary-state equilibrium with perfect competition (similar to

the Walrasian state of equilibrium). Every firm is in perfect equilibrium, costs equal

income, prices equal average costs and net profits are zero. The circular flow follows

from continuous adoption of small external changes that are absorbed in familiar routines

of company behaviour. Through innovation, the economy is driven away from this

neighborhood of equilibrium. Then gradually, as the effects of innovation "wears off', the

economy settles at a new equilibrium until a second innovation takes place. 8

5 See Rosenberg (1974, 1976). 6 See, for instance, Tirole (1988). 7 Note that invention and innovation can also take place simultaneously. Schumpeter (1975(1942)) suggested that in a mature phase of capitalism, firms are able to endogenise its inventive R&D activities. 8 The Schumpeterian approach gives full credit to the brilliance of individual entrepreneurs in bringing about technological progress. But according to the Marxian framework, social conflict and class interests are believed to be the most important determinants of technological progress. To quote Marx, "A critical history of technology would show how little any of the inventions of the eighteenth century are the work of a single individual." (as cited by Rosenberg (1982), page 6). Marx suggests that technological progress acts as an instmment used by the entrepreneurial class to generate greater profits defin;:d as the surplus of value added over wage bill.

15

An innovation results in a transient monopoly structure where the first mover gets

a temporary edge over its competitors. Before diffusion takes place, during the transient

monopoly phase, the innovator enjoys super normal profits. In the Schumpeterian sense,

profit is thus a reward for innovativeness, which gets eroded as diffusion takes place.

Ultimately, we return to a perfectly competitive market structure with zero profits.9 Thus

the possibility of a long run monopoly, as opposed to a transient one was considered as a

'rare' occasion in the Schumpeterian framework. In fact, Schumpeter did not believe in

any static form of market structure. He viewed capitalism as a dynamic evolutionary

process where market structure continues to change, largely driven by 'technological

breakthroughs'. He termed this phenomenon as 'creative destruction'. 10

Primarily by technological progress of a firm Schumpeter refers to innovations

resulting in new input combinations. Hagedoom (1989) has however stated that in some

of Schumpeter's writings, concepts similar to a 'shift' in production function are used to

characterise technological progress/ innovation. We reproduce a part of his original text

to demonstrate the breath of the Schumpeterian concept of innovation or technological

progress as:

f. The introduction of a new good -- that is one with which consumers are not yet familiar --

or a new quality of good.

2. The introduction of a new method of production, that is one not yet tested by experience

in the branch of manufacture concerned, which need by no means be founded upon a

discove1y scientifically new, and can also exist in a new way of handling a commodity

commercially.

9 It may be of interest to note that in the Marxian framework profits never get squeezed to zero as it includes the returns to capital in contrast with the Schumpeterian structure where profits are a residual (attributable to innovativeness) and the returns to capital and labour are regarded as part of income. 10 Strassmann ( 1959) criticises this viewpoint. He cites example when inspite of "major innovations", industries with two generations of technologies coexisted.

16

3. The opening of a new market, that is a market into which the particular branch of

manufacture of the count1y in question has not previously entered, whether or not that

market has existed before.

4. The conquest of a new source of supply of raw materials or half-manufactured goods.

again irrespective of whether this source already exists or whether it has first to be

created.

5. The canying out of the new organization of any indust1y, like the creation of a monopoly

position (for example through trustification) or the breaking up of a monopoly position. 11

This is sufficiently broad a concept of technological progress capable of

representing technical change, diversification and a change in the element of market

structure (through creative destruction). Schumpeter's theory, however, is often narrowly

construed in the later literature only to explain the link between market structure and

R&D, and has thus failed to appreciate the all-pervasive nature of the Schumpeterian

argument.

Schumpeter's view that monopoly situations and R&D are intimately relat,ed may

be traced to two distinct, but apparently contradictory, arguments. First, monopolies are

the natural breeding ground for R&D, and secondly, its creation is a necessarily evi1. 12 To

understand why monopoly firms may supply more innovation than competitive firms, we

quote Schumpeter: 13

"There are superior methods available to a monopolist which either are not available at all to

a crowd of competitors or are not available to them readily: for there are advantages which.

though not strictly unattainable at the competitive level of enterprise, are as a matter of fact

secured only on the monopoly level, for instance, because monopolisation may increase the

11 Schumpeter (1980(1934)), pp 66 and Schumpeter (1939) pp 84-85 as cited in Hagedoorn (1989). 12 Monopoly promotes appropriation of new knowledge, but at the cost of its wider use. Hence, 1t IS

regarded as an evil. There is a clear trade-off between the dynamic gains from new knowledge and the static loss resulting from a lower monopoly output. 13It is often suggested that it was with the publication of Capitalism, Socialism and Democracy in 1942 that the importance of large firms enjoying monopoly power as engines of technological progress was recognised for the first time. This was a deviation from the spiri~ of Schumpeter's earlier writtings (Schurnpeter 1934, 1939) where new and small firms were posited as more conducive to technological progress.

17

sphere of influences of better and reduces the sphere of influences of inferior, brains. or

because the monopoly enjoys a disproportionately higher financial standing. "14

In other words, large firms are better qualified, or perhaps more eager to

undertake R&D than smaller firms because of following reasons. First, R&D ts

characterised by increasing returns to scale which a large firm can exploit better. Second,

since R&D activity involves a high level of risk that is difficult to eliminate with

insurance (for reasons of moral hazard), large firms may be more willing to take these

risks as it can diversify this risk over a wide range of product lines. Third, the production

pattern in a large firm is more systematic and routinised making it easier for them to

implement a new innovation. Fourth, a monopolist does not have any ready competitor

who can imitate his innovation or can circumvent an existing patent on his innovation.

According to Tirole (1988), however, Schumpeter remains vague about whether the

above arguments are associated with monopoly power or with bigness of firms. In this

context, Dasgupta (1986) argues that "Schumpeter seems to be saying that large ~ize has

distinct advantage" whereas "elsewhere in the same page he recognises that monopoly

and large firm size are not identical".

In most of the empirical work, the Schumpeterian theory has been broadly

interpreted as stating that "bigness and fewness encourage technological advancement". 15

According to Dasgupta (1986) the lack of clarity of Schumpeter's writing was partly

responsible for most of the empirical research attempting to establish a unidirectional

relationship between market structure and research effort, ignoring the process of creative

destruction. Fisher and Temin (1973) argued that the true Schumpeterian hypothesis is

not sufficient to ensure that bigness or fewness encourages technological advancement.

This view is shared by Dasgupta ( 1986).

14 Schumpeter (1986 (1954)) pp 107. 15 Fisher and Temin (1973)

18

To analyse the role of firm size in R&D, Fisher and Temin (1973) proposed to

examine the responsiveness of R&D output to firm size defined as:

0 = (S/RF)8(RF)/ as, where

Sis the number of non-R&D work force,

R is the number of workforce engaged in R&D,

F(R, N) denotes the value of per worker output from R&D expressed as a function

ofR and N.

