Industrial Economics Module II

Industrial Economics - Theory and Policies Distance Learning material
MEKELLE UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
INDUSTRIAL ECONOMICS
Theory and Policies
A
Learning material for Distance Students
MODULE II
Prepared by
Jayamohan.M.K
Tadesse Demissie
Department of Economics
Faculty of Business and Economics
Mekelle University
May, 2006
Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 1

CHAPTER SIX
ADVERTISING DEBATE
Prompting Question
Why do firms incur so much expenditure on advertising?

Why the economic analysis of adverting is required?
What is the impact is the impact of advertising on market performance?
What is the benefit/cost of advertising for society?
What is your opinion towards the role of advertising in the market?
State the reasons for the differences in advertising intensity for different
products.
What is the role of advertising in reducing transaction /search cost?
Objectives of the chapter
The objectives of this chapter are to:
Introduce the concept of advertising and concern for its economics analysis.
Discuss the generic objectives of advertisement
Explain reason for variation in the amount of advertising level for different
goods/services
Discuss the different views of economists on advertising

Introduction
Advertising is a mass paid communication, the ultimate purpose of which is to impart

information, develop attitudes and induce action beneficial to the advertiser. It can take
many forms: media advertisements, direct mail, leaflets, or sponsorship. The content of
an advertisement can vary considerably. It can simply display the name of the product or
it may compare the product with that of rivals. It may provide detailed information about
the product's attributes, or may simply enhance its image.
Advertising is one of many forms of promotional activity. Instead of advertising, a firm

might promote sales by employing more sales representatives, by altering the product's
packaging, or by widening wholesale and retail margins. Advertising can be either a
substitution for a complement to, other forms of promotional activity. This complicates
the economic analysis of its effects since it is difficult to separate them from those of
other promotional activities. Indeed, some economists refer to 'advertising' when they are
really discussing promotional activity in general. They recognized the fact that different
promotional activities overlap. Given that the effects of advertising and other promotional
activity are similar, empirical work which considers only advertising will give misleading
results.
6.1 Why advertise?
Whereas marketing aims to identify markets that will purchase a product (business) or
support an idea and then facilitate that purchase, advertising is the paid communication
by which information about the product or idea is transmitted to potential consumers.
In general, advertising is used to convey availability of a "product" (which can be a

physical product, a service, or an idea) and to provide information regarding the product.
This can stimulate demand for the product, one of the main objectives of advertising.
More specifically, there are three generic objectives of advertisements:
(i) communicate information about a particular product, service, or brand (including

announcing the existence of the product, where to purchase it, and how to use it),

(ii) persuade people to buy the product, and

(iii) Keep the organization in the public eye (called institutional advertising).
Most advertising blends elements of all three objectives. Typically new products are
supported with informative and persuasive ads, while mature products use institutional
and persuasive ads (sometimes called reminder ads). Advertising frequently uses
persuasive appeals, both logical and emotional (that is, it is a form of propaganda),
sometimes even to the exclusion of any product information. More specific objectives
include increases in short or long term sales, market share, awareness, product trial, mind
share, brand name recall, product use information, positioning or repositioning, and
organizational image improvement. Examples of the ideas, informative or otherwise, that
advertising tries to communicate are product details, benefits and brand information.
6.2 How much advertising?
A profit maximizing firm engages in advertising up to the point at which the expected
marginal benefit from advertising equals the expected marginal cost of advertising. The
intensity of advertising varies according to the nature of product to be advertised and the
market characteristics that affect the efficiency and cost-effectiveness of advertising.
Explanations for variations in the levels of advertising between industries therefore turn
on differences in product and market characteristics. Advertising is more suitable for
promoting consumer goods than industrial products because it involves mass
communication. The markets for consumer products are generally larger and
geographically scattered. Industrial buyers are likely to be smaller in number and require
more detailed information than can be provided by an advertisement.
Consumer durable goods have a longer life, are often more complex products, and tend to
involve a greater outlay than consumer non durables. An error of judgment in purchasing
a durable good has a greater effect on the consumer's welfare. Consequently, consumers
require more information than can be communicated effectively via advertising. The
more complex the product, the greater the use consumers make of alternative information
sources. Consumers have evolved 'rules' that influence their purchasing behavior seek out

information for durable goods, do not bother for non-durable goods. With durable goods,
advertising is also likely to be less effective in promoting sales than competition on the
basis of price products.
The importance of product type can be illustrated by introducing the concept of search
(Stigler, 1961). When knowledge is imperfect, consumers can improve their decisions by
searching for information on product characteristics, product availability and alternative
prices. Search can take 'several forms - visiting or telephoning sales outlets, surveys of
available literature, and verbal enquiries. However, the incremental benefit received by
the consumer is likely to decline as the amount of search increases. This can be illustrated
by considering a consumer wishing to purchase a car. Assume he has already decided
upon the make and model, but wishes to buy the car at the 'best' price. The greater the
number of dealers already contacted (searched), the less likely it is that contacting an
additional dealer will locate a better offer and, even if a better offer is found, it is likely to
be only marginally better. In other words, both the prospect of making savings from
identifying a lower price, and their size, will fall with the number of dealers contacted.
Recognizing also that the collection of information is costly, search is worthwhile only up
to the point where the expected marginal benefits equal the expected marginal costs.
The optimal levels of search for durable and non-durable goods are compared in Figure
6.1. For exposition, it is assumed that the marginal costs of search (CC) are constant and
the same for both types of good. The marginal benefit functions differ (DD for the
durable good, NN for the non-durable) since the potential discounts on the durable goods
are likely to be much larger in absolute terms. Given the higher unit price and the larger
expected savings from identifying a lower priced source, the optimal level of search for
the durable good will be higher (OY compared to OX).
The optimal amount of search may also be lower for goods that are purchased frequently,
or which account for a relatively low proportion of a consumer's total expenditure. For
inexpensive goods, efforts to use sources of information other than advertising are
unwarranted - and, in the case of frequently purchased goods, the consequences of a
mistaken purchase are relatively short-lived. Therefore, in both cases, it is often rational

for the consumer to make a decision between products with unknown characteristics on
the basis of advertising messages.
N D
Marginal
Cost &
Benefit of
C’ C’
Search
C C
N D
O X Y quantity of search
Figure 6.1 the optimal level of search
Nelson (1974) takes the analysis further. Search goods are those consumer goods whose
qualities can be evaluated effectively before purchase (such as books or compact discs).
The qualities of experience goods can only be evaluated effectively after purchase (such
as food at restaurant, shampoo and photographic film). Whilst advertising has a role in
informing consumers about the features of search goods, it can only signal the existence
of experience goods. Higher levels of advertising are likely in the latter case since
advertising may be the only source of information available to the consumer.
Higher levels of advertising for experience goods should also be positively associated
with product quality. This behaviour can be explained from the perspective of the new
institutional economics1. Individuals or groups evolve procedures (or 'rules') to simplify
complexity. They will repeat their purchases if an experience good prove to be of high
quality. This will encourage firms offering good quality products to advertise more
heavily because of the prospect of earning larger returns on their advertising outlays.
High advertising may be interpreted by consumers as evidence of product quality and a
firm's intention to remain in the market. The more volatile is the market (for whatever
1
The new institutional economics is interested in the social, economic and political institutions that govern
everyday life. it is concerned with rules and customs that make up the institutional environment are
primarily economy-side phenomena and focuses on agreements made by specific individuals to govern
their own relationships.

reason), the greater the level of advertising. Where there is a rapid turnover of customers
(as in the baby food market) there will be heavy advertising to inform the new consumers
(although customer turnover above some critical level actually reduces the returns to
advertising, making it less attractive). Furthermore where product characteristics change
rapidly, there will be a need to advertise to increase consumers' awareness.
Advertising levels will also be relatively high where the entry of new firms is rapid. New
entrants must counteract the influence of past advertising by existing firms: heavy
advertising is required to inform consumers of the attributes of their own products.
6.3 Debates on advertising
Advertising is a prominent feature of modern economic life. Consumers encounter

advertising messages as they watch TV, read magazines, listen to the radio, surf the
internet, or simply walk down the street. And the associated advertising expenditures can
be huge. What, then, do economists have to say about advertising?
The traditional view of advertising is that it persuades people to buy a firm's product, so
increasing the firm's market power. Advertising not only distorts consumer choice, but
uses resources which could have been used elsewhere. Society's welfare is reduced firms
enhance their profits at the expense of consumers. Many firms advertise their goods or
services, but they are wasting economic resources. Some economists reckon that
advertising merely manipulates consumer tastes and creates desires that would not
otherwise exist. By increasing product differentiation and encouraging brand loyalty
advertising may make consumers less price sensitive, moving the market further from
perfect competition towards imperfect competition (see monopolistic competition) and
increasing the ability of firms to charge more than marginal cost. Advertising is
economically wasteful and damaging to welfare as it distorts consumers' preferences,
thus creating monopoly power for firms that produce heavily advertised brands. Heavy
spending on advertising may also create a barrier to entry, as a firm entering the market
would have to spend a lot on advertising too.

However the traditional view of advertising is increasingly questioned. The alternative

school of thought takes a broader view of competition and stresses the informative role of
advertising. Advertising may perform a valuable role, enabling consumers to make better
informed choices and promoting the operation of the competitive process. In a world
characterized by uncertainty and ignorance, it is argued that advertising has a key role to
play in providing consumers with information, reducing search costs and enabling them
to make better informed choices. Advertising is economically valuable because it
increases the flow of information in the economy and reduces the asymmetric
information between the seller and the consumer. This intensifies competition, as
consumers can be made aware quickly when there is a better deal on offer. In general
there two main divergent views of advertising emerged, including the persuasive view,
and informative view.
The 'advertising as persuasion' view

Advertising will not only bring benefits to the firm in the form of increased sales, it will
also have an impact on the environment within which the firm operates and the prices
charged to consumers. The traditional view - advanced, among others, by Bain (1968)
and Comanor and Wilson (1974) –is that advertising works by persuasion, and results in
increases in both market power and prices (the process is summarized in the following
figure)
Consumers: Performance:
Advertising Preferences altered Higher prices and costs;
in favor of heavily increased non-price
advertised goods competition; higher profits
Market Entry barriers:

structure Heightened
Figure 6.2 ‘advertising as persuasion' view

The advertising as persuasion view implicitly assumes that advertising distorts

consumers' preferences. This may cause consumers to make wrong choices, selecting
advertised goods instead of those which would give them greater satisfaction or buying a
product in the mistaken belief that it is better than its rivals. By altering consumers'
preferences to favour the advertised product, demand for the 'product becomes less
sensitive to price changes. Advertising also has the effect of reducing the cross elasticity
of demand between the advertised product and its close substitutes. This makes
consumers less responsive if rival firms reduce prices or increase their promotional
activity.
Advertising can create first-mover advantages which confer entry barriers. Since
customers display a greater attachment to the products of existing firms, there will be
fewer people switching between brands, and hence likely to try a new product. To
overcome brand loyalty an entrant must either advertise more heavily or offer substantial
price discounts. In either case, the entrant's profitability is adversely affected. Moreover,
advertising is a sunk cost to the extent that it is product-, rather than firm-, specific. The
more the new entrant has to engage in advertising whose benefits are limited to the
promotion of the product in question, the less attractive entry to that market will be.
Consumers are reluctant to try new products of unknown quality, and this experience-
based asymmetry between established and new products may be exacerbated in the
presence of heavy advertising by established firms.
Existing firms will be able to exercise their market power once the threat of new entry
has been reduced. This will result in higher prices for consumers and higher profits for
producers. If the market has become more concentrated - because either economies of
scale or threshold effects in advertising confer a cost advantage on large firms - then the
effect on prices and profits will be particularly marked.
The 'advertising as information' view
This alternative view, adopted by Stigler (1961), Telser (1964) and Nelson (1974b,
1978), stresses the role of advertising in providing information. In an environment where

knowledge is imperfect and uncertainty abounds, advertising plays an important part in

reducing consumers' ignorance. As in the 'advertising as persuasion' view, it is recognized
that advertising influences consumers behaviour, but it is not regarded as having adverse
consequences for consumers' welfare. For consumers to make the 'best' choices they need
to be fully aware of all possible alternatives. Stigler's analysis shows that, for any
product, there is an optimal amount of search - or, in other words, an optimal amount of
knowledge. Although all decisions will be made on the basis of incomplete information,
advertising reduces this incompleteness by effectively reducing transaction costs through
lowering the costs of search. Consumers benefit by being able to choose those products
that match more closely their preferences.
The informative view holds that advertising primarily affects demand by conveying
information. The advertised product thus faces a more elastic demand. This elasticity
effect suggests that advertising causes lower prices, an influence which is reinforced
when production scale economies are present. Advertising (and other forms of
promotional activity) can make consumers more responsive to price changes and price
differentials, increasing their concern to buy the 'right' alternative. With demand more
price-elastic, it follows that the profit-maximizing price will be lower. If consumers are
more responsive to price signals, firms will be under more pressure to offer attractive
prices. Prices will also be lower because of the increased competition brought about by a
reduction in entry barriers. Entry is facilitated because advertising offers an effective
means whereby new firms can make potential customers aware of their existence and of
the attributes of their products.
The informative view suggests further that advertised products are generally of high
quality, so that even seemingly uninformative advertising may provide the indirect
information that the quality of the advertised product is high. There are three reasons.
First, the demand expansion that advertising induces is most attractive to efficient (low-
cost) firms, and such firms are likewise attracted to demand expansion achieved by
offering low prices and high-quality products. Second, the product experience memories
that advertising regenerates are most valuable to firms with high-quality products, since
repeat purchases are then more likely. Third, a firm sensibly targets its advertising toward

consumers who would value its product most. The informative view holds further that
advertising is not used by established firms to deter entry; instead, advertising facilitates
entry, since it is an important means through which entrants provide price and quality
information to consumers.
Advertising helps the competitive process: by supplementing other sources of

information, it facilitates entrepreneurial action by economic agents. Taking the view of
advertising as information, rather different conclusions emerge as to the effects of
advertising on market structures and prices (summarized in figure 6:3)
Advertising Consumers: Performance:

Better informed Lower prices; increased
enabling better competition; efficient
purchases firms enabled to expand
Market Entry barriers:

structure Reduced
Figure 6.3 ‘The advertising as information’ view

Multiple Choice Questions

Choose the best alternative among the given choice for the following questions.
1. One of the following is not true about the traditionalists’ view of advertising.
A. Advertising performs a valuable role which enables consumers to make better
informed choices.
B. Heavy advertising creates a barrier to entry and discourages the operation of the
competitive process.
C. Advertising enhances firms’ profits at expense of consumers.
D. Advertising merely manipulates consumers tastes and creates those do not exist.
E. Advertising makes consumers less price sensitive.
F. Advertising distorts consumers’ preference and reduces social welfare.
2. Proponents of ‘Advertising as information view’ affirmed, except.
A. In an environment where knowledge is imperfect and uncertainty bounds,
advertising plays important role in reducing consumers’ ignorance.
B. Advertising eliminates the incompleteness of information by effectively reducing
transaction costs through lowering the costs of search.
C. Advertising facilitates entrepreneurial action by economic agents.
D. Advertising makes consumers more responsive to price changes and price
differentials.
E. The informative view suggests the quality of advertised product.
F. None of the above.
3. Which of the following can not be considered as ultimate purpose of advertising?
Advertising
A. Imparts information, develop attitudes and induce action which is beneficial to
the advertiser.
B. Persuades people to buy product.
C. Stimulates demand for the product.
D. Keeps the organization in the public eye by improving its image.
E. None of the above.
4. A profit maximizing firm engages in advertising up to the point
A. Where profit is maximized from the increased sales induced by advertising
campaign.
B. At which the expected marginal benefit from adverting equals the expected
marginal cost of advertising.
C. Where the actual total cost of advertising is equal to the actual total benefit from
advertising so that optimal advertising level is achieved.
D. Where the firm incurs the minimum possible advertising cost and generates the
maximum possible revenue from it.
E. At which increase in sales attributed to advertising intensity is maximized.
5. Identify the incorrect statement
A. The more complex a product the less consumers depend on advertising as
source information.
B. For durable goods, advertising is more effective in promoting sales.

C. When knowledge is imperfect, consumers can improve their decisions by

searching for information on product characteristics, product availability and
alternative prices.
D. Advertising can communicate product details, benefits and brand information.
E. Search goods are those consumer goods whose qualities can be evaluated
effectively before purchase.
F. The more volatile is the market the greater the level of advertising.
Questions for Review and Discussion

Attempt the following questions. Write your answer in your own words. Do not
directly copy from the module.
1. What is advertising? Mention and explain the forms of advertising
2. Why the economic analysis of advertising is complicated? Discuss
3. List and briefly explain the objectives of advertising.
4. Explain the concept of search and show optimal search for different types of
goods (i.e.; durable and non-durable) with the help of graph.
5. Briefly discuss the different economists’ views on advertising?

CHAPTER SEVEN
INVENTION, INNOVATION AND DIFFUSION
Prompting Questions:
What are the intentions behind launching of new products in the market?
Why organizations are spending more on research and development activities?
What determines innovation?
Is there any impact of invention and innovation on employment?
Desired Objectives
The reader will get acquainted with
The meaning of Invention, Innovation and Diffusion
The importance of Invention, Innovation and Diffusion in the performance of a
firm.
The diffusion of innovation.
The relation between Innovation and employment
The characteristics of firms and markets in the process of change

Introduction
In this chapter we are going to discuss about the analysis of innovation and research
and development (R&D) activities which are quite prevalent in manufacturing and
other business circles. Innovation is one of the several strategies through which a firm
could change its situation in the market in pursuit of its objectives. It is an instrument,
which the firm uses to enhance its competitive power in the market. It provides a basis
for greater degree of diversification and hence growth of the firm. The major elements
of innovation or technological change, such as,
New products,
New methods of production,
New markets and
New forms of industrial organization etc,
These make the firms and industries to run efficiently over time. Recognizing such
role J.A. Schumpeter took innovation as "the fundamental impulse that sets and keeps
the capitalist engine in motion". He found innovation as the outstanding fact in the
economic history of capitalistic society. Innovation is not confined to such a society
only. It is a common feature in almost every economic system whether capitalistic or
socialistic or something else. Science and technology become operative through
innovation.
In the modern world,
An individual wants to be more creative,
A firm or corporation strives for the progressiveness of its business and
A government works for the collective security and welfare of masses.
Innovation is an important weapon for all these. In fact, survival of mankind depends
to a great extent on innovation, particularly in the fields of material requisites of life.

What are the sources of innovation?
Innovation in business is achieved in many ways, with much attention now given to
formal (R&D) for "breakthrough innovations." But innovations may be developed by
less formal on-the-job modifications of practice, through exchange and combination of
professional experience and by many other routes. The more radical and revolutionary
innovations tend to stem from R&D, while more incremental innovations may emerge
from practice - but there are many exceptions to each of these trends. Another key
source of innovation is user innovation, innovations developed by individuals when
existing products do not meet their current needs.
There are different aspects of innovation (i.e. stages of technological change) for study
to be examined as follows.
7.1 The process of innovation: Concepts and Relationships
The terminology of innovation consists of a set of interrelated terms. The first and
perhaps the most important one is the concept of invention.
An invention is the creation of the new technology. By 'technology' we mean any tool
or technique, any product or process, any physical equipment or method of doing or
making, by which human capability is extended. It is an intellectual act which involves a
perception of a new image, of a new connection between old conditions, or of a new area
for action. All inventions, big or little, are made for some practical uses. The process of
adopting an invention in a practical use is called innovation. It is the implementation of
a new or significantly improved idea, good, service, process or practice that is intended to
be useful.
If the existing product line is changed by a firm, i.e. it introduces a new product with or
without displacement of the old ones, and then it is defined as product-innovation. If a
new method is initiated to produce existing products then it is process innovation. Both
of these are the elements of 'technological innovation'. When a firm makes changes in
its marketing strategy we define that as 'market-innovation'.

Similarly, there may have innovation in organizational practices, financing and any other
aspect of business conduct. The concept of innovation is, thus, very broad. The
entrepreneur or manager when performs the act of innovation is called 'innovator'. He
invests resources for the innovation and takes the risks involved in that. This is a very
important role, indeed a pivotal one, for the growth of industries. Innovation occurs
when the entrepreneur believes that it is worthwhile to commercialize the invention.
Schumpeter identifies five types of innovation, viz
1) The introduction of a new good —that is one with which consumers are not yet
familiar—or of a new quality of a good.
2) The introduction of a new method of production, which need a discovery

scientifically new, and can also exist in a new way of handling a commodity
commercially.
3) The opening of a new market that is a market into which the particular branch of
manufacture of the country in question has not previously entered, whether or not this
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 carrying out of the new organization (the reorganization of methods of

operation) of any industry, like the creation of a monopoly position or the breaking up of
a monopoly position.
Another useful concept related to the innovation process is 'imitation'. It is a situation

when an innovation is copied by others. That is, the innovation spreads across the
market. In other words, we call it 'diffusion of the innovation'. Such diffusion may be
rapid or slower depending on the market situation, but it will be easier or safer than the
act of innovation.

The three terms -invention, innovation and diffusion -are the successive stages of the
process of innovation or technological change. Diffusion is not possible without
innovation which in turn is not possible without invention. The entire process of change,
i.e. from invention to imitation, comes under research and development (R&D) activity
of the firm.
7.2 Stages of Technological Change

Let us examine each stage in the process of change in some details for full
understanding.
The first stage (Invention) is carried on by individuals or corporate bodies like research
institutes, universities, government bureaus and companies- the source of invention. It is
just like any other corporate activity such as sales or production where certain inputs are
used to get some output in a broad sense; we may call invention as output of the research
industry. If so, an invention will be a goal-oriented activity. A government or
corporation will be making invention for solving some social problem or for the sake of
extra profits or money. To achieve the goal of invention a series of steps will be taken
beginning from the definition of the problem, the alternative routes to its solution and
finally the output in the form of the invention. It is an orderly sequence, a matter of
applying conscious intelligence to the solution of the problems. The ‘output’ of the
process may not come during the stipulated time. There may be frustration, delay,
failures, etc., but the process of invention goes on. In general invention can be taken as
an orderly, intellectual, goal oriented process, a fundamental one, for the innovation or
technological change in a society. It does not usually move in a straight line according to
the plan, but takes unexpected twists and turns to reach the destination.
The Second stage (innovation) is a logical extension of invention. When an invention is

made, its fruits are made available to the society through innovation. An entrepreneur or
corporation comes forward, makes the required investments for the innovation. As
mentioned earlier, innovation may be in product or process of manufacturing or any other
activity of the corporation. It involves risks and uncertainties. An innovator bears them
and it is precisely on this ground that economists justify existence of excess profits for
him. Process-innovation and product-innovation are two important types of innovation.

Process innovation arises when relative prices of factors of production change. If labour
becomes costly, the firm may think of cost saving by adopting capital intensive technique
and vice-versa. In the familiar isoquant framework, it implies a movement along the
isoquant when the input prices change. There will not be any R&D expenditure involved
in this, as technology will not change. Only the equilibrium situation for the least cost
combination of inputs changes. Further, if technology changes this means a new
production function causing a shift of the isoquants. In this situation, the need for process
innovation is obvious. The input proportions to produce a given level of output will
change if there is technological change giving rise to the process innovation.
Product innovation is necessitated because of a variety of reasons. Primarily, a product

change may be stimulated either by a new technology or by a change in relative prices of
existing products. Changes in consumer preferences and cost of production- are the
sources of change in relative prices of the products. If a product is costly for the firm and
at the same time its price declines in the market because of unfavorable circumstances, it
will be less profitable and, hence, is likely to be replaced by a new one.
The process of innovation has a well defined goal and the adaptation of the new
technology or product to achieve the goal is an orderly management function of the firm.
The third stage (Diffusion) is the imitation of innovation. The innovation, initiated by
an innovator, spreads in the market. The rate of diffusion depends on market structure. If
there are rigid patent practices and the government assistance in technological progress is
negligible, then we expect a low rate of diffusion of the innovation. On the other hand, if
technology is freely available, there are no rigid patent practices and investment
requirements for the new technology are not alarming, then the rate of diffusion will be
fairly high. From social point of view diffusion or spread of the innovation is desirable
but from an individual firm & point of view it is not, as the firm would not be able to
maintain its gains through innovation when it is imitated by its rivals.