Where N is the total number of workers in a firm,

A value of 0 > 1, according to Fisher & Temin, is consistent with the "broad

Schumpeterian hypothesis". However, given that 0 = (S/R)8R/8S + (S/F)8F/8S, whether

value of the research output will increase more than proportionately with firm size will

depend "not only on whether R&D inputs increase but also on whether output per unit

input does not decrease with firm size". Moreover, they also argue that interpreting the

"true" Schumpeterian hypotheses as 8F/8R >0 and 8F/8N > 0 (i.e. large R&D

departments are more productive than small (given firm size), and a given R&D spending

yields a greater return per worker in large firms than in the smaller ones), 16 does not

guarantee 0 > 1 required for the "broad Schumpetrian hypotheses" to hold. Accordingly

Stoneman (1983) suggests that if Fischer and Temins's (1973) interpretation is accepted,

then the "broad Schumpetrian hypotheses" is a misleading derivation of Schumpeter's

view. 17

According to Nelson and Winter (1977), the Schumpeterian hypotheses involve

the demand as well as the supply side of new knowledge generation. While the supply

16 According to Fisher and Temin ( 1973 ), these two relations constitute the so-called "true" Schumpeterian Hypothesis. 17Fisher & Temin's (1973) interpretation has been challenged and modified by several authors like Rodriguez ( 1979) and Kohn & Scott ( 1982). However, their basic contention remains unaltered.

19

side deals with firm size and the returns to scale in research production, 18 the demand side

focuses on the incentives to produce new knowledge. Unfortunately, most of the studies

have considered only the supply side, "and that too only in a limited manner". 19

To analyse the demand side factor, Nelson and Winter (1977) have qualified the

concept of monopoly power by distinguishing monopoly power in product market and

monopoly power in R&D output market. Both are important in determining the rewards

of innovative activity. In fact, according to Nelson, what might have played a crucial role

behind the Schumpeterian proposition that "monopolies are the natural breeding ground

for innovation", was perhaps the belief that information monopoly is not secured enough.

Therefore monopoly in the product market was sought as an alternative mechanism to

appropriate the output of research and recover at least a part of the cost of innovation.

However if information monopoly is completely secure, then the above arguments

supporting the Schumpeterian Hypotheses become weak and vulnerable.

2.3.2 The Neoclassical Models: Search for an ideal market structure

Indeed along this line, it was Arrow (1962a), who posed the first major theoretical

challenge to the Schumpeterian Hypothesis. Arrow showed that it is the perfectly

competitive market structure, and not monopoly, which is more conducive to R&D. This

result spurred off a parallel line of modelling, which is seen in the literature as an

antithesis to what Schumpeter had postulated.

Arrow compared the incentives for innovation in three kinds of market set ups,

namely socially managed economy, competitive economy, and monopoly. His findings

suggest that due to secured position in the product market, a monopolist has generally less

18 Nelson, unlike other, acknowledged the Scumpeterian process of creative destruction and suggests that size distribution of firm can not be viewed as static. Nelson's view on the returns to scale in R&D has already been discussed earlier. 19 Nelson & Winter (1977)

20

incentive for innovation. He found socially managed system as most favourable for R&D

activities ranking even higher than a competitive firm. This is because a social planner

can trace the source of externalities (like rise in labour productivity due to learning by

doing) which an individual firm under a competitive structure can not. Arrow (l962a)

essentially compared the surplus that an innovating firm can extract following an

innovation under different market forms. He showed that this appropriable surplus is least

for a monopolistic producer who therefore has the least incentive to innovate.

According to Nelson and Winter (1977), Arrow's (1962a) conclusion is based on

the assumption of a completely secured property right in the information market. But this

can be questioned. It is now perhaps well-established that information monopoly is not

secured, especially in disembodied process innovation, which Arrow had considered.

Nelson and Winter (1977), therefore, argue that the incentive for innovation might

justifiably lie on appropriating some returns before imitation takes place, which may be ~~~1

facilitated by monopoly power. X X. ( L.-)() :); "-&1-·4'-f ' \o I

Moreover, Arrow did not consider the threat of potential entrants in a monopoly

set up. In this case, the monopolist actually replaces himself as a cheaper production

source with innovation, an effect known as replacement effect. However, if there is a

threat of potential entry, a monopolist may actually be thrown out of the market if the

entrant gets hold of an innovation, which is drastic in nature.20 This would encourage

innovation by the monopolist through the efficiency effect. Therefore, the incentive to

innovate in monopoly markets would perhaps be higher than what Arrow had postulated.

Stiglitz (1986) criticised Arrow's (1962a) construct because of its partial

equilibrium framework. He has also argued that for a more meaningful comparison

between different market structures one should characterise two economies by two

THESIS 338.095412

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different market structures rather than dividing total economy into several market

structures. He has shown that if labour is taken as the only factor of production and if

there are two economies, one characterised by monopoly and the other by perfect

competition, then research intensity would depend on the elasticity of labour supply. If

we further assume inelastic and identical labour supply (particularly, production labour)

in both economies, then pre-innovation output would be the same in both (not less in

monopoly). Thus the assumption of cost spreading advantage of the competitive economy

(to appropriate the innovation) would not hold any more.21

Arrow (1962a) deals with one innovation already made. The process leading to

that innovation is not analysed. We now discuss some of the later literature, which

incorporates this phenomenon. Most of these models assume an oligopolistic market

structure, and thereby possibly weakening the seemingly obvious one to one

correspondence between market power and monopoly.

Dasgupta & Stiglitz (1980) assumed a process innovation with all firms behaving

identically. This identical nature of all firms causes diffusion to take place

instantaneously.22 Instantaneous diffusion provides a negative impetus for firms to

undertake R&D activities. While Arrow (1962a) considered technological choice to be

discrete, Dasgupta and Stiglitz (1980) argue that firms may be interested in marginal

(continuous) changes. This could be a marginal decrease in cost or a marginal increase in

risk or a marginal increase in the speed of research. They have also criticised the "neo-

20 Drastic innovation are those which result in post innovation monopoly price to be strictly less than the pre-innovation marginal costs, thus driving out all competitors after innovation. See, for instance, Tirole (1988) chapter 10. 21 Stiglitz has also questioned another result of Arrow (1962a), namely the incentive to innovate would be the maximum under a social planner. He argued that to maintain subsidy in R&D, the social planner (effectively government) will have to collect revenue and there could be a distortionary effect of govt revenue collection. In that case the appropriable surplus would be less than what Arrow liad shown. 22 Gomulka ( 1990) argued that if this was not the case, the innovating firm, in the absence of imitation, could have derived a considerable advantage to exploit ~cale economies in R&D. This would have resulted in ti1eir gaining con:>iderable market power which would lead utlimately to a monopolistic market structure.

22

Schumpeterian" view, which considers market structure to be exogenous. 23 According to

them, market structure and research intensity are simultaneously determined and there are

other theoretical dimensions which affect a firm's technology decisions. In particular,

demand elasticity, nature of capital market and the cost and nature of R&D have

important bearing on firm's technology decision besides concentration and market power.

Some ofthe results derived in this paperin the context of R&D in an oligopolistic market

structure are discussed below.

In an attempt to endogenise market structure, market equilibrium with free entry is

assumed. The firms are typical profit maximisers and the number of firms is determined

by the zero profit condition at the margin. If the number of firms is large, they show that

at the margin (with free entry) industry profit equals total industry R&D expenditure (non

zero). This means each firms in equilibrium enjoys a mark up of price over costs and thus

holds some amount of monopoly power. This is in line with the Schumpeterian argument

that monopoly power is necessary to do R&D. To quote Dasgupta and Stiglitz (1980),

"since R&D involves fixed cost we can not expect an industry engaged in it to be

characterised by perfect competition."

It has also been shown that high concentration is associated with high research

intensity, for a given elasticity of demand. In this model, the elasticity of demand does not

play any direct role in determining optimum research intensity (Z*) of the industry, but it

determines the level of concentration (measured as inverse of the total number of firms).

High elasticity would result in smaller number of firms, which therefore indirectly results

in a high Z*.

Another result of Dasgupta and Stiglitz ( 1980) supports Schmookler' s ( 1962)

view that growth in demand serves as a stimulus to R&D activity geared towards cost

23 The neo-Schumpeterians are "concerned with a possibh: causal flow . . . from market structure to technological innovation". (See Scherer (1980) as cited in Dasgupta and Stiglitz (1980) pp 266).

23

reduction and quality improvement. They captured the level of demand by the size of the

market, and found a positive relationship with firm's R&D expenditure. 24

By assuming entry barrier, Dasgupta and Stiglitz (1980) have also tried to explain

whether an increase in the number of firm results in higher cost reduction. Their finding

suggests that following an increase in the number of firms total industry research

increases but R&D of each firm goes down. This was interpreted as a rise in wasteful,

duplicative research activity.

In order to explain the relation between market structure and speed of research,

Dasgupta and Stiglitz (1980) also constructed a model of patent race in the absence of

uncertainty. 25 It is shown that if the first winner is granted patent, 26 and with the

possibility of potential entry, active firms in the race would hold Cournot conjecture

about themselves but would operate at the entrants reaction curve, signifying Stackelberg

conjecture. Ultimately market will be characterised by "at most one firm doing R&D".

But it should be noted that this phenomenon (only one firm doing R&D) does not; in any

way, reflect that competition is weak. In fact, it is the result of intense competition. The

apparent similarity of this result with the Schumpeterian hypothesis is only limited to the

creation of transient monopoly that any major innovation brings about.

Thus to summarise, this model considers a wide array of theoretical determinants

of nature and direction of R&D activity. Although they have endogenised market

structure, but the static nature of their model fail.s _to capture the dynamic interaction

between R&D and market structure in an effective manner. 27 Though they have

acknowledged the role of monopoly power to facilitate R&D, their result is by no means

24 If o: is the elasticity of cost reduction and ~:: is inverse elasticity of demand, then equilibrium solution requires 1:: > o:(l-~::). Inelastic: demand (high~::) is favourable for the equilibrium condition to hold. 25 Models incorporating uncertainty is discussed by Kamien and Schwartz ( 1978). 26 We have already argued that effectiveness of patent protection in process innovation is not unquestionable.

24

"Schumpeterian" as the latter explicitly considered a monopolistic market structure as

opposed to an increase or decrease in market concentration in an oligopolistic market

considered in this model. In fact Dasgupta and Stiglitz (1980) suggest that the "pace of

innovative activity must be traced neither to the degree of concentration nor to the degree

of monopoly in the industry in question, but to more basic ingredients like demand

conditions, ... nature of the capital market etc".28

According to Stoneman & Leech (1980), the Dasgupta-Stiglitz model suffers from

certain limitations; it considers only one innovation to be innovated at a time; it also

considers only process innovation. They argued that the static nature of the model also

inhibits the accumulation of knowledge. Accordingly, Stoneman and Leech (1980)

developed a model where.a firm's R&D expenditure can either be directed towards cost

reducing process innovation or to a demand-stimulating product innovation.

Their model suggests that:

1. If innovation is of cost reducing type then, keeping other things unchanged,

R&D to sales ratio would be negatively related with market share.

2. R&D to sales ratio varies negatively with the expected retaliation. (i.e. spill

over reduces research effort).

3. The more productive the R&D process, the greater is R&D to sales ratio.

4. A higher R&D expenditure to sales ratio is associated with higher economies

of scale and lower discount rate. 29

The first and second results seem to contradict each other. Larger market share

should imply less scope of spill over and therefore a higher R&D to sales ratio according

27 As a proxy for time dimension they resorted to cross section comparisons among markets with varying degrees of monopoly and research intensity. 28 They subscribe to the view that if firms have to fund R&D activity internally in the face of capital market imperfections, then the size of the firm does matter. 29 The discount rate shows how one values the future vis-a-vis the present; a low rate necessarily implies a higher value attached to the future and therefore encourages a firm to undertake R&D expenditure.

25

to second result. But first result suggests the opposite. Cowling (1972), made an attempt

to reconcile these two arguments by saying that ideally retaliation increases with

concentration up to duopoly level, causing R&D intensity to fall up to this point. But then

R&D intensity should be very high at the monopoly level in the absence ofretaliation.30

There exist another strand in the literature, which attempts to relate R&D

expenditure with the date of innovation. Higher the rivalry, shorter would be the

development period requiring higher R&D expenditure. Kamien & Schwartz (1980)

suggest that as rivalry increases, innovations would be introduced more rapidly. But there

is an inflexion point of rivalry, up to which this trend continues and beyond which firms

start postponing the innovation date.

2.3.3 Internalisation vis-a-vis Networkin~

Internalisation of R&D

Both the schools of thought, the Schumpeterian and the neo-classical, emphasise

upon relationships between size/ market structure and R&D. However, one basic point

needs to be addressed at this juncture: why is it necessary to intemalise the R&D effort of

firms? The neoclassical paradigm has sought to find the answer in terms of transaction

costs and principal-agent problem.

Transaction cost arises out of bounded rationality. If R&D is contracted out, an

agreement must be reached involving a transaction (of research outcome) to be carried

out at a future date. Due to bounded rationality, it is difficult for the contracting parties to

specify all contingencies that can arise in this transaction. This affects transaction costs in

two ways. First, it increases the ex-ante cost of drafting a suitable contract. Secondly, it

30 It is often postulated that extent of retaliation varies with firm size where smaller firms may expect greater retaliation from their larger counterparts as "larger firms often undertake protective R&D or build excess capacity". (Freeman (1965), as cited in Stoneman (1983) pp 37). Thus any defmite result is difficult to p:edict.