7.3 Measurement of Innovation Activities
We need precise measurement of innovation like any other economic activity. There is no
unique method for this. Researchers in the field tackled the problem by measuring either
the inputs (i.e. total cost or some component of it in money or physical terms) put in the
process of R&D or the output of this activity. The most simple and widely used method
is to take the statistics of R&D expenditure, absolute or a proportion of total annual
budget of the firm, as a measure of innovation activity. The assumption for this method is
that larger the volume of R&D expenditure more will be the activities in innovation. This
method is useful if all R&D activities are in organized form. There may be significant
contribution by the individuals or departments of the firm which do not come under R&D
unit. How to measure their contribution is a problem. At present it is generally ignored
and available statistics on R&D is used simply to measure the innovational activities.
There is another method in which the number of scientists and engineers in the R&D
department is taken as a measurement of innovational activities. The assumption in this
case is that the greater the number of such personnel the more will be the R&D activities
of the firm or research organization. This measure has limitations similar to the R&D
expenditure. Contributions made by non-scientists or non-engineers are not captured by
this index.
From the output side one may use either the number of patents issued or sale of new
product as appropriate measurements of innovation or R&D activities. Taking number
of patents as a measure of innovation has some draw backs. Patenting generally refers
to invention stage. It does not reflect innovation and diffusion stages properly. Further,
all inventions are not patentable equally. Large firms doing research may avoid
patenting of their inventions in order to escape from monopoly regulation practices.
They may keep their inventions secret for long time, as we observe in drug industry, by
not registering the patents since a patent can be bought or copied by rivals. Further,
patenting is more appropriate for product innovation. In the case of process innovation it
does not fit properly. Patent system does not reflect the quality of innovation also. On
the whole, taking number of patents as a measure of R&D activities is a partial index. In

spite of its drawbacks the index is popular for empirical studies.
The index of sales of new product is another measurement of R&D output. But this is
again a partial index reflecting the side of product innovation. It does not take into
account changes in the process of manufacturing and saving of costs arising as a result of
innovation.
7.4 The Theory of Technological Innovation
Attempts are being made by economists to identify the conditions (or determinants)
which encourage initiation and adaptation of a new technology. To begin with the
identification of such conditions, we may pose a simple but basic question related to the
technological innovation.
Why do scientists or engineers or anybody else make invention?
In a different way, we may ask this question as:
Why is a huge amount of money being spent on R&D activities all over the world?
The answer to this question is straight forward, that is, inventions are made because there
is a need for them. Fast moving modes of transportation came into existence because
there was need for them. Radio, television and hundreds of other inventions were made
with some purpose. Through inventions and their commercial exploitation man controls
his environment. An invention without commercial exploitation for personal or social
uses cannot be viable. Given this basic proposition of need which backs up inventions,
that, makes them goal oriented, we have to identify the conditions which are conducive or
which accelerate the pace of invention and innovation or broadly the technological
change in economy. Since we are concerned with the study of the economic behavior of
firms, and industries in this course, we will therefore examine the determinants of R&D
intensity in this context.
The first and most intensively debated determinant of R&D is the market structure of the
industry. Particularly, the elements of market structure such as the degree of market
power and absolute size of firms were used in theory and empirical work on R&D
behaviors of the firms and industries. Perfect competition and monopoly were taken as

two extreme contrasting situations to analyze the link between innovational motivation
and market power. To test this link, the major hypothesis was put forward by Schumpeter
who argued that a monopoly firm has a greater demand for innovations because its
market power increases its opportunity to gain from them. This assertion has not been
accepted by the economists unanimously. At present they are divided into two opposite
schools, such as
Competitive pressure school and

Monopoly profit school.
The competitive pressure school argues that in an atomistically competitive situation,

with its strong tendency for a uniform normal rate of profit, there will be great pressure
and hence inducement for making cost-saving innovations. Such pressure diminishes as
market power of the firm increases and so the rate of innovation will be inversely related
to the degree of market power.
The monopoly profit school does not agree with such contention. It argues that since
innovation is risky, it will not be undertaken in atomistically competitive markets where
the gaps from innovation will be momentary. According to this school, the conditions for
sustained R&D activities are best provided by the monopoly or concentrated markets.
Through R&D activities a firm gains and acquires monopoly power over its rivals. The
firm would like to perpetuate its monopoly power by undertaking new innovational
activities. There is thus a positive relationship between the rate of innovation and the
degree of monopoly power as conceived by the monopoly profit school. Normally, large
firms in industries will be having considerable monopoly power. They will be capable of
providing adequate resources for R&D and taking the associated risks. The monopoly
power and large absolute size are thus complementary attributes which are relevant
determinants for R&D activities. Taking this view in mind we may summarize the stand
of the monopoly profit school as “… the greater the profits and the degree of market
power or firm size, the greater should be the efforts to innovate.”
Another important factor that affects the rate of innovation is the nature of the elasticity

of demand for the product or products of an industry. Rapid technological changes are
seen in the industries' having elastic demand. Most of the luxury goods industries fall in
this category.
We know the link MR = P [1-1/ed]

Where;
MR is marginal revenue,
P is price and
ed is price elasticity of demand.
This equation shows positive marginal revenue when elasticity of demand is greater
than unity and negative marginal revenue when ed is less than unity. MR will be zero
when ed = 1.
Suppose there is process innovation such that cost of production reduces. By a

reduction in cost of production the firm position to reduce product price in order to get
more revenue (i.e. positive MR) if elasticity of demand is more than one. The firm will
do so. It is beneficial to the firm as well as to the consumers of the firm since they pay
less price for the product now and the firm gets more revenue. Thus, there will be more
inducement for innovation when price elasticity of demand for the products of the firm
or industry is elastic.
R&D intensity also depends on diversification. The basis for this relationship is that a
more diversified firm will be in a better position to exploit unexpected research outputs
than the one having a narrow base of operations.R&D activities also show strong
positive association with growth of output of a number of industries. R&D activities
are committed intensively where the growth prospects are good and profits are likely to
be high. However, there may be an upper limit for such positive relationship. A stage
will come when a product reaches ‘maturity’ stage of its life cycle with no more
growth prospects. At this stage, the firm has to go through intensive R&D activities in
search of a new product or products to replace the old one. The relationship therefore
may not hold true or it may be negative after such stage is reached. Yet another factor
that we may mention here as a determinant of R&D behaviour of the firm. We have

discussed the general factors that determine the R&D behaviour of a firm or industry.In
brief, we may say that R&D activities of a firm depend on
(i) market structure,

(ii) size of the firm,
(iii) technological opportunities,
(iv) nature of elasticity of demand for the products of the firm,
(v) the degree of diversification,
(vi) growth of market, and
(vii) Expected return on R&D investment.
The list of determinants is not exhaustive. There may be more depending on specific
situations. The material presented above gives us a fairly good description of the
theoretical determinants of R&D activities of the firms. There are many analytical models
suggested by the economists for determinants of R&D. let as review one of them.
Dasgupta and Stiglitz Models

Dasgupta and Stiglitz jointly produced exhaustive theoretical material related to the
relationship between industrial structure and the nature of innovating activities. The basic
stand taken by them in their analytical framework is Neo-Schumpeterian in nature where,
except in the short run, both market structure and the nature of inventive activity are
endogenous. They are determined by some more basic factors, such as the technology of
research, demand conditions, the nature of capital market, i.e. market rates of interest and
the ability of firms to borrow to finance R&D outlays, and the legal structure related to
patent rights. To analyze the R&D behaviour, the authors postulated market situations
such as the socially managed market, the pure monopoly, the imperfectly competitive
markets like oligopoly with free entry, oligopoly with barriers to entry, and duopoly.
Both, certainty and uncertainty situations were considered by them separately in
developing the R&D behavioral models. The equilibrium conditions derived by them for
different market situations are based on maximization of gains from R&D activities. The
major conclusions established by them are:
1. Even when, market structure is endogenous, if the degree of concentration in

industries is small, industry-wide R&D effort is positively correlated with

concentration. When the degree of concentration in industries with free entry is small,
R&D effort per firm, and therefore cost reduction, is often positively correlated with
concentration.
2. High degrees of concentration are by themselves not an evidence of lack of effective
competition.
3. Both optimal R&D expenditure and R&D expenditure per firm in a market economy
increase with size of market. They decrease with increasing cost associated with
R&D technology if demand is elastic and increase with increasing cost if demand is
inelastic.
4. If there are barriers to entry, an increase in the number of firms would result in a
decrease in R&D expenditure per firm in a market economy, although industry
output/would increase, and therefore, the degree of monopoly would decrease.
5. There is some presumption that cost-reducing in an industry in a market economy,
even when there is free entry, is less than the socially optimal level.
6. If demand is highly inelastic, total R&D expenditure in an industry with free entry
exceeds the socially optimal level.
7. There may be excessive duplication of research effort in a market economy in the
sense that industry wide R&D exceeds the socially optimal level even though cost-
reduction is lower.
8. In the case of process innovation, a good case can be made for encouraging investment
in risky research projects, even if society is risk-averse.
9. A pure monopolist appears to have insufficient incentive (a) to undertake R&D
expenditure, and (b) to engage risky research ventures.
10. Since the mark6t power of a firm increases as its cost advantage over its rivals
increases, there is a presumption that competitive markets encourage firms to engage
in overly risky research projects.
11. Pressure of competition may result in excessive speed in research and, in general,
there is no presumption that a market economy has a tendency to generate inefficient
information.

As one may infer from these conclusions, the extreme ends of market structure, e.g. pure
monopoly and perfect competition, may not provide significant incentives for R&D
activities. The type of market structure between these two extreme forms such as
duopoly, oligopoly and monopolistic competition are likely to provide the incentives as
well as competition for R&D activities of the firms.
7.5Innovation and Employment
Although innovation leads to benefits for society, it does not necessarily follow that every
member of society gains. Since welfare has increased overall, in principle the gainers
could compensate the losers. However, while the benefits are generally spread thinly over
consumers as a whole, the losses may be concentrated on just a few. The latter may well
resist such a change. Analysis of the effects of innovation on the employment of factors
of production will identify groups likely to suffer a loss of welfare as a result of change.
Figure 7.1The impact of a process innovation on factor employment in a perfectly

competitive industry

Figure 7.1 shows the impact of a process innovation in a perfectly competitive industry.
Demand and supply curves for the product are shown in the upper part of the diagram.
Initially the market price and output are OPl and OQl respectively. The corresponding
derived demand curve for labour (Nl) is shown below the horizontal axis. (It might
equally well have shown the derived demand for capital). Before the process innovation,
OLl units of labour are required to produce quantity OQl.The process innovation, by
reducing marginal cost, shifts both the demand for labour schedule and the market supply
curve to N2 and S2 respectively. If the effect of the new production method leaves the
capital-labour ratio unchanged then the demand for both factors of production increases.
In this example, labour demand will increase from OLl to OL2, with a similar increase in
the demand for capital. Alternatively, if the change results in a higher capital-labour ratio,
then the demand for labour will fall. This is shown by the post-innovation demand for
labour curve N3 in Figure 8.1, with employment falling toOL3.
Assuming perfect knowledge and homogeneous factors of production the reduction in

welfare suffered by displaced factors will be transitory as they will be rapidly re-absorbed
into the economy. With imperfect knowledge, it may take time for displaced factors to
find alternative employment. Also, the expanding industries may require different labour
skills. Technological unemployment can arise if the growing sector requires skills highly
specific to the new technology but displaced labour is skilled in more traditional trades.
When skills become redundant, the value of human capital is reduced. Social problems
may also arise, particularly if the industries adopting labour-saving innovations are
regionally concentrated.

1. Science and technology, which is the instrument for rapid economic growth, becomes
operative through
A. Invention
B. Innovation
C. Diffusion
D. Technological progress
2. The most radical and revolutionary source of innovation is
A. Research and Development (R&D).
B. On the-job modification of practice.

C. User innovation.
D. The exchange and combination of professional experience.
E. The entire are fundamental sources of the process of technological change.
3. __________ is commencement of a new method to produce the existing product.
A. Product-innovation
B. Market-innovation
C. Process-innovation
D. Organizational innovation
E. Technological innovation
4. The relatively safer or easier stage of technological change process is
A. Invention
B. Innovation
C. Diffusion
D. All stages are equally risky.
E. None of the above.
5. Identify the correct statement
A. All forms/industries provide equal opportunities for technological change
process in market economy.
B. Diffusion is more desirable for individual firms than for social aspect, as it
makes individual firms more efficient than the economy as a whole.
C. The innovation stage does not have any well defined goal than simple
adaptation of the new technology.
D. The invention process moves in a straight line according to the plan with out
taking any twists and turns until it reaches the destination.
E. Imitation is the creation of new technology.

1. Innovation leads to benefits for society, but it does not necessarily implies that
ever member of society gains. Examine this statement based on the relation
between innovation and employment
2. Explain different stages of Technological change with some examples from your
experience.
3. Patent system does not reflect the quality of innovation. Why?
4. Critically examine the theories of technological innovation.
5. What market failures do economists argue occur in markets for knowledge? In
what ways do these market failures affect the level of innovative activity? State
policy options for correcting the market failures relating to knowledge

CHAPTER EIGHT
DIVERSIFICATION, VERTICAL INTEGRATION

AND MERGER
Prompting Questions:
Some firms are producing different producing different types of products; why?
Equally competitive firms are some times trying to merge each other. what are the
intentions behind.
Desired Objectives
The reader will get acquainted with
The meaning and basic concepts of Diversification, Vertical Integration and

Merger
Motives for Diversification, Vertical Integration and Merger
Empirical evidences
Implications for public policies

Introduction
Diversification, Vertical Integration and Merger are three important elements of market
structure. All the three are no doubt different but closely interlinked. We will therefore
study them together in the coming discussion. The immediate task before us is to define
these concepts first. Then we will be discussing the motives behind them, and then, exa-
mine them in the context of public policy.
8.1 Definitions
A. Diversification
In order to define the concept diversification, let us start with a simple situation. Suppose
a firm produces some varieties of a product which are close substitutes for each other in
the market, if the firm adds one more variety of the product then it is not diversification.
We may simply call it product variation or differentiation. However, if the firm produces
a totally different product which is not a substitute for the existing products in the
market then it is called diversification. A firm producing margarine starts producing
soap, for example. This comes under diversification. Similarly, when a leather tanning
firm starts manufacturing boots and other leather goods, we will then call it
diversification because here the products are different as a result of which the market
'area' for the firm expands from one class of consumers to another one. Diversification is
thus "the spreading of its operations by a business over dissimilar economic activities".
According to Penrose, a firm is said to diversify, whenever, without entirely abandoning
its old lines of product, it embarks upon the production of new products, including
intermediate products, which are sufficiently different from the other products it produces
to imply some significant difference in the firm's production and distribution
programmes. In the process of diversification, a firm makes significant changes in its
'areas' of operations related to technological base, market areas and productive activities
in which it has acquired experience or knowledge in the past. Four different possibilities
have been mentioned by Penrose for this:

(i) When there are additional products within the firm's existing technological bases
and market areas;
(ii) When there are products involving the existing technological bases but destined
to new market areas;
(iii) When there are products which involve altogether new technological bases for
the existing markets; and
(iv) When there are new products with new technological bases for new market areas.
When a firm introduces new products there will be a change in productive services and
marketing areas or activities. Diversification thus cannot be conceived of changes in
the products only; it implies the other two aspects of the change also, i.e. changes in
the technological base and market areas.
B. Vertical Integration
It refers to operations by a firm in two or more industries representing successive stages

in the flow of materials or products from an earlier to a later stage of production or vice
versa. Thus, it is a type of diversification but it may be looked as 'vertical concentration',
and if the process takes place by merging of two different firms then it is 'vertical
merger'. How ever, vertical integration is a popular term for all these. Essentially, it is the
integration among the intermediate products used introduction of a commodity. It may be
initiated in either way i.e. a firm itself starts manufacturing all of them or different firms
producing goods at different stages of the process merge together.
C. Merger
The term merger refers to amalgamation or integration of two or more firms. The firms
under different ownership and management controls come under a unified one through
merger. The terms 'acquisition' and 'takeover' are also used for merger, which implies
that a firm acquires assets or stocks in part or full, of other firm or firms to get
operational control over them. In legal sense, there is difference between these terms but

from the point of view of the economic analysis they are alike. The important feature of
merger is the transfer of control of business activity from one firm or firms to another.
Situations of merger:
(1) A horizontal integration or merger of firms whose products are viewed by buyers as
identical that is their products have high cross elasticity of demand and supply;
(2) A vertical integration or merger of firms where there is a successive functional link
between their products, that is, the output of a firm is input for the output of another firm
at higher stage of production. There may be such integration between a producing and a
marketing firm for the same commodity or commodities; and
(3) A conglomerate integration or merger of firms which are producing altogether

different products, i.e., which are not substitutes for each other (zero cross elasticity of
demand and supply) such as merging of a cloth making firm and a drug manufacturing
one. The amalgamated firm in this situation will be a market-diversified firm.
Diversification is also implied in the situation of vertical merger.
The terms 'diversification', 'vertical integration' and 'merger' have been defined above in
brief. We have to examine now the motives behind them. The next section deals with
this.
8.2. Motives for Diversification, Vertical Integration and Merger
I. Diversification
Motives for diversification depend on its types. It will be thus convenient for us to
examine the motives for different types of diversification and then synthesize them
together. The types of diversification as observed in practice and motives for them are the
following:
1. Lateral Diversification: When a firm produces different goods which diverge from the
same process or source or which are used as materials for the same process or market.

For example, a leather tanning firm will have lateral diversification when it starts making
boots and shoes leather garments and suitcases itself, because all such businesses diverge
from leather tanning business. Similarly, a meat seller will have lateral diversification if it
starts selling hides, horns, bones and even raw wool. A soap manufacturer may start
margarine and chemical manufacturing itself which are used in soap making and thus
indulge in lateral diversification.
Reasons for lateral diversification
A firm may resort to lateral diversification because of the following reasons:
When production of one commodity necessarily involves production of another,

say, in by-products form, there would be a natural scope for lateral diversification in
order to avoid wastages and gain advantages from the business. Production of
mutton and wool, bitumen, lubricants, paraffin, raw chemicals, etc., together with
petroleum refining, coal, coke, and their by-products such as benzene, etc., is few
examples of this situation.
When market demand for the existing products is declining or stagnant, a firm
has to diversify its business laterally in order to maintain its earnings or to increase
it.
Better utilization of existing facilities such as managerial talents, R&D activities
and certain categories of machines, etc., may be looked as a motive for lateral
diversification.
The market complementarity or interlocking pattern in seasonal demands also leads
to lateral diversification say, for example, one may produce colours and water
sprayers together for festivals. This type of diversification when done through
merger brings more market power by reducing competition and through extension
of operations in different industries.
To maintain the rate of growth, without being accused of monopolizing. This type
of diversification is very much suitable and actually being followed all over the
world.

Lateral diversification is an effective barrier to entry to reduce potential

competition.
2. Conglomerate Diversification: In this type of diversification, the products need not to

have diverged from the same product or source, or converge at the same process or
market as is the situation in the case of lateral diversification. The products will be quite
unrelated. At this stage we can simply express that all motives of lateral diversification
will also be motives of conglomerate diversification.
In brief, it
Helps in extension of market power of the firm
Brings stability in earnings through cross-subsidization, i.e. loss of one product is
covered by the gain from other
Causes an increase in the barriers to entry
Provides more options for risk taking for the sake of profits
Maintains the process of growth
Gives pecuniary gains to the firm
Provides better utilization of some facilities, etc.
3. Vertical Diversification: This is vertical integration in fact. It involves diversification

into process of manufacturing or distribution which precedes or succeeds those in which
the firm is already engaged. It can be either 'backward integration' or 'forward
integration'.
Backward integration is seen where a firm starts manufacturing products previously

purchased from others in order to use them in making its original product line. A milk
product company may have its own dairy farm and similarly, a bakery may have its own
flour mill and so on.
Forward integration occurs when the firm moves nearer to the final market for its
product and carries out a function which was previously undertaken by its customers. A
shoe making firm may start its own distribution or selling shops, a flour mill may start

making its own bakeries; a spinning mill may also start weaving activities and like that-
are few examples of forward integration.
Vertical diversification, whether initiated by a firm itself or occurring by merging of two

or more firms has several motives some of which are as follows:
It provides security to the firm. Say, a firm integrates backward in order to have
assured sources of supplies. The intensity of such integration will be more when
demand conditions for the final product of the firm are very bright. Similarly, the
firm integrates or diversifies in forward direction in order to assure market for its
product.
Vertical diversification or integration provides economies of linked processes and,

thus, the efficiency of the firm goes up due to improvements in capacity utilization.
There will be economies in marketing such as saving of transportation,

advertisement, procurement and selling costs.
There may be saving by eliminating 'the middle man' and his 'unnecessary' profit
margin in the process of production.
On the whole the firm gets more market power through its size or absolute cost
advantages or pecuniary gains through vertical integration. It gives strength to the
barriers to entry and, therefore, reduces competition in the market.
4. Diagonal Diversification or Integration: It consists of the provision within same

organization of auxiliary goods and services required for the several main processes or
lines of production of the organization. For example a firm may have its own power
house to generate electricity or machine tool making units since such things are required
for running almost every processing activity. The motives of diagonal diversification or
integration will be more or less the same as for lateral and vertical diversification. Among
them the major one will be:
mopping up of excess capacity
Reduction of the risks.

The motives of all types of diversification can now be summarized in condensed form as:
(i) Profitability or earning motive which implies fuller utilization of

resources/capacities at the disposal of the firm;
(ii) Stability motive which implies reduction of risks and uncertainties through assured
supplies of resources and markets for main line of production;
(iii) Growth motive which means expansion of productive capacities without being
charged for being monopolizing, and in the face of market limitations; and
(iv) Market power motive which is assured through increase in barriers to entry as a
result of diversification.
In general, a new industry will have higher degree of diagonal and vertical integration but
a mature industry will resort to more lateral diversification. This is because, in the case of
a new industry, auxiliary services may not be available at all, so the firms have to make
for their provision within its organization. For a mature industry like textiles the demand
for such services will be large enough, so independent units may come into existence for
their supplies in an efficient way.
II. Vertical Integration
The motives for vertical integration have already been discussed above under vertical
diversification. One point we must make clear here, whenever there is vertical integration
between two or more firms, it means vertical integration between their products. Such
integration between products exists in the situation of vertical diversification which we
have discussed earlier. The condition of vertical integration between the firms for vertical
integration in the products may not necessary. However, when we talk of vertical inte-
gration, in reality it implies integration between the firms. The integration in their
products is implicitly obvious here. Increase in profits or profitability either by fuller
utilization of resources and saving of costs through backward or forward integration may
be looked as principal motives pf vertical integration. The other two general motives, i.e.,
stability and growth are equally sustained through vertical integration. The motives of the

firms involved in vertical integration play important role in determining the price and
quantity of output of the industry to which they belong.
III. Merger
As indicated earlier, merger implies diversification except horizontal integration between

the firms. The motives of diversification will therefore be equally applicable to merger
also. However, there are some other important motives of merger -which are not linked
with diversification as we will see below in the list of general motives for all types of
merger.
Increase in Profitability: This may be possible either through increased degree of

diversification of the combined firm or through other consequences of merger such
as increased efficiency and market power.
Stability in Earnings: Profit rates of individual firms whether they are in the same
industry or in others may fluctuate widely as they are exposed to a greater degree of
risks. When they merge together there may be little variation in their combined
profit rate. This means the get stability in earnings by merger. The variability of
profit rates is generally measured through their variance or standard deviation. The
variance of profit rates of the combined or merged firms will be lower than the
variance of the profit rates for individual firms. A simple situation for this is when
one firm is having negative profit rate, the other one positive. When both merge
together, there will be likely a stable positive profit rate for them. This is what we
may take as cross-subsidization motive for the sake of stability and reduction of
risks. It may be emphasized here that a reduction in variability of profit rate is a
possible but not a necessary outcome, of merger. There may be situations when
there is an increase in it as it consequence of unforeseen business uncertainties after
merger.
Stock market gains: firms would like to merge together if there is a difference in
the earning-price ratio or market price for there shares in the stock market. There
will be mutual gain for them by merger in this situation.

Efficiency Motive: This motive may be stronger in the case of horizontal and
vertical mergers. As a result of such integration one can expect economies of scale
in a variety of ways, such as reduction in inventory requirements, transportation and
distribution costs, duplicate R&D activities, cheaper raw materials due to increased
size of purchases, better management, etc. In the case of conglomerate merger such
economies of scale are doubtful but there may be better management and more
pecuniary gains.
Market Power Motive: This may be a major motive of merger, as fulfillment of the
other motives like profitability, reduction in risks, growth, etc., which are
complementary to the market power motive becomes easier and almost certain.
Market power is a command over pricing and output decisions by the firm. It
certainly goes up in the case of horizontal merger as potential competition is
reduced in this situation through merger. Similarly, vertical merger in either
direction can increase market power.
For conglomerate mergers the following factors are mentioned as sources for market
power:
extended monopoly power,
encouraged cross-subsidization,
increased deep pocket advantages,
increased entry barriers,
increased non-economic reciprocity arrangements,
increased macro-concentration, and
increased size of power groups.
Growth Motive: This is a possible outcome of merger. A firm grows by

expanding itself in the market or by acquiring some existing firm or through
merger. Combined firm after merger will command more assets, more sales and
more market power.

8.3 Implication for Public Policies
Diversification and integration, whether vertical, horizontal or conglomerate, are

important market strategies which affect the competitive environment of an industry and
economy as a whole. When a firm diversifies, it has certain well-defined motives for that.
Its actions will not be unnoticed by its rivals. They will also have countermoves in order
to maintain their market shares particularly when the products are closely related. Thus,
we expect an increase in the competitive climate in the industry by diversification. The
firms as well as their products compete for scarce resources and markets under such
situation. The question now arises whether such competition involves all firms in the
industry or only a few of them. Common observation is that such competition will be
between large firms only. They find diversification a way to maintain their growth and
market power without being charged for monopolizing in the market. But when only few
large firms control the market and put barriers to entry for new competitors, it leads to an
increase in market concentration so that we may say that diversification explicitly or
implicitly causes market concentration. Under such situation there is a direct implication
of diversification for public policy as no welfare state will allow concentrating market for
a commodity or commodities in the hands of few firms.
Similar situation arises in the case of vertical and horizontal integration among the firms.
It is generally agreed that vertical integration does have the potential to increase market
power either by reducing the competition or through economies of scale. But there is a
counter-argument for this according to which vertical integration does not harm
competition. In fact it helps in increasing competition by bypassing monopolistic
suppliers. There is thus a controversy about the effect of vertical integration on
competition but from policy point of view there is again a strong need to regulate such
phenomenon. For horizontal and conglomerate mergers, there is greater probability of
their causing market concentration, so, they are strictly regulated through-public laws. A
public policy is designed to achieve some chosen objectives or goals.
These may be, say, for example:

(1) To diffuse economic power;

(2) To have efficient allocation of scarce resources; and
(3) To ensure economic freedom of mass participation in the economy.
All mergers and diversification policies of the individual firms in the market are to be
evaluated in the light of such social goals. If the policies are in conflict with such goals
they are to be checked and controlled effectively. Most of the governments appoint
Antitrust or Monopoly and Restrictive Trade Practices Commissions for this purpose.
There will be a set of rules or guidelines which will be implemented by such
commissions to regulate mergers and diversification strategies of the firms by
maintaining a balance between private and public interests.

1 If Sheba Leather Tanning factory starts making different leather products (such as
shoes, leather jacket. etc.), it is best defined as
A. Horizontal merger
B. Vertical integration
C. Lateral diversification
D. Conglomeration
E. Amalgamation
2. The Highland Drinking Water Bottling Company and Abyssinia natural spring water
are blended because consumers view their products as identical, it is
called____________
A. Forward integration.
B. Horizontal integration.
C. Diagonal diversification
D. Conglomerate integration
E. Vertical merger.
F. Vertical integration
3. . A firm may exploit economies of linked process that enhances efficiency through
improvements in capacity utilization mainly by
A. horizontal merger
B. conglomerate merger
C. vertical merger
D. vertical diversification
E. lateral diversification
4. Lateral diversification brings market power

A. by reducing competition
B. through extension of operation in different industries

C. by better utilization of existing facilities

D. all of the above
E. A and B
5. One of the following is not among the motives of conglomerate diversification in
particular
A. better utilization of existing facilities
B. maintaining the process of growth
C. reduction of risks
D. strengthening barrier to entry
E. bringing stability in earning
F. A and D
Questions for review and discussion

Attempt the following questions. Write your answer in your own words. Do not directly
copy from the module.
1. Explain different motives behind diversification, vertical integration and merger with
examples from real life.
2. Discuss the implication of diversification, vertical integration and merger for public
policies in developing economies

CHAPTER NINE
INDUSTRIAL POLICY
Prompting questions
1. Why industrial policy is required? Why not we rely on market system instead of
direct intervention in the industrial sector?
2. What are the importances of industrialization for ones nation economy?
3. What are the economists’ justifications for the intervention in industry?
4. What do you know about industrial policy in Ethiopia?
Chapter objectives
The objectives of this chapter one to:

• Define the concept of industrial policy and explain the need for the intervention in
the industrial sector.
• Discuss different approaches and forms of intervention in industry.
• Broadly discuss key issues in the debate on industrialization.
• Explain the industrial problems and strategies of Ethiopia.
• Mention and briefly discuss the specific objectives of industrial policy in Ethiopia.
• List and discuss different promotional measures for undertaking industrial policy in
Ethiopia.
• Identify incentive instruments to for industrial policy in the Ethiopian context.
• Recognize measures of control, institutional requirements and macro & sectoral
policies to be taken in to account for effective formulation and implementation of
industrial policy in Ethiopian.

Introduction
According to the United Nations Industrial Development Organization (UNIDO), quoted
in Dr. Eshetu Chole (1986:p.2), Industrialization defined as “the process of economic
development in which a growing part of the national resources is mobilized to develop
technically up- to- date diversified domestic economic structure characterized by
dynamic manufacturing sector having and producing means of production and consumer
goods and capable of assuring a high rate of growth for the economy as a whole and of
achieving economic and social progress”. This definition states that industrializing is a
sustained process. It requires the application of modern science and technology to the
production process. In the process of industrialization manufacturing sector plays the
leading and dynamic role. It also brings about structural transformation of the entire
economy in terms of the composition of out put and pattern of employment.
Industrialization is advocated on the ground that it can strengthen the economy and offer
substantial dynamic benefits that are important for changing the traditional economic
structure of the less developed economies. Industrialization is regarded as an important
policy to affect fundamental economic and social changes in least developed countries
(LDCS), which are taken as a necessary condition to improve their growth potentials. It is
taken as a basic strategy for achieving a faster rate of economic growth and a higher
standard of living in many developing countries. LDCs should establish their own
industries in order to produce consumer goods, capital goods and other essential materials
instead of highly being dependent on imported goods. Industrial development can also
provide abase for rapid and continuous increase in the income of the people. Through
industrialization LDCs can improve their terms of trade. The income elasticity of demand
for agricultural goods is (mostly the export of LDCs) low while the income elastic ties of
demands for manufacturing goods is (which are the imports LDCs) very high. As a result
of these disparities in export and import elasticity, LDCs will face a chronic balance of
payment deficit and the term of trade goes against these countries. Industrialization
provides job opportunity for an excessive population of LDCs. It is some times regarded
as the major way of solve the problem of unemployment and under-employment in
developing countries. It is possible to expand and diversify other sector of the economy

of LDCs through industrialization. In general Industrialization can alter the present

economic and social structure of many LDCs; which is not conducive for achieving a
higher level of economic development. It can reduce the problems of raw materials,
unemployment, capital goods, foreign currency and the like, industrialization is
considered as necessary condition for attaining higher level of economic growth.
Industrialization is capable of generating these all because of its some unique features. A
number of distinct features of the manufacturing industry enable it to play a dynamic role
in terms of economic development. This includes among others,
Economies of Scale: Industrial production is particularly subject to economies of scale.
The cost per unit of production is inversely related to the volume of production. Large
firms incur less unit cost than smaller ones. But this is not true to the some extent in
agriculture, or indeed in many services. So the move to industrialize would significantly
increase the production efficiency of developing economies, thereby accelerating growth.
Externalities and linkages: Another reason for supposing that industry is particularly
important for economic development is that externalities are more significant than in
other sectors. The setting up of one activity creates benefits for others, thereby
introducing positive externalities. A more specific application of this is the notion of
linkages. The setting up of an industry creates both backward and forward linkages.
While the demand for inputs creates backward linkages, the provision of services
downstream, such as whole selling and retailing, maintenance, etc., form forward
linkages. Industry, particularly manufacturing, creates more linkages than other sectors
(particularly agriculture) and can therefore give a much greater impetus to economic
development. Productivity increases: Industry is also characterized by more scope for
increases in productivity than other sectors. It has been historically observed that the
faster manufacturing output increases, the greater the rate of productivity growth,
reflecting increased learning and the incorporation of new, higher productivity
technology, which depends on the rate of growth of output. Also, since the industrial
sector provides machinery and equipment for other sectors, increases in productivity in
manufacturing can reduce costs elsewhere in the economy, thus contributing to the
development of other sectors.

This chapter deals first with the concept of industrial policy; it is followed in sequence
with the sections on theoretical case for industrial policy; different approaches to
intervention; key issues in the debate on industrialization and industrial policy in the
Ethiopian context.
9.1 What is industry policy?

Most government action has some effect on the industrial sector of the economy. In many
instances, this is simply a consequence of policy elsewhere for example, import controls
to help the balance of payments, prices and incomes policies to counter inflation and
increases in interest rates to control the money supply or to halt an exchange rate
depreciation. In other instances, government action has a more deliberate effect on the
operation of industry, but would generally still not be considered as 'industry policy'. This
is because the main objective is to influence some other aspect of the economy, as is
often the case with expenditure on infrastructure and on education.
Industry policy usually relates to those policies whose main direct effect is upon
individual firms and industries, or on industry as a whole. As Lindbeck2 defines the term:
By industry policy is meant political actions designed to affect either the general
mechanisms of production and resource allocation or the actual allocation of resources
among sectors of production by means other than general monetary and fiscal policies
which are designed to influence various macro-economic aggregates.
9.2The theoretical case for industry policy
Economists normally argue that intervention in industry is justified if it results in a net

increase in economic welfare. Most change benefits some people, and adversely affects
others. As long as those who gain could, in principle, compensate those who lose, whilst
still deriving benefit from the change, welfare is enhanced (this is the potential Pareto
improvement criterion). Although a theoretically sound objective, changes in economic
welfare are difficult to quantify. Proxies such as improved employment, increased output
2
Ferguson, Paul R: Industrial Economics: Issues and perspectives, page 137

or a more favourable balance of trade must be rejected because they are often poorly
related to economic welfare. For instance, measures to increase employment or output
could lead to the production of a quantity, quality and mix of goods and services which
reduces society's welfare.
The time dimension adds a further complication, because there is a trade-off between
current and future levels of welfare. Assuming full employment, more resources devoted
to the production of goods and services in the present implies fewer resources devoted to
investment aimed at enhancing future production. Society will be willing to forgo current
welfare if it is compensated by a sufficient increase in future welfare. The rate of
compensation depends on the rate at which society discounts future benefits (the social
time preference rate); the lower the rate of discount the greater the quantity of resources
that should be devoted to investment and to research and development (R&D) activity.
While the market rate of interest can be used to derive an individual's willingness to forgo
marginal changes in current benefits in exchange for future benefits, this may not apply
to society as a whole.
It is argued that government intervention can improve welfare in cases where markets fail
to provide an efficient utilization of resources. Five circumstances are cited where
markets produce levels of output that are not optimal from the viewpoint of society:
1. Monopoly;
2. Public goods, such as defense;
3. Externalities, such as pollution or congestion;
4. Common property rights;
5. Differences between private and social time preference rates.
An analysis of the exact circumstances in which markets fail is a prerequisite to the

examination of corrective policy measures. It is crucial to recognize that the case for
industry policy depends on uncertainty, imperfect information and as a result the
presence of transaction costs. This means that neoclassical economic theory is an
inappropriate basis for policy prescriptions. Furthermore, when it is recognized that the
governments too may fail, it becomes even more difficult to provide an economic

rationale for industry policy.
A large literature on public choice theory suggests that many political acts can be
understood by assuming that the objective of politicians is to maximize chances of re-
election. Such acts may be inconsistent with welfare maximization. A vote-enhancing
strategy causes politicians to intervene in cases where market failure arguments do not
apply. The consequence is that governments may be willing to implement industry
support programmes even where the result is to reduce the overall level of welfare.
The ability of politicians to pursue non-welfare maximizing objectives stems from the
presence of imperfect information. This also explains how, where competitive forces are
weak, managers in private sector firms are able to pursue objectives of which the
shareholders would disapprove. If the electorate were fully aware of the costs of
intervention as well as its benefits, then any policy that failed to enhance overall welfare
would lead to a net loss of votes.
Even where motives are altruistic, government intervention to correct market failure may
not be merited. Government intervention is unlikely to be warranted where few parties
are involved, property rights are clearly assigned and transaction costs are low. In such
circumstances market failure is unlikely. For instance, with just one party involved, the
brewery is easily able to identify the source of polluted water and arrive at an optimal
solution by negotiation. However, with air pollution, market failure is more likely, even
where inhabitants have been assigned a right to clean air. The costs to an individual of
enforcing his rights will be high in relation to the benefits to be gained from clean air.
Here legislation and effective enforcement procedures to limit pollution, commonly
found in advanced economies, may increase economic welfare.
The government may find it difficult to identify cases of market failure. In the absence of
perfect knowledge, costs are incurred in acquiring the necessary information to intervene
successfully.
In the neoclassical literature it has been traditional to presume that if some decision
maker is at an informational disadvantage, optimality can be rescued through the

intervention of some omniscient policy maker with privileged access to informational

secrets.
Even when a case of market failure has been correctly identified, the government faces a
further problem in that it cannot know with certainty the most appropriate form of
intervention. A decision widely perceived as 'correct' in the current time period may lead
to an undesirable outcome in the future. For example, controls on a monopoly to improve
the current allocation of resources may lead to reduced innovation. Only where the
optimal prices, products and technologies of the future are currently known could
intervention be guaranteed to bring an improvement in welfare.
Another reason why the presence of market failure is not a sufficient condition to support
intervention is that government action uses scarce resources. Resources are used in the
administration of the policy; furthermore, intervention may take the form of transferring
resources towards favoured areas. There is also a dynamic impact. Government actions
may induce changes elsewhere in the economy. Taxation to finance grants to small firms,
for instance, may deter other firms from undertaking the investment required to maintain
their own future competitiveness.
It is impossible ever to know whether industry policy has been successful. Intervention
itself alters the future state of the world, but is not the only force leading to economic
change. In order to evaluate the impact of policy, those changes which are the result of
intervention need to be identified. However, this requires knowledge of the state of the
world which would have prevailed in the absence of intervention. Consequently, the
success of a policy can only be judged qualitatively.
These problems leave governments with a dilemma. The type of policies that are more
acceptable politically are those directed at improving the dynamic performance of the
economy. Such policies cannot be addressed under neoclassical theory. The theories of
the new institutional economics can give support to intervention that is designed to
improve the workings of the market economy and to remove impediments to the
competitive process. This intervention would include measures aimed at improving

information flows, at strengthening legal rights and improving the framework for their
enforcement.
9.3 Different approaches to intervention.
Given the limited theoretical basis for industry policy, government involvement is very
much a matter of judgment and it is not surprising that there are many differences of
opinion about the best approach to adopt. Moreover, these approaches cannot be precisely
evaluated. Nevertheless, certain desirable features of an industry policy can be specified.
First, any policy should be capable of performing well in an environment where
transaction costs are the norm, and where economic agents lack knowledge and are
continually having to adapt to change. Secondly, the opportunity cost burden of the
policy must not exceed any perceived, potential benefits, having regard to its static and
dynamic effects on the industries involved and also on the rest of the economy.
Four distinct approaches to industry policy can be identified:
1. Laissez-faire 3. Active
2. Supportive 4. Planning
The laissez-faire approach is founded on the presumption that information flows are
perfect, and holds that the market is a better judge of desirable actions than government
agencies. Most types of intervention commonly pursued under the name of industry
policy are rejected. Appropriate policies are those aimed at strengthening and promoting
a competitive environment (for instance, through the control of monopoly or measures to
remove ambiguities in the assignment of property rights).
The supportive approach also believes in the underlying superiority of market forces, but
acknowledges the presence of imperfect information and transaction costs. Proponents of
the supportive approach would agree with the laissez-faire approach in advocating
policies to help markets function more effectively, but would often disagree over the
form of desirable measures. In particular, the supportive approach would argue for
intervention to improve the allocation and enforcement of property rights, to encourage
education and entrepreneurship in order to foster the process of economic change. This

approach also recognizes that external constraints may force the adoption of less
desirable, or 'second-best', policies. For example, if Japan were to adopt protectionist
measures then Ethiopia would be justified in adopting similar policies, with the ultimate
intention of enforcing trade liberalization.
The active approach argues for wider and more direct government involvement in the
industrial sector. This approach differs crucially from the previous ones in that market
judgments are often supplanted by those of government agencies. Selected industries
would typically be given financial support to promote restructuring and be protected from
external competition by tariff and non-tariff barriers. Although protected from external
competition, measures would again be taken to promote competition domestically.
The planning approach is a more extreme version of the active approach. Its rationale is
that welfare can be improved through centralized planning. It argues that central planners
are in a better position - because of their superior, economy-wide information - to make
welfare-enhancing decisions than individual firms. This advantage is greater where
information flows are imperfect and where the economy is changing rapidly. Intervention
is much wider-ranging and more comprehensive than under the active approach.
These policy prescriptions vary because of different perceptions about the efficiency of
markets and the ability of government agencies to identify and to correct market failures.
The basic dichotomy in these views is between advocacy of non-interference (the laissez-
faire and supportive approaches) and advocacy of a large element of government
involvement which includes targeting policies to particular firms, sectors or activities (the
active and planning approaches). In the laissez-faire and supportive approaches, the state
is acting as an adjunct to the market, working at the edges of the market system whilst in
the other approaches the state acts to shape the industrial landscape, taking a leading role
in the industrial economy - a proactive rather than a reactive role. The greater is the belief
in the efficacy of the market and in the impotence of government agencies, the greater the
tendency to reject intervention and to favour an essentially 'hands off' industry policy.
Similarly, the greater is the doubt that the principal objective of politicians is the
enhancement of society's welfare, the greater the tendency to advocate an industry policy

that involves minimal government intervention.
The choice between the laissez-faire-supportive approaches and the active-planning

approaches therefore turns on views as to which uses information more efficiently, state
agencies or the market. Whilst it is undoubtedly true that state agencies have the ability to
be better informed about government intentions and have wider sources of information
than an individual agent, this does not necessarily imply that they have an informational
advantage. One of the main strengths of the market mechanism is its ability to collate and
to make full use of widely dispersed information. Although each agent commands but a
tiny fraction of total information, by responding to price signals from the market each
agent reacts as if he were much better informed.
Even so, most governments have chosen to intervene heavily in the operation of industry.
In some cases, intervention has taken the form of accelerative policies designed to
improve the speed at which the market operates. In others, a decelerative policy stance
has been used to retard the operation of the market. More commonly, both stances have
been adopted simultaneously for different areas of the economy. Few governments have
chosen to make use solely of neutral policies (aimed simply at reinforcing the efficiency
of the market). These would be more consistent with a laissez-faire or supportive
approach, although they have sometimes been included as part of an active or planning
approach. Table 9.1 summarizes the types of policy consistent with these different
approaches.
Accelerative industry policy

The objective of accelerative industry policy is to speed up the innovation process by
providing financial support to the most promising firms, markets or technologies. The
premise behind such a policy is that an economy benefits from adopting innovations
ahead of its trading rivals. This owes little to traditional arguments about intervention to
correct market failure. Moreover, the essentially dynamic nature of the intervention
proposed means that neoclassical theory has little to contribute.

Table 9.1 Taxonomy of industrial policy
Policy approach Policy form
Laissez faire Very limited intervention through neutral policies
Supportive Neutral policies
Active Accelerative and/or decelerative policies
Planning Accelerative and/or decelerative policies
However it is doubtful whether such government intervention to accelerate the

introduction of desirable new products and processes is worthwhile. Three main problems
can be identified. First, uncertainty and information costs make the correct anticipation of
market trends, technological developments and new market opportunities very difficult.
In an uncertain environment the greatest chance of success comes from those who are
best able to gather relevant information. These are the entrepreneurs most closely
involved with a particular area. Government agencies are less likely to have the necessary
specialist information about particular market developments. Secondly, having identified
areas to support, how should the policy is implemented? General support to all new firms
in a favoured area would lead to a considerable waste of resources given the high failure
rate of new firms. Directing funds to potential 'winners' is ruled out by the absence of a
mechanism to identify such firms. Advocates of selective intervention may argue that
uncertainty can be reduced by supporting firms with a proven record, but past success is
not a reliable guide to future performance. Thirdly, the opportunity cost of accelerative
policy must be taken into account. While favoured firms are nurtured, the development of
other sectors is hampered. Extra taxes or higher interest rates are imposed on firms and
their customers to finance industry policy, resulting in an overall reduction in the demand
for goods and services. These other sectors, although not apparently promising, may turn
out to be the real winners.

Decelerative industry policy

Decelerative policies can be of two types. If an essentially viable concern is facing
temporary financial difficulties, bankruptcy or liquidation may be avoided by providing
assistance to help it rationalize production methods or to improve its product range. In the
case of a firm facing permanent problems, the intention of decelerative industry policy is
to moderate the externality effects of its closure and to attain a better utilization of
resources. Proponents argue that, while economic forces may quickly lead to a firm's
collapse, markets operate too slowly in re-absorbing displaced resources. Instead of
suggesting intervention designed to enhance market forces they seek to maintain the
employment of resources in their current use. They propose intervention because of the
length of time markets will take to re-establish equilibrium. Neoclassical theory can give
little support to this because it implicitly assumes that adjustment is instantaneous.
Decelerative policies have been justified on social grounds, the argument being that
preventing (or slowing down) firm closure leads to the attainment of a more equitable and
less divided society. However, the most frequent justification for support to failing firms
is that their collapse will lead to adverse effects on economic welfare. Externalities may
arise from the closure of a major employer in a particular locality, causing a large
proportion of the population to become unemployed with consequent ill effects on the
rest of the community. There may also be domino effects on other companies. For
instance, the failure of a motor manufacturer will harm firms supplying components to
the motor vehicle industry. It would also lead to difficulties among firms involved in the
distribution of motor vehicles. These domino effects would also follow from the failure
of a small firm although, in most cases, decelerative policies have been biased in favour
of large firms. The explanation for this is probably political, stemming from the
widespread publicity given to the failure of large firms. Moreover, smaller firms are
generally less experienced in lobbying for government assistance.
Despite the externalities generated by the premature collapse of a potentially viable firm,
the economic case for government intervention to help it through its temporary
difficulties is dubious. If financial markets are efficient, a basically sound company
should be able to obtain financial support from the private sector. Conversely, if a firm

cannot convince lenders of its basic soundness, then government resources should not be
advanced to try to improve its operation. Even if financial markets do sometimes fail to
recognize an inherently successful company (for example, because of transaction costs)
this does not invalidate the basic argument. The government is likely to be at an
informational disadvantage compared with firms already operating in similar lines of
business. Such firms are more likely to possess the information on future demand
relevant to identifying a failing company, taking it over and turning round its
performance. Furthermore, financial support from the government may fail to promote
efficiency, for it enables management, which has demonstrated its incompetence, to
retain control of the company.).
As with firms in temporary difficulties, support cannot be given to every firm in terminal
decline, otherwise the economy would strengthen and become progressively
uncompetitive. Since funds are likely to be limited, selection is required and here the
government encounters another information problem. Choice of unsuitable subjects will
lead to a waste of resources.
In most cases, it is expected that financial support will be required for a short period, but
the process of readjustment is often protracted. Devoting resources (particularly over long
periods) to the pursuit of decelerative policies incurs significant opportunity costs. Again,
the success of companies elsewhere in the economy will be hampered by higher taxes or
higher interest rates causing a reduction in demand for their goods and services. In other
words, the financing of decelerative policy generates its own domino effects leading to
the contraction, reduced growth or even accelerated failure of companies in the
unsupported sector. In principle, it is impossible to say how the domino effects of
government policy on the employment of labour and capital compare with the domino
effects consequent on the natural decline of firms. However, the overall effect is to
reduce welfare because resources are switched from areas where revenues exceed costs of
production to areas of failure, implying revenues below cost. There is also the cost
incurred in the administration and implementation of the policy.
There is a real opportunity cost - in the form of a burden placed on the rest of the

economy - incurred by the pursuit of decelerative industry policies and their 'success' or
'failure' can be established only after taking these costs into account.
What is the alternative to decelerative policies? In the absence of government support the
assets of the failing firm would be sold to the highest bidder. It can be argued that this
would be a better way of ensuring an efficient use of resources because the entrepreneur
willing to pay the most for the firm will be the one (often already operating in a similar
area) which sees the most profitable uses for the resources of the failed company.
Company failure is an important' aspect of the competitive process, serving to transfer
resources from the hands of a management which has incorrectly predicted market
developments.
Neutral industry policy
Neutral policy seeks to improve the market framework within which economic agents
operate. This type of policy is consistent with economic theories that explicitly
recognized the presence of transaction costs. It is often advocated by those who recognize
the difficulties involved in trying to pursue accelerative and decelerative policies. The
task of government should be to try to create an economic, social and political
environment that is conducive to efficiency and new initiatives. The government may not
be responsible for picking 'winner' industries, but for increasing labour mobility,
improving long-run employment prospects, and hence reducing the resistance to change.
Specific examples of neutral policy include attempts to ensure that property rights are
clearly assigned. The more certain it is that the legal system will enforce such rights (and
the cheaper it is to seek legal remedy against infringement), the greater the incentive for
citizens to acquire private property. Similarly, the easier and cheaper it is to transfer
rights over property, the more desirable it is to own property. Following Coase’s work,
clearly assigned property rights would help to eliminate many cases of market failure.
The pursuit of increased competition - for instance, by the elimination of institutional
barriers which prevent the entry of new firms - could also be regarded as a neutral policy.
Stimulating competition within the legal profession might be particularly beneficial. This
would improve the efficiency of the system for enforcing property rights.

Conclusion
In developing their industry policies governments have often paid little attention to
economic arguments. One reason is because of a difference in objectives. Economists are
concerned with the enhancement of economic welfare, but this may not ensure re-election
for the politician. Secondly, neoclassical economics has little contribution to make to
many of the issues which governments usually consider vital. This is because traditional
analysis is unsuited to problems where change is endemic because of its generally static
thrust and tendency to ignore problems of uncertainty and lack of information. Thirdly,
the approach of the new institutional economics, which can explicitly deal with such an
environment, is generally hostile to the type of unplanned intervention favoured by
politicians.
Many governments have adopted an active or planning approach to industry. Evidence

from particular countries appears to suggest that accelerative industry policies have been
more successful than decelerative ones. For instance, some of the strength of Japan's
successful industries stems from that country's willingness to phase out less successful
ones
However, it is impossible to say categorically whether these successes and failures are
directly attributable to government policies. It is also impossible to judge how
successfully an economy might have developed without the opportunity cost burden
imposed by the operation of industry policies. The opportunity costs associated with
accelerative and decelerative policies are likely to be high. Given that markets fail and
that there is a need for some government intervention in industry, neutral policies as part
of a supportive policy aimed at improving the operation of market forces would appear to
be the most promising.
9.4 Key Issues in the Debate on Industrialization

1. Introduction
Development thinking/theory since its emergence in the aftermath of the Second World
War with the independence of many Asian and African countries has taken turns and

twists. With the collapse of primary commodity exports during the great depression and
the acceptance of Keynesian ideas in developed economies, laissez faire policies based
on orthodox economic theories, gave way for structuralism which accorded central role to
government in economic development. Though the exact role of the state differed from
country to country there was agreement on a number of key points: first, market forces
alone had failed to bring about economic development and therefore the state must
actively seek to promote it; second, development must be achieved by transforming
predominantly agricultural economies into industrial ones; and that economic growth and
structural transformation required an increase in the level of investment in the economy.
Despite remarkable economic growth and progress in industrialization, developing

countries remained dependent on international capital for investment, failed to bring
about technological dynamism and to transform the traditional sector. As a result
unemployment grew worse. Moreover, the strategy failed to exploit the opportunity from
international trade. Despite the strategy's dominance in development thinking and
practice for over two decades, however, sustaining it became difficult as it coincided with
the emergence of the oil crisis of the 70s and the international financial (debt) crisis of the
early 80s.
This situation, particularly the debt crisis, thus set the stage for the emergence of neo-
liberalism as the dominant development thinking with strong support from developed
economies, and international financial institutions, such as IMF and the World Bank, for
its application.
At the heart of neo-liberal policy making is market liberalization (both domestic and
international) and the reduced role of the state. Many developing countries adopted the
prevailing neo-liberal policy package under stabilization and structural adjustment
programs of the IMF/WB through out the 80s and 90s. The neo-liberal approach
however, produced little result in reducing poverty, let alone introducing development.
As a result of the lack of visible success emerging from the implementation of this
dominant paradigm, a serious debate has ensued among development thinkers and
practitioners concerning the theoretical validity and practical applicability of its policy

prescriptions. This rethinking process has again brought into focus some of the old ideas
in development economics that were disparaged by the new paradigm while others have
sought to carefully look at the experiences of successful developing countries particularly
in East and South East Asia, to draw lessons for the less successful ones.
This section tries to briefly look at key issues in the current debate in the development
literature particularly related to strategies or models of industrialization.
9.4.1 The Neo-Liberal approach

Based on the classical theory of comparative cost advantage, the neo-liberal approach
essentially leaves industrialization (the nature, rate, etc) to be determined by market
forces. Central to neo-liberal thinking is the notion of price distortion. It underlines the
belief that market prices provide the best indicators, or 'signal' for decision about resource
allocation. If prices diverge from their free market level (i.e. if distorted) because, for
example, of government price control or subsidies, then the economy will not attain
efficiency. In this context, for a small developing economy, the relevant free market
prices, it is argued, are those set on the world market. Though, prices in the real world are
often distorted, which could be due to monopolistic tendencies, fragmented or
nonfunctional markets, neo-liberals hold that in most instances it is government
intervention in pursuit of some social or economic objectives that generate these
distortions.
Alongside the importance of freeing market prices, the neo-liberal perspective strongly
emphasize the virtues of free international trade based on static comparative advantage.
Accordingly, each country concentrates on producing those goods in which it has a
relative (comparative) advantage instead of trying to produce goods which could be
imported cheaply from countries producing them at the lowest cost. The effort to
encourage local production of goods, which can be produced cheaply abroad, deliberately
interferes with trade and introduced inefficiency.
Another major strand of neo-liberal thinking is related to the role of the state. Relying on
the market as the best arbitrator of prices and efficiency, the state should take a hands-off

approach to development. Economic decision should be left to private agents and the
state should only provide those goods and services with demonstrable market failure and
the provision of public goods such as infrastructure, education and health, which would
not otherwise be provided by the private sector. Not only protectionism in international
economic relations, but also other forms of interventions in the domestic economy are
considered counter productive. These include any form of national planning, all forms of
intervention in the market and direct investment in the production of goods and services
that can be produced by the private sector through state enterprises. All these are
presumed to lead to a high budget deficit, spiraling inflationary pressure, rent seeking
behavior and generally, to an inefficient allocation of economic resources.
As such, the emphasis of the neo-liberal approach is on individual economic agents and
on the free play of market forces to provide short-term allocative efficiency, in the belief
that achieving such efficiency would inevitably lead to long-term growth and
development
Neo-liberal policy prescription

The policy prescription drawn from the neo-liberal approach is straightforward:
The first is market liberalization, often referred to as 'getting prices right'. It mainly
involves removing price controls, financial liberalization and less intervention in
labor market.
Trade liberalization to move the economy towards greater outward orientation, i.e.,
removing import quotas, reducing tariffs and maintaining a realistic exchange rate.
Reducing the role of the state in the economy through privatization and reduced
government spending.
These policy prescriptions are expected to limit the role of the state as an economic agent
and restore market forces, both domestic and international, which facilitate the free and
efficient operation of the economy. Then the activities of individual economic agents, in
the context of competitive domestic and international markets, will lead countries
towards an optimal allocation of resources. Hence, an attempt to direct an economy
towards certain kinds of production activity would be counter productive to the

development process.
Given the current circumstances of the country, this implies that since Ethiopia's
comparative advantage is in agriculture, the country should concentrate its efforts at
developing this sector and making it competitive in the international market.
Industrialization, if it happens, must come as a result of the operation of market forces
rather than through a deliberate intervention on the part of the state through industrial
policy.
9.4.2 The Structuralist perspective

The Structuralist perspective is based on the theory of dynamic comparative advantage
and the experience of industrialization in other countries. Its proponents argue that the
doctrine of classical/traditional comparative cost advantage is essentially concerned with
static efficiency in the allocation of resources, and is not conducive to long-term
development, which is the chief concern of Least Developed countries (LDCs). In other
words, there is a possibility of incongruence between market determined comparative
cost advantage in the short-run and the acceleration long term development. It starts from
the premise that certain special features of the economic and social structures of less
developed economies and the international environment in which they operate make a
significant part of neo-liberal analysis inapplicable and misleading. Thus, there is the
need for a conscious and home tailored and specific industrialization strategy and policy
package. This approach has the following underlying features:
(i) Skepticism about the beneficial effects of unadulterated free market. Structuralism
questions the neo-liberal premise that the free play of market forces (both domestic
and international) by itself can bring about economic development in LDCs.
Countries are linked to the global economy largely through trade and movement of
goods, services and capital. For the long term development of a country, what matters
is not only its active participation in international trade on the basis of comparative
cost but also the nature of the commodities it specializes in. This is because demand
conditions differ depending upon the nature of the commodity. The demand for
primary commodities, for example, tends to be income inelastic. Accordingly, as the

demand for primary commodities (LDCs' main exports) in developed economies is

falling relative to those of manufactured goods (LDCs' imports), LDCs are facing an
unfavorable terms of trade.
The flow of capital in the form of foreign direct investment, to LDCs has been at best
limited, as it primarily requires necessary economic infrastructure, large market and
guaranteed political stability, which developing economies may not satisfy. Even
when the inflow occurs, it may eventually act as a break to growth as a result of
increased outflow of profit. Foreign loans too, have their own adverse effects. The
sharp rise in international interest rate, over which LDCs have no control, and
eventual outflow of interest and dividends, may have devastating effects. In addition,
banks' reluctance to extend loans and the political criteria attached to bilateral, and
even multilateral loans, cast great doubt to the availability of capital for long-term
development.
Moreover, real world markets are often segmented along the lines of quality, design,
geography (creation of blocks), etc, and therefore the world market may, not be as big
and as open as it seems, given that it takes time and resources to penetrate into new
markets.
(ii) Emphasis on structural change. Development is seen as a process of transformation

of economic and social structures in which industry, particularly manufacturing
industry, plays a crucial role. Economic history of developed countries shows that the
importance of industry has been steadily increasing over time. Moreover, studies
comparing the economic structure of developed and developing countries revealed
that the major difference lies in the size of their industrial (and largely its derivative,
the service) sectors compared with their respective agricultural sectors.
While the neo-liberal approach has generally no concern for sectoral differences,
treating all activities as equivalent, structuralists believe that a number of features of
industry, such as economies of scale, externalities, productivity, etc. enable it to play
a dynamic role in economic development.

(iii) Emphasis on the dynamic aspects of technology. Technology plays a critical role in
development. As such, developing local technological capability has prime
importance. On the contrary, neo-liberals hold the view that as developed countries
have comparative advantage in industrial technologies as a result of long experience
as well as ample financial resource and human capabilities (skills), LDCs would be
better-off (in light of limited resources) to import existing technologies, but not re-
invent the wheels. An extended version of this view argues that LDCs should not
introduce technologies that divert development away form basic needs. Less
developed countries can, therefore, acquire technological capabilities by integration
into the world economy, relying on foreign technology and through direct foreign
investment and/or licensing.
For the alternative approach, technology is rather the outcome of research and
development by firms or research institutions and on-the-job learning (learning by
doing and learning by using), which is referred to as 'endogenous growth' in the
literature. Importing foreign technology does not, therefore, necessarily offer a short
cut to industrialization. Rather, excessive reliance on imported technology may lead
to technology dependence. This may create a number of problems, including
acquiring an expensive and outdated technology (because of LDCs' weak bargaining
position due to lack of expertise, inadequate information and lack of alternative
sources of supply), importing inappropriate technology (in terms of intensity of factor
inputs and scale/capacity of production), and inability to adapt imported technology
due to lack of local technological capability.
(iV) Capital accumulation and investment in productive sector. A high rate of capital
accumulation is a necessary condition for bringing about structural transformation
and increased level of productivity. However, for increased levels of accumulation to
give rise to faster industrialization, resources should be channeled largely into
productive investment rather than consumption. As pointed out above, for the neo-
liberals the type of activity engaged in does not matter for economic development;
while for the Structuralists, economic development requires higher investment in
industry by channeling resources from other sectors.

v) Ownership and control of resources. Highly concentrated ownership and control of

resources affect the outcome of economic policies and processes. Hence, ownership
should be taken into account. While the contributions that foreign ownership can
make by introducing advanced technologies and providing access to foreign markets
is well recognized, unrestricted foreign ownership might have negative effects on
economic development. Because of considerable market power, and various
accounting procedures, Trans National Corporations (TNCs) may evade taxes and
repatriate a large amount of profit. Another effect of high ownership concentration is
skewed income distribution, which in turn may also have an adverse impact on long-
term development.
Structuralist policy prescription

The state in less developed countries should pursue active strategic interventions in order
to promote industrialization/development. There are a number of key areas in which the
state can play a promotional role.
(i) Link with the world economy: As the free play of market forces tends to lead
further polarization, the state must intervene to mediate the relations between
national and the world economy. With respect to prices of primary commodities at
the international market, LDCs should together create international commodities
agreements, or form producer cartels, like OPEC, to stabilize prices of primary
commodities.
(ii) Infant industry Promotion. Infant industries can be pressurized to make

improvements in their productivities and overall efficiency levels only over time
since learning and acquisition of technological capability take a considerable period
of time. Until then, however, industries should be given some form of support to with
stand the pressure from experienced and technologically advanced and highly
competing foreign firms. The state has a vital role in managing the required positive
intervention.
The modality, however, may not necessarily be the traditional across the board,

indefinite and unlimited protection, which was practiced in the past in many
developing countries with adverse economic consequences. Rather, protection should
be applied selectively, at a limited level and for a fixed period of time.
Protection should be selectively targeted. It should be a reward to a specific firm for

achieving a targeted performance related to productivity, production, export, etc. It is
not necessary that all industries be equally and simultaneously protected.
Moreover, if a given target is to be achieved, then there must be a time limit. Hence,
protection should be temporary. It is essential to avoid monopoly tendencies. While
firms are externally protected, internal competition should be encouraged.
Competition against imports should be enhanced gradually.
Lastly, the level of protection must be limited. It should not be excessive to eliminate
competition from abroad altogether, or too low to avoid exposing the industry
concerned to the dangers of foreign assault.
Infant industry protection, therefore, should not be a blank check. It should be

accompanied by regular pressure to make firms improve their productivity and
efficiency, which will in turn make them competitive internally as well as externally.
In a way, the ultimate objective of protection is to create a competitive market. If for
structural reasons infant industries cannot altogether compete even the domestic
market, let alone exporting, then the market, in effect, is a siege monopoly market.
Government should also actively promote/encourage exports. While on the one hand
the domestic market is protected for selective products, firms should be encouraged
and pushed to compete in the international market. Import substitution and export
promotion are not, after all, contradicting, but rather reinforcing policies.
(iii) Priority setting. Establishing new industries involves a great risk; hence producers
have to be provided with extra incentives to enter the business. In such cases, the state
should provide the required incentives, if such industry falls in the priority list.

(iv) Coordinating complementary & substitutable investments. The importance of

coordinating complementary investments in the presence of capital market
imperfection and significant economies of scale, require the intervention of the state.
The state should also coordinate competing industries (so called managed
competition) to avoid Oligopolistic (wasteful) competition.
(v) Efficient scale operation. Government should encourage the establishment of

factories, which are well above the minimum efficient scale but not those which are
too much below the minimum efficient scale.
(vi) Ownership and structural change of industries. Certain key industries involve high
risks or may require large capital investments, which may not be attractive to the
private sector. Hence, in such industries (e.g. steel, petrochemicals, large engineering,
etc.), which are essential for creating an integrated industrial sector, the state should
necessarily invest to create complementarities in the sector.
When production enterprises turn into declining industries due to structural problems
(so called structurally depressed industries), the state should accelerate resource
transfers and help the producers upgrade their technologies.
(vii) Structure of the industrial sector. To ensure that adequate investment is flowing to
priority sectors or sub-sectors, such as capital goods industries, to keep the balance
between large and small scale industries or to create input-output linkages between
industries, the state should play a key role by providing adequate incentives.
(viii) Technology transfer. To reduce the cost of imported technology, the state should
intervene in technology transfer. This would be essential to import only
technologies that are not available at home. This is the so called 'unpacking
technology'. The state should also be involved in direct support for applied research
and providing fiscal incentives for such expenditures by the private sector, to
enhance local technological capacity.

(ix) Foreign investment monitoring & control. While recognizing the benefits which
TNCs offer in terms of technology transfer and access to foreign markets, state
awareness and reaction on the behavior of TNC's is necessary if the costs of foreign
investment are to be minimized. The state should monitor and control the pricing
practices of foreign enterprises. The state should also directly negotiate with foreign
companies to obtain more favorable terms in revenue through taxation, royalties and
share ownership than the free market can provide. Moreover, the state must have a
role as the organizer of domestic firms into implicit cartels in their negotiations with
foreign firms or governments.
For successful industrialization, Structuralists call for a 'hand-and-glove' approach

between all stakeholders in the economy, namely the state, private
investors/producers, labor unions, and consumers. The overall state intervention
program, including promotional support and corresponding obligations, duration and
level of support and targets to be achieved, should be discussed, understood and
agreed upon, particularly between the state and the concerned business community.
This is critical to control the level of government intervention so as to avoid
government failure and enterprise inefficiency.
9.4.3 Micro-Level Perspective of the Neoclassical Approach

The above discussion focused largely on the macro version of contending theories. An
important extension of the macro version, particularly from the point of view of its
relevance to industrial policy is, however, the micro-level implications of these
theoretical perspectives.
Neo-liberal micro-development perspective
In the standard neoclassical approach, all markets, including markets in developing
economies, are assumed efficient. Product markets give the correct signals for investment
in new activities, and factor markets respond to these signals without serious lags or
friction.
No activity that is efficient will by definition die out and none that is inefficient will
survive. The demise of inefficient activities will release productive resources for others

that are efficient and that will spring up in response to the new price signals. Resources
will move with little lag and with no constraints from missing or defective markets.
Comparative advantage in industry, as given by resource endowments, will thus be fully
realized, not only in a static sense but also in the emergence of new advantages that arise
from the accumulation of capital.
At the firm level, given perfect competition, information, foresight and efficient factor
markets, the optimum point on the production frontier is chosen according to prevailing
relative factor prices. All firms are by definition equally efficient: technology is freely
available, with full knowledge on techniques available to all firms - most importantly, it
is costless and instantly absorbed, and any learning process is known, predictable and
automatic.
Overtime, as factor prices change to reflect changing endowments, their activities change
accordingly. This represents the optimal pattern of specialization and forms the basis for
evolving comparative advantage. Hence static optimization in turn leads to dynamic long-
term growth.
A revised version of this paradigm, the market-friendly approach, drops some of the
assumptions of the neoclassical approach. It accepts that factor markets may not operate
perfectly, and that education markets, in particular may need interventions to create the
human-capital base for industrialization. These interventions are taken to be 'market
friendly' (i.e. not selective), on the implicit assumption that skills are generic and
fungible. Thus different patterns of industrialization are taken to have similar skill needs.
The market-friendly approach also accepts market failures in coordinating investment
decisions within industry for several reasons: Missing information markets (financial
markets), capital-market deficiency, economies of scale, interdependent investments in
vertically related activities, externalities in skill creation and learning, and 'multiple-
linkages'. However, the conclusion remains the same: that market failures are
unimportant and selective interventions not effective.

Neoclassical Assumptions on Technological Development

The implications of the neoclassical theory to industrial policy go beyond what is hinted
above. Moreover, there are additional detail assumptions on technology that are central to
the debate on Industrial and technological development policies.
In the neoclassical world, all firms operate with full knowledge of all possible
technologies, equal access to these technologies and the ability to use them efficiently
without risk, cost or further effort. The import of technology is just like the purchase of a
good: there is a given market price based on perfect information about the product and its
competitors, and technology is sold and bought like a physical good. There are no, tacit
elements in the transfer, no learning costs and no need to make adaptations. Thus all
firms can immediately use technologies with the same degree of efficiency - all at best
practice levels. In this setting, technical inefficiency is due only to managerial slack or
incompetence, and can only exist if governments intervene to create barriers to trade or
competition.
With regard to the learning process, it is believed to be fairly short and predictable. It is
confined to running in a new plant until it reaches rated capacity, and until the benefits of
passive learning by repetitive activity are released. It is generally assumed that such costs
are relatively trivial and similar across industries. The learning process does not involve
investment, risk or long maturation periods. Firms know what to do to reach best practice
levels: they have full information on what to do to become efficient. Given perfect capital
markets, firms can borrow to finance the entire learning process wherever resource
endowments justify the technology. If there are capital market failures, these should be
tackled at source, rather than by governments, 'picking winners', and protecting or
subsidizing them.
Firms are assumed to operate as individual units, essentially in isolation. There are no
linkages between them, and no externalities resulting from individual efforts to generate
skills and information. Since all markets function efficiently, there is no need to create
institutions to provide information, technology, and so on. Since there are no
externalities, there is no need to coordinate investment decisions across activities that

may have intense linkages. Nor are some sets of activities more significant for industrial
development than others in that they have more beneficial externalities.
9.5 Industrial Policy Framework in the Ethiopian Context3
1. An Overview of Industrial Problems and Strategies

Ethiopia's industrial base and economic development are the lowest even by African
standard. There are various constraints to the country's industrial development. Among
the many constraints the most notable ones are:
While, the sector has been dominated by capital-intensive technology, and it is fully
dependent on foreign capital goods and to a large extent for raw materials, its foreign
currency earning capability has been limited; the foreign currency earning of Ethiopia is
based upon primary agricultural outputs but as the country is by and large a price-taker in
the international market for these products, the country finds it difficult to generate all the
foreign currency required for its industrial development; obsolescence of machinery and
equipments, and the low level of local technological development; lack of technological
information; lack of skilled labor; low demand for Industrial goods which emanate from
low level of income; low quality of locally manufactured goods and hence consumer bias
against local products; lack of well developed infrastructure and under capacity
performance. Manufacturing sector of Ethiopia is structurally unbalanced and
technologically backward, resulting in a state of declining productivity and deteriorating
competitiveness. The policies pursued in the past failed to initiate appreciable
industrialization in the country. On the other hand, experiences of successful
industrializers, clearly underline the need for a guided industrial policy.
To enhance industrial development the governments of Ethiopia have been pursuing

different development strategies. In the Imperial era import-substitution strategy was
formally pursued. Industrialization of the time was characterized by the promotion of
foreign investment, the establishment of large and medium scale foreign-owned
enterprises active in import substitution production and strong growth. A series of
3
This part is taken from Ethiopian Economic Association Report on the Ethiopian Economy volume III
2003/4 entitled: Industrialization and industrial policy in Ethiopia,

policies were formulated to promote foreign investor participation. These incentives

included 5 to10 years tax holidays, low duties 'for imported raw materials and export
value-added goods, tax exemption on dividends and the expatriation of profits and
proceeds obtained from sale of assets etc. As the effort was concentrated on large and
medium scale industries the small-scale industry was almost neglected. The trend of the
industrial development took a new turn since the mid 1970’s when the strategy for
industrial development was pursued by the sole involvement of the government and the
private sector was discouraged. The 1974 coup has made it possible for all major
industrial operations to come under the direct control of the government and the private
sector was discouraged. This led to restructuring, reorganizing and centrally planning of
industrial development. Private ownership was mainly limited to small-scale and
handicraft industries. The import-substitution strategy adopted by the Imperial
government, however, was further pursued. In the post 1991 period the change in
government brought a bout significant change in industrial policy in favor of
liberalization and privatization of the Industrial sector especially the manufacturing sub-
sector. The current industrial development strategy is based upon the overall economic
development strategy known as ADLI. The major goals of the ADLI are the use of labor-
intensive technology and local resources; promotion of economic efficiency; achievement
of international competitiveness in areas of clear comparative advantage in Industrial
exports; development of domestic technological capabilities for the production of
intermediate Inputs, spare parts and capital goods etc.
In the following section brief highlights of some the issues that need careful
consideration in formulating an active industrial policy for the country by drawing
lessons from successful late industrializers and firmly based on the concrete conditions
that currently prevail in the country's manufacturing.
2. Specific objectives of industrial policy in Ethiopia

While the overarching long term objective of industrialization remains high employment,
thereby improving the standard of living of the population, industrial policy should
primarily identify the specific objectives/goals to be achieved over a defined period of
time. Countries differ in their industrial structure, technological status, efficiency,

competitiveness, etc. This in turn leads to differences in their specific objectives. Most
manufacturing industries in Ethiopia are technologically backward and the sector as a
whole has very weak sectoral linkages and internally an unbalanced structure. As a result,
it is dependent almost entirely, on the rest of the world for its intermediate inputs and
capital goods; it has very low and declining productivity; and internationally, it is least
competitive. This characteristic, therefore, suggests what the specific objectives should
be. Successful industrialization in Ethiopia, therefore, should basically achieve the
following objectives.
(a)Create a more complete structural linkage between manufacturing and agriculture
(b) Create an internally balanced manufacturing sector
(c) Enhance the productivity and efficiency of firms
(d) Develop dynamic comparative advantage of industries
(a) Sectoral linkages:

A unique feature of manufacturing is its position vis-à-vis the other sectors of the
economy. It is the only sector that has a linkage with all other sectors of the economy,
including agriculture, mining, transport, communication and services through its input-
output structure, i.e., demand for raw material inputs and supply of intermediate and
capital goods. In the Ethiopian context, the backward linkage of manufacturing with
agriculture is significant. The manufacturing sector largely feeds on domestically
produced agricultural raw materials. However, its forward linkage with agriculture is
loose. Traditional agriculture requires a great deal of modern technology inputs including
fertilizer, pesticides and insecticides, labor saving improved farming and harvesting
implements, and transport supporting facilities to enhance productivities. In this respect,
the manufacturing sector failed to supply such implements to agriculture. As a result,
agriculture heavily depends on outdated traditional farm implements and inputs and on
imports for its intermediate inputs capital goods. So, a prime and immediate objective of
industrialization would be to meet the demand for inputs and capital goods of agriculture.
(b) Balanced structure among industries: the structure of industries within

manufacturing, i.e. structural linkages among consumption, intermediate and capital

goods industries is grossly unbalanced. As the sector is overly dominated by consumption

based firms, demand for capital goods and intermediate goods are largely met through
imports. The linkages among industries are very weak. Critical intermediate inputs are
largely imported. A developed manufacturing sector satisfies its own intermediate inputs
and capital goods from within. Another important objective of industrialization,
therefore, would be to create a structurally balanced manufacturing sector, less dependant
on the external economy at least for critical and timely inputs, and more vibrant and
dynamic internally.
(c) Productivity and efficiency: Survey results have shown that productivity and
profitability of most firms have been declining for long, rendering them less competitive
even in the domestic market, thereby operating at a level less than full capacity. Because
of technological backwardness, most firms are inefficient. Another central objective of
industrialization, therefore, is to enable firms update their technology, improve their
managerial and labor skills, and enhance their marketing capability so as to move to a
high productivity and efficiency frontier. It should be underlined that an industrialization
strategy in countries such as Ethiopia should not be simply picking winners and dropping
losers. Given the underdeveloped nature of the sector, Ethiopia cannot afford to abandon
firms and waste the few experienced managers and workers. So the strategy should be to
support firms in all possible accounts while simultaneously pressurizing them to improve
their productivities irreversibly, and remain in the business.
(d) Dynamic comparative advantage: Ethiopia's comparative advantage today

lies in its natural endowments, mainly agriculture and cheap (and trainable) unskilled
labor force. However, given the low level of labor productivity and the weakness of
agriculture, even this cannot be relied on for long. Dynamic industrialization primarily
requires developing technologically leading industries which could create positive
externalities and spillover effects for other industries. The competitive edge of today's
industrialized economies lies on dynamic comparative advantage, which is essentially
superiority in technological capability -high tech industries and technically skilled labor.
Thus developing broad based technological capability in order to emerge efficient and

competitive in the long-run, should be the central objective of industrialization in

Ethiopia.
3. Selection of industries for promotion

As noted above, most manufacturing firms are structurally weak and inefficient. In this
respect, promoting manufacturing industries in Ethiopia would involve considerable
financial, human and other resources that could not be easily affordable. It would be
beyond the capacity of the state to support many industries simultaneously. Effective
industrial promotion, therefore, can only be carried out selectively, on priority basis, and
in phases or sequences.
Moreover, selection of firms/industries should be based on a set of identified criteria,

which would satisfy the specific objectives outlined above. Accordingly, industrial
groups which satisfy the basic objectives, and hence which should be given more
priorities than the rest, include the following:
(i) Industries producing modern technical inputs to agriculture: This involves firms
manufacturing fertilizers, pesticides, insecticides and improved implements. There is
little disagreement on the critical role that technical inputs play in raising productivity.
Currently, only less than half4 of the farmers in the country (much less in terms of
acreage) use fertilizer. Moreover, the rate of fertilization is much less than the
recommended minimum. Increasing productivity in agriculture significantly, therefore,
demands augmenting the level of fertilizer input exponentially.
Moreover, as the merit of inorganic fertilizer is becoming questionable world wide, the
applicability of alternative inputs (organic fertilizer) is widely under consideration. It is,
therefore, essential that Ethiopia shifts to such alternative inputs not only to enhance
productivities, but also to maintain and further promote its agricultural export. This calls
for producing such technical inputs which are suitable to the specific soil condition of the
country in large scale.
Also, Ethiopian subsistence agriculture is dominated by micro size plots, largely less than
4
Ibid page 292

a hectare. While application of mechanized farming is not easily practicable because of

small size farms and difficult terrain, as well as the problem of affordability, farmers are
still deploying age old farming and harvesting tools and techniques. In many countries
the green revolution has already introduced various labor-saving, low cost and
productivity augmenting appropriate implements. In Ethiopia little has been done in this
particular case.
Therefore, manufacturing industries in these areas, specifically those engaged in the

production of fertilizer, pesticides, insecticides and improved farm implements have to be
encouraged. Promoting such firms has many advantages. Primarily, it supports the food
security and poverty reduction programs. It also creates a regular and reliable supply of
inputs, and labor being relatively cheap; it can also be expected to lower production costs,
at least, in