26

raises the ex-post cost of administration to amend the contracts in case of unforeseen

contingencies. In this context, Kreps ( 1990) distinguishes between self-interest and

opportunism. An opportunistic behaviour is different from self-interest in the sense that

the former arises out of the dishonesty on the part of contracting parties unlike the latter

(which is simply a reflection of the assumption of "rational individual") and results in a

typical principal-agent problem. While transaction cost arises out of the incapability of

the contracting parties to take care of all possible contingencies (for spot as well as

forward transaction), the principal agent problem arises because of the possibility to

violate the laid out norms by the contractee due to their opportunistic behaviour. 31

It is well known that appropriation, tacitness of knowledge and uncertainty are

central issues in any technology transaction. Hence problems of transaction cost and

moral hazard arise in research networking. DeBresson and Am esse ( 1991) highlight that

costs arising out of the threat of leakage (of knowledge) is particularly true if both the

parties are potential competitors in the final product market, since network is often a very

"loose and decomposable system". 32

However, research networking and collaborations takes place, all these problems

notwithstanding. In a comprehensive survey of the literature on networking, Debressen

and Am esse (1991) point out that synergetic creation of knowledge through interaction,

dynamic technological accumulation, and social learning are the three major thrusts of

networking, especially when uncertainty is very high. 33 In this context the transaction cost

theory has been criticised as "insufficient" because of its lack of focus on these

prospective dynamic gains of networking. In fact, durable networks are believed to reduce

opportunistic behaviour to a great extent and thereby minimise the principal-agent

31 Note that the contracting parties may be completely rational in this case. See Kreps (1990). 32 Other main costs are the costs of coordination. See Hakansson (I 989), Smith et a! (I 99 I), and Szarka (1990) for some explorations of hierarchy in networking resulting in take-over or break down of networking.

27

problem.34 If indeed these dynamic gains are realised, then one can argue in a nutshell

that dynamic gains from flexibility in the size of investment (and sunk cost) and a broader

scope of technological exchange may outweigh the static transaction costs of networking.

This may raise the relative benefits of networking vis-a-vis internalisation ofR&D.

Intemalisation of Production vis-a-vis Subcontracting

The threat of leakage of knowledge generated through R&D also comes from

production networking. According to Williamson ( 1985) problems of transaction cost

play an important role in shaping the structure of production organisation as well. Firms

may want to integrate vertically in order to minimise transaction costs. However, there

are other explanations of vertical integration as well. Foreclosing rival firms from

accessing scarce raw materials, creating other forms of entry barriers and attempting to

increase monopoly power are some of them. Stigler (1951) presented a life cycle

explanation to this issue. In his opinion, urge for vertical integration increases both at the

initial phase and the late phase of an industry's development. At the initial phase, a

product is untried and untested, and many technical problems may have to be overcome.

This is perhaps best tackled when the firm has control over its entire production

organisation. At the late (declining) stage, integration is preferred since supporting and

complementary industries also decline along with the industry in question. Williamson

(1985) however, predicts a reduction in the vertical integration at the matured phase of

development of an industry. Blair and Kaserman (1983) believe that uncertainty can

cause vertical integration as upstream firms can eliminate demand variability due to the

behavioural uncertainty of . the downstream firms. 35 There may be additional

33 See Lund vall ( 1990), White ( 1988), Pavitt et a! ( 1989) for details. 34 Sax en ian ( 1991) also points out that trust is the single most important factor behind persistent networks. 35 Kathuria ( 1996) argues that a part of this behavioural uncertainty can also be explained in terms of transaction costs.

28

considerations with regard to vertical integration in less developed economies, which we

discuss later in section 2.5.

All the above arguments notwithstanding, contract manufacturing continues to

remain as an important form of production organisation, perhaps due to a natural limit to

vertical integration. Indeed, contract manufacturing involving two given parties can prove

to be a stable form of production networking if we consider the learning costs associated

with making a contract. As Lundvall (1988) argues, building up of a contract involves a

learning process and hence breaking an existing contract proves to be costly as it nullifies

the efforts already made to build up a relationship by two parties. Citing Arrow ( 197 4 ), he

compares establishment of codified information flow with investment on physical capital,

where development of common code is time consuming and involves learning. This

creates an inertia to switch contracting parties, if both contractor and the contractee are

risk averse in nature.

2.4 THEORIES OF DIFFUSION AND INCREMENTAL INNOVATION

2.4.1 Models incorporatine Diffusion

The neoclassical models in the Arrovian tradition (following Arrow (1962a)) gave

less than necessary importance to diffusion as an R&D output. Neither the time cost nor

the research cost involved in the diffusion process received adequate attention in these

models. A possible reason could be found in the underlying concept of 'drastic

innovation', where the monopoly price charged by the innovator is lower than the

previous marginal cost threatening to drive the competitors out of the market. The means

the competitors will have a very high incentive for instantaneous imitation at whatever

cost. This is perhaps why these models assumed instantaneous diffusion without

29

explicitly taking into consideration the costs involved.36 Hagedoorn (1989) notes that

technology is often subject to considerable modifications and changes during its diffusion

process. This continuous change of a given technology may actually be the outcome of

in-house R&D at firm level geared towards 'minor' innovation (which we discuss later at

length).

Stoneman (1987) identified three prevailing approaches to analyse the

phenomenon of diffusion. In the first (information based) approach, diffusion essentially

reflects a process of information acquisition and learning. A new technology is not

adopted instantaneously because all relevant information about the new technology is not

readily available to potential users. It is assumed that the number of potential users is

fixed. The time path of diffusion reflects learning by each of the potential buyers, which

can either be an epidemic process or a bayesian process. The former process assumes the

expected future profit and firm size to remain fixed during the diffusion process, only the

degree of uncertainty regarding the expected future profits declines with diffusion over

time. The latter process assumes continuous revision of firm-size and expected profits in a

Bayesian manner, thus making the number of end users endogenously determined.

In the second (difference-based) approach, on the other hand, firms are assumed to

have the necessary information regarding new technology. But inter-firm difference exists

in terms of either their financial capability or their valuation of the new technology. The

cost of acquiring the technology is also assumed to fall over time. In this approach,

adoption decision (and the time of adoption) is determined by the equilibrium condition

of marginal cost of adoption being equal to the marginal benefits derived. In both of these •

approaches it was assumed that benefits from adoption is independent of the number of

the users.

36 Tirole (1988) shows that there can be a case where a non-drastic innovation will never be imitated in a Bertrand competition framework with identical costs.

30

This last assumption is discarded in the game theoretic approach, where the

benefit from the new technology is believed to vary with the number of users. If X is the

number of users at any point of time, then g(X) is the valuation function where 8g(X)/8X

is generally assumed to be negative. Thus there is an incentive to be the first user. If,

however, 8g(X)/8X >0, then the diffusion process will not be automatic and some form of

governmental intervention would be required to start the process.

Stoneman (1987) also introduced the supply side of the diffusion process along

with its demand side to endogenise the price of the new technology (to be determined by

the interaction between demand and supply), hitherto considered as parametrically given.

The introduction of the supply side makes it possible to examine the welfare gains/losses

of diffusion defined in terms of consumer and producer surplus.

Using this demand-supply framework, Stoneman (1987) fommlated a two-period

model of diffusion. In this model, diffusion can occur only through the sale of capital

goods, assuming that information about the new technology is not saleable separately.

Since new technology (assumed to be a process technology) reduces cost of production,

supplier industry can hope to extract the surplus generated by the use of new technology

(for simplicity we may assume it to be the difference between constant marginal costs

before and after adoption). Thus profits of the supplier industry is generated through

R&D resulting in new technology. Stoneman (1987) also derived the optimum diffusion

path under different market forms using the difference-based approach. One may note

that if the producer of a ~ew technology is also a producer of the commodity produced

with that technology, in violation of Stoneman's assumption, then the incentives for

technology diffusion through sale of technology/ capital goods may disappear.

Cohen & Levinthal (1989) explicitly considers the role of in-house R&D in order

to enhance absorptive capacity and better assimilate knowledge available in the public

31

domain. They argued that "R&D not only generates new information, it also enhances the

firm's ability to assimilate and exploit existing information." This role, according to

them, "would change the traditional (negative) relationship between spill-over and R&D

incentive into a positive one".37 Then, besides the information generating aspect of R&D,

they consider absorptive capacity building dimension of R&D as well. The absorptive

capacity (or learning) is, therefore, endogenised in this model. One should note that

learning through R&D, as conceptulised here, is different from learning by doing. 38 The

latter is related to gains in efficiency for a given technology, whereas the former refers to

a change in the absorptive capacity implying a change in the technology level of a firm.

In-house R&D is expected to enhance the firm's capability to extract and exploit outside

knowledge as well as its ability to access intra-industry spillover. Outside knowledge

refers to technology embodied in suppliers' machines or generated through research at'

universities and governmental organisations.

The model defines Zi, the i-th firm's stock of scientific knowledge as:

Z; = M; + Y;(BLMj + T) j#

where e = the extent of spillover. 0 < e <1.

Mj = jth firm's R&D investment,

T =extra-industry (outside) knowledge,

Mi = ith firm's (concerned firn1) investment in R&D

Yi = fraction of knowledge in the public domain that a firm IS capable of

assimilating and exploiting, i.e:, the firm's absorptive capacity.

The model assumes gross return to Zi to increase at a diminishing rate (oll/oZi >0, and

37 Cohen & Levinthal (1989), italics own.

32

......

Again Yi = Yi (M, p) (with YM >0 and YMM< 0 ). P is the characteristics of extra

industry knowledge like the complexity of knowledge. It is assumed that. When outside

knowledge is less targeted (generally the research at university level or that in the basic

science area) to a firms requirement, R&D should be enhanced to maintain a given level

of absorptive capacity. Higher values of p are therefore associated with a greater

dependence on own R&D to acquire absorptive capacity. This is because with higher p,

first of all, the marginal impact of R&D is higher, and secondly, firms would tend to

increase R&D as less absorptive capacity can be acquired from a given R&D if outside

knowledge is more complex.

One important aspect of the model is that it acknowledges firms' need to rely on

own in-house R&D effort even to access existing intra-industry knowledge. In this regard,

it is a development over the information-based approach, which considered only the time

cost to explain diffusion.39

In this model, a firm is a typical profit maximiser in a static framework. The

model obtains three results using comparative static analysis. The results pertain to the

direct effects on R&D of (a) ease of learning (b) intra-industry spill over and (c)

teclmological opportunity.

Result (a) describes that there is positive relationship between a firm's incentive to

conduct R&D and the complexity of knowledge (p): its own R&D becomes more critical

\

to build up absporptive capacity as p increases. Also a rise in p reduces the competitors'

levels of absorptive capacity and therefore their ability to exploit the knowledge base of

the concerned firm. This reduces the threat of leakage and provides additional incentives

for this firm to conduct R&D.

38 Arrow (1962b) made a pioneering attempt to introduce and formally incorporate the concept of 'learning by doing' into mainstream economic theory.

33

Result (c) shows that when absorptive capacity is not endogenous to the model,

own R&D can be seen as a substitute to technological opportunity. But when we

endogenise absorptive capacity, firm's R&D effort tends to increase as firm has to put an

extra effort to acquire extra knowledge available now in the public domain. Therefore

result is ambiguous.

We now focus particularly on the second effect (result b) pertaining to intra-

industry spill-over, which gives a new insight into the variations m firm-level R&D

effort.

MaxTJ => dDildM = Oyields M

Equating marginal return to own R&D (R) with per unit cost of R&D would give us

optimum level of M* for each firm. To get the effect of R&D investment following

increase in e, model uses sign Re to represent Sign (8M/8 9)

First effect is that benefit due to increase in the absorptive capacity and second

effect is the loss of appropriability as spill over increases. When absorptive capacity is an

endogenous variable, increase in e raises absorptive capacity of all firins. The desire to

assimilate the knowledge generated by other firms provides a positive incentive to R&D

with rising e. However, rising spillover could generate a disincentive to the firm's R&D

as rising e implies a rise in the degree of exploitation (y) by all firms of the i-th firm's

R&D output. Since y<l, the second effect is expected to be weaker and the total effect is '

likely to be positive. This iikelihooci increases with higher p (implying greater impact of

own R&D on absorptive capacity). The model also suggests that this positive effect of

39 Although the importance of learning was acknowledged in the information-based approach, it failed to

34

spill over increase with higher demand elasticity and lower market concentration.40 This

may be because of the fact that with an increase in competition the private loss associated

with spill over falls relative to the private gain from exploiting competitors spill over.

2.4.2 The Evolutionary Models: Incremental Innovation

Nelson and Winter ( 1982) adopted an evolutionary framework to explain

innovations and technological progress, where the equilibrium adjustment process

following an innovation is modeled as a gradual and evolutionary process. This is in

contrast with the neoclassical approach, where innovation is followed by instantaneous

diffusion and firms and industry attain equilibrium almost instantaneously. The

evolutionary approach also acknowledges the role and importance of incremental

innovation in technological progress. The framework subscribes to the view that firms

need to invest on R&D even to imitate an already existing technology, somewhat similar

to the idea of creating absorptive capacity put forward by Cohen and Levinthal (1989).

The evolutionary model is characterised by the existence of inter finn differences

m technology level with market structure as endogenously determined in a dynamic

framework. The model considers non-price adjustment as an important mechanism to

arrive at equilibrium along with the usual price adjustment mechanism emphasized by the

neoclassical paradigm. This framework proposes that even with a constant input price,

R&D may alter the input proportion by changing the decision rule of a firm.

This non-price decision rule parameter can be affected by exogenous shocks that

affect the economic environment. According to Nelson (1986), the 'oil shock' in the

1970s resulted in a situation where many firms had taken up R&D without knowing the

likelihood of success at all. So, it was, contrary to the neoclassical view, more than a mere

capture the explicit R&D costs needed for this learning process.

35

search effort from a known outcome set.41 This 'shock' had thus surely resulted in a

change in the market structure where winners started dominating and losers got squeezed

out of the market. This example realistically reflects the uncertainty of R&D outcomes. It

is also argued that firms need to invest in R&D even to capture the knowledge available

in the public domain.

Due to all such possible manifestatig_n of risks and uncertainty the assumption of

perfect capital market does not hold good. We have already discussed that there may be

situations where outside funding becomes difficult to tap and firms have to rely on

internal fund raising capacity in order to carry out R&D. Thus, according to the

evolutionary model, large firn1s are in a better position than small firms, because the

former enjoys a larger stock of internal capital. Large firms also enjoy an edge in

appropriating process innovation, as it can spread its research cost over a larger output

level.

Nelson and Winter ( 1977) acknowledge the possibility of inter industry

differences in the potentiality of technological progress. The different levels of

technological potentialities have been defined as 'latent productivity', which is governed

by external factors like progress in basic science etc.

Nelson ( 1987) argued that explicitness and high level of understanding of the

technology, which might have resulted in instantaneous diffusion is a gross simplification

of reality. He suggests that firrhs, especially in developing countries, are "idiosyncratic"

and behave quite cautiously before adopting a technology new to the firm42.

Gomulka (1990) presents a variant of this model in the evolutionary tradition. A

firm undertakes research keeping in view two options: one is to innovate a new

40 This in contrast with the result of Dasgupta and Stiglitz ( 1980) where as number of firms increases total industry level R&D increases but R&D by each firm decreases. 41 See Gomulka (1990). 42 See also Lall (1987).

36

technology and the other is to imitate a technology already existing in the market. This

model recognises inter-firm differences since imitation is neither costless nor

instantaneous. One has to undertake some level of R&D to understand the rival's

technology.

Firm j 's existing technology is defined by its constant labour and capital

coefficients (aLj,aKj) and its scale of operation (indicated by Capital Stock, Kj). Capital

stock is assumed to be fully utilised. Thus stock of capital determines the levels output

and labour. The wage rate (w) is the single endogenous price in this model, determined by

L 5(w) = L. The model uses the behavioural assumption where capital stock and therefore

size of a firm expands or shrinks following profit or the loss incurred by the firm,

respectively.

A firm's technology search can take two alternative routes: innovation and/or

imitation. In the first route, the probability of identifying a new technology h1 is Ps(h1)

and it is assumed to be a declining function of the distance between h1 and ho, the existing

technology level:

In the second route the same probability, but now obtained through imitation, is defined

as Pm (hi) and it is assumed to depend on the share of output accounted for by firms using

h1 in the current period. Combining the two, the probability of discovering a technique h1

is given by:

P (hi)= APs(hi) + (1-A)Pim(hi) where 0:::; A:::; 1

In case of research, a firm is trying to improve the productivity level of the

industry. But in imitation it searches for the best available technology level without

pushing the technology frontier any further.

37

R&D expenditure is assumed to be directly proportional to sales, thus giving an

opportunity to larger firms to grow even larger. But as the gap between the firm's

productivity level and the latent productivity of the industry narrows down, the scope of

any further productivity gain reduces and therefore reversing the advantages to smaller

and relatively unproductive firms.

The Evolutionary approach therefore differs from the Schumpeterian approach

with regard to two specific dimensions. While the Schumpeterian theory postulates

definite reasons for success or failure defined in terms of firm size or entrepreneurial

excellence, the evolutionary approach (by Nelson and Winter) does not identify firm­

specific variations in R&D decision making. It emphasises on the distance between the

existing and targeted technology levels as main determinants of the probability of success

or failure: larger distance reducing the probability of success. This model, therefore,

views technological progress in a continuum giving particular importance to minor

changes at the margin (incremental innovation) as opposed to the Schumpeterian

proposition of 'major breakthroughs' in the process of technology generation. It is this

concept of incremental innovations introduced by evolutionary models, which forms the

backbone of the conceptual foundation for technology generation in LDCs.

2.5 TECHNOLOGY GENERATION IN LDCS

The Schumpeterian and neoclassical theories of innovation and technological

progress evolved against the backdrop of developed industrialised economies, which

operate on the frontiers of global technology and are actively involved in the generation

of new technology. Less developed economies, on the other hand, were believed to be

only a passive recipient of technologies from the developed economies in the mature

38

phase of the product cycle.43 This phenomenon was justified on the ground that

production of technological output requires skilled labour as well as capital. LDCs are at

a disadvantage vis-a-vis developed countries with respect to both of these factors.

Moreover, the demand for new technology-intensive goods generally comes from high

income consumers, which again is scarce in LDCs. This implies that there would not be

adequate supply as well as demand incentives in LDCs for producing new-technology

products, and therefore the countries would only be concerned with the production of

standardised commodities.

The product cycle paradigm, predominantly propagating for the transfer of

standardised technology from developed to developing countries, has come under

frequent attacks. Theoretically, it has been challenged on grounds of differences in market

size, consumer tastes and, most importantly, factor proportions and shares between the

two sets of countries, and thereby making the process of technology transfer far from

being smooth and easy as presumed by the product cycle theory.44

The major empirical challenge to the established technology gap v1ew m the

product cycle paradigm was posed by Japan, which emerged in the late 1960s in the

forefront of global technological activities. Ironically, the overwhelming acceptance of

this "product cycle" view was to a great extent responsible for USA's inability to

understand the real reason behind Japan's growing comparative advantage over the USA

in some of the major industries.45 This phenomenon was initially attributed to Japan's low

labour cost, in the line with the product cycle theory. Only later, it was accepted that

43 See Vernon (1966) 44 Stiglitz (1987) is, however, sceptical about the argument of differences in factor shares invalidating the product cycle proposition. Particularly, when there is an absolute dearth of skilled labour, their shadow price may well exceed the market price. Hence, there may be situations where the direction of technological progress of developed as welt as developing countries would be the same. Essentially his argument boils down to the simple proposition that technologies suited to developed economies may also be suitable to LDC conditions. 45 See Rosenberg and Steinmueller (1988)

39

Japan's capability to understand and "invent around" a given technology was responsible

for this remarkable growth in its competitive edge over the USA.

This realisation resulted in a shift of focus to indigenous technology generation as

an important source of technological competitiveness of developing countries.

2.5.1 Minor innovation

Japan's competitive edge over US in the 1960 should not be interpreted as Japan's

capability to produce major innovations (or frontier research) better thanUS. 46 Indeed,

equating technological progress with the movement of frontier brings us to a new debate

regarding the economic definition of an "innovation", initiated by Rosenberg (1974,

1976), Rosenberg and Steinmueller (1988) among others. According to these writers, a

technological breakthrough need not be called an innovation in economics if it does not

generate sufficient economic value. In their view, the developmental portion of R&D is of

crucial importance to an economic agent. It is this development over the~ initial

breakthrough, which generates economic value and not the basic innovation itself. This is

also argued to be consistent with the Schumpeterian view of innovation, emphasising on

its economic value or commercial use.47

Lall (1987) also argues that "considering technological progress only as a

movement of the frontier is a highly simplified neo-classical view because 'major

technological innovations' are not the only, perhaps not even the main, source of

productivity improvement in the history of industrial development. .. and ... minor changes

to given technologies - to equipment, materials, processes and designs - are vital and

continuous source of productivity gain in practically every industry". In fact, since LDCs

do not usually operate on the frontiers of global technology, major innovations are almost

46 In fact, Fransman (1984) has pointed out that "in general, LDCs very rarely produce products and processes that are in a fundamental sense new to thP- world".

40

I

non-existent and certainly not a constituent of their productivity gams. Only mmor

innovations act as instrument of growth and technological progress in LDCs.

2.5.2 Technological Capability: Know-how and Know-why

One can argue in line with Bell (1984) that technological effort of LDCs should

ideally be viewed as "conscious use of technological information and the accumulation of

technological knowledge, together with other resources, to choose, assimilate and adapt

existing technology and/or to create new technology". Lall (1985) calls this technological

capability. More specifically, he defines technological capability as the capacity to select,

assimilate, adapt and improve given (imported) technologies. Indeed, adaptation of

foreign technology to suit the local conditions constitutes a prime motive behind in house

R&D operations by LDC firms. This adaptation may take the form of scaling down of

production to suit the demands of a smaller market size, changing production

specifications to suit local climatic conditions or taste and preferences of local consumers,

or substitution of imported raw materials by domestic ones.

Following Lall (1985), we can categorise technological capability as "know-how"

and "know-why". Know-how is acquired through "not only the assimilation of impm1ed

techniques (which itself can be a lengthy and active learning process) but also quality

control (which also involves active technical effort), improved plant layout and

production practices, slight modifications to equipment and tooling, troubleshooting, the

use of different raw materials and so on",48 all of which can be summarised as production

engineering. Know-why is the next stage of technological development, which involves

the understanding of the nature of the process and product technologies leading to the

development of new improved designs. Applied research and frontier R&D leading to

major innovations follow this stage.

47 See Rosenberg (1976) 48 Lall ( 1985), page 116.

41

This multidimensional character of technological capability is also reflected in

Adboye and Clark (1997): "it (technological capability) comprises of conventional

economic aggregates such as investment as well as institutional context within which this

takes place .. .It is closely related to the pattern of linkages across sectors and fim1s. It

operates ... both at micro and at macro level."

In a recent attempt, Evenson and Johnson (1998) has classified developing

countries into six levels of technological capability. Countries belonging to the lowest

three levels of technological capability generally do not undertake any R&D work.

Though a little bit of R&D work is visible in the third level, it is mostly directed towards

pirating of trade marks and design. In these three levels, production technology is

essentially purchased in an "inter-linked" contractual form. In the fourth and fifth levels

of technological capabilty, the dominant objective of firm level R&D is to facilitate

technology purchase, directly (licensing) or indirectly.49 Here the role of R&D is to create

absorptive capacity to understand and adapt and implement the purchased techllology

successfully. Some adaptive invention is undertaken, usually stimulated by domestic

intellectual property rights. The technological competence developed through R&D in

these countries is instrumental in initiating activities of reverse engineering or imitation.

In the sixth level of technological infrastructure, imitation is generally taken up as a

conscious policy of technology generation through a more structured "buy-then-imitate"

strategy. According to this classification by Evenson and Johnson (1998), India falls into

the fifth level of technological capability.

Lall (1990) also acknowledged the possibility of difference in the levels of

technological capability among developing countries. He points out "even if the

motivations and determinations of firm level behaviour were essentially same ... (the) end

49 It has been argued often that good technological capability is required even to get superior quality technology from abroad (Adboye and Clark,l997)

42

result... would differ. Firms would be starting from different levels of development, skill

content. .. and within different demand structure. The structure of incentive, factor

market. . .institutions would differ. And of course social, political and cultural traditions

would be different".

By introducing the concepts of know-how and know-why, Lall has basically

broadened the definition of technological output whereby a research unit need not come

up with a very different product or process but still be acknowledged as an innovator, of

albeit "minor" rather than a "major" innovation.

Similarly, Katz (1984) has also emphasised the need to broaden the definition of

technological output. For instance, adaptation of foreign technology in a domestic

environment, substituting foreign raw materials by a domestic one, change in the market

structure should all be treated as part of an innovative process in any growing market. In

one of his case studies analysing the extent and nature of technological activities of Latin

American firms, Katz noted that in the early years of a firm's operation, the focus is on

product modification and product differentiation. In this period, the firm generally

concentrates on adapting an existing product according to consumer tastes. Later, it thinks

of changing the process of production. Katz extended the concept of technological

activities to include even changes in the organisational planning, which is consistent with

the broad Schumpeterian concept of technological progress already discussed in section

2.3.1. Katz further observed that at a much later stage firms introduce changes in its

approach towards marketing, corpor&te planning, organisational restructuring (opening

new departments for better division of labour) and R&D decision.

Importance of internal organisation has also been explained by Williamson

(1975), who suggests that "measures of internal organisational structure will eventually

43

be joined with measures of market structure in attempting to explain conduct and

performance in industrial markets and subdivisions thereof. "50

Consequences of Technological Capability

The improvement in technological capability can have far reaching economic

impact. In this thesis we limit our analysis to export perfom1ance as a result of

development in technological capability of an industry. Since technological development

has often been seen as synonymous to reduction in marginal cost of production, it may

lead to an increased export competitiveness.51 Krugman (1979), in the line with Posner

( 1961) and V em on ( 1966) argued that technological factor can augment the export

performance ofLDC-firms only at a matured phase of product cycle, when its technology

becomes standardised. These theoretical explorations, however, give less than adequate

importance to south-south trade. Lall (1985), arguing a case for India, suggested that

know-why capabilities can augment exports but only to markets of limited size in other

developing countries. We discuss the empirical findings on technology and' export

performance in chapter 3 (section 3.4.2).

2.5.3 Technoloeical Learnine

Another departure point for LDCs from the technological activities of developed

economies is, perhaps, the absence of the so called 'technology shelf in LDCs.

According to Ranis (1990), LDC firms have little or no information on what is available

in the world or even in their own country, and therefore technological activities can not be

viewed as a probabilistic search process with a known probability distribution and from a

known outcome set. This absence of a 'technology shelf generally implies higher search

50 Williamson (1975, pp 8) as quoted in Kathuria (1996). 51 This is undoubtedly true if the exporting firm faces a downward sloping export demand curve in a monopilistically competitive market. However, if the export market is perfectly competitive, then the relative position of the average export revenue function and the marginal cost function would be of r~levance. If the MC cost lie above the average export revenue curve even after the technological development, no export will be possible.

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cost for LDC entrepreneurs. Ranis (1990) has accepted Nelson's (1987) view that firms

engage in two kinds of research activities: one is to find the best technology among the

existing set, and the other is directed towards achieving a completely new technology.

Indeed, learning is the most essential component of technological activities in developing

countries.

Bell (1984) divided the learning process into two groups: (1) 'doing based'

learning and (2) 'learning by training' or 'learning by hiring' or 'learning by searching'.

Strictly speaking, learning by doing refers to the learning process at the shop floor,

although the nature of this learning process is not clearly spelt out. The second type of

learning depends upon the allocation of resource devoted to formal learning. In other

words, while learning by doing, based solely on experience accumulation, is assumed to

be virtually automatic and costless process, the second type of learning calls for explicit

effort and investment.

The importance oflearning is echoed in Nelson (1987) as quoted below:

" ... To the extent the technologies are tacit, firm's production sets are fuzzy around the edges. To

the extent imitations are not trivial, the idea of having an industry wide production set the elements

of which are accessible to all firms is a misleading abstraction .... To the extent that technology is

not well understood, sharply defined invention possibility sets are misleading concept and

interaction between learning through R&D and learning through experience is an essential part of

the invention process .... "52

According to Katz (1987), the sequence of learning would be different for

different 0\vnership categories of firms. He has categorised LDC firms into four broad

ownership groups: a) family enterprises, b) domestic subsidiaries of large multinational

corporation, c) public enterprises, and d) large domestically owned incorporated firms1

52 Nelson ( 1987) seems to be suggesting that the existence of well-defined production·- and innovation­possibility frontiers, in a way, undermines the importance of learning.

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Among these, family owned firms are least exposed to any technological

information. They are likely to use mainly self-designed and self made items. Skill

generation is given much more importance than other things like plarming and

organisation. These firms generally rely largely on self-financing or at best they can

exploit government regulated loans. Access to capital market is generally denied. In

Indian context these characteristics can be linked to small-scale enterprises. Regarding the

management structure, these firms can be divided into two subgroups: first group consists

of the firms where decision-making process is generally very informal with family head

taking most of the decisions. In second type of firms, managerial decision making may

have undergone a generational change and controlled by formal managers and lawyers.

Katz believes that family owned firms are most dependent on the entrepreneurial

brilliance for technological progress as postulated by Schumpeter.

Katz (1984) does not distinguish much between local subsidiary of MNCs and

large domestically owned incorporated firms with respect to their financial capability or

managerial decision making. However, MNC subsidiaries are better exposed to advanced

technology as they can get ready-made designs from their parent bodies. Hence they can

afford to focus only on trivial modifications and adaptati~ns.53 On the other hand, private

large firms will have to rely on technology purchase and/or in house technological

activities to develop new designs. Thus MNC subsidiariys have a considerable start up

difference relative to large private enterprises. Accordingly, we may hypothesise that

learning is less obvious and less time consuming for MNCs, probably the least among all

three. In this context, one could again refer to the distinction between know how and

know why. In the Indian context, there is some evidence that privately owned Indian

53 Recently there is a trend among MNCs setting up more and more research units in some of the developing countries as part of their global R&D operations. This is done to exploit the comparative advantage offered by these host LDCs with respect to skilled labour and technological experience and infrastructure at lower relative costs.

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firms and public sector firms generally pay more attention to know why building

· activities than the multinational firms. 54 Regarding the learning behaviour of public sector

firms, Katz posits that their learning pattern is most erratic. This is because public sector

firms can afford to stay longer out of equilibrium than the private firms due to the weak

profit motive of the former.

2.5.4 Output Stretchine versus Cost Reducine Innovations

The direction of technological progress changes with time and with growth of the

market. It is acknowledged that one of the main motives behind any technological activity

is to resolve production bottlenecks. Therefore in emerging markets like LDCs, initially

firms concentrate on output stretching innovations. Cost becomes the factor of primary

importance in the later phase only when firms are threatened by competition.

Teubal (1987) argued that, in the beginning of technological activities m an

economy where demand is growing and market is unsaturated, a country faces many

production bottlenecks, which essentially compels firms to look for output stretching

innovations. He argues that orthodox theory can not take into account this output

bottlenecks because of its static framework. The assumption of perfect inter-sectoral

capital mobility also negates the chance of reaching a point beyond which output can not

be increased because of financial bottlenecks. Teubal acknowledges that an output

stretching innovation may also be cost reducing, but not necessarily so. The development

of Jenny from Spinning-wheel is one such example where the main motive was to raise

supply efficiency, but some cost reduction was also achieved only as a by-product.

2.5.5 Market size, Production Oreanisation and Technoloeical Activities

Another characteristic of LDCs, which has a bearing on their firm-level R&D

activity, is the small market size. Katz (1987) argues that small size of the market often

54 See, for instanc<!, Lall (1984)

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compels a firm to go for a higher degree of vertical integration, possibly involving too

many dissimilar activities. This, in his opinion, is responsible for insufficient attention

being paid to the R&D in any particular line of activity by these firms. Lundvall (1988)

argues that a vertically integrated firm narrows down its interaction with others. First, the

integration reduces the necessity to interact, and secondly any non-integrating firm is shy

of interaction with integrated firms because of the fear of leakage of knowledge.

Increasing vertical integration therefore may impair the scope of learning. 55

Katz (1987), mainly in the context of machine tool industry, has argued that LDC

firms need to adapt the technology imported from developed countries which is usually

meant for a higher scale of operation. Desai (1984) pointed out that, for Indian industries

this process of adaptation (scaling down) varies with the degree of integration of the

plant. In process industries where operation is rigidly defined, scaling down was applied

to every operation and consequently resulted in a plant that had to be "custom-made". On

. the other hand, in engineering industries, where operations are more flexible, scaling

down implied less automation and use of more and more manual machines in :individual

operation.

This, in a way, implies that there is indeed a case for 'appropriate technology' in

LDCs, an issue discussed by Stewart (1984) among others. 56 The firm has to leam how to

run the machine profitably at a smaller scale of operation, and many other economic and

climatic conditions. The issue of appropriate factor intensity has also been addressed. In

this regard, Katz suggests that, as opposed to a continuous flow process, often a

55 According to Lall (1985), there are two dimensions of the cost of vertical integration (i) reflected in terms of loss of scale economy advantages of the upstream supplier and (ii) imposition of higher degree of government regulation (monopoly preventing) on large firms. 56 There are two definitions of 'appropriate technology'. One focuses on the social welfare maximisation aspect of a technology while the other focuses on some specific set of characteristics in defining it. Morawetz (1974) belongs to the first school of thought and defines appropriate technology as "set of techniques which make optimum use of available resources in a given environment. For each process or project, it is the technology which maximises social welfare if factors and products are shadow priced".

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discontinuous batch process is more suitable for less developed economies. The latter can

cater to the needs of smaller market more profitably than the former by reducing the time-

cost of keeping the machine idle.

2.6SUMMARY

In this chapter we have traced the developments in the theoretical literature on

technological progress with a view to understanding the process of technology generation

in LDCs. However, we noted that most of theoretical models in the neoclassical paradigm

explain technological progress against the backdrop of advanced industrial economies

with perfectly functioning markets. It is the evolutionary approach which fits most closely

the conditions of LDCs. Evolutionary theorists recognise the important role of diffusion

in technical progress and view technological growth as continuous process of minor

changes where learning and spill over act as important determinants. All these aspects

prove to be extremely useful in understanding the process of technology generahon in

LDCs. However, much of the literature on the determinants and consequences of

technology generations in LDCs are based on empirical analyses. A detailed review of the

empirical literature on the subject is, therefore, essential for a comprehensive

understanding of the process of technology generation in LDCs. This is attempted in the

following chapter 3.

This view is criticised because of the conceptual and practical problems for determining social values and shadow prices. See Stewart ( 1987) for a comprehensive review of these different schools of thought.

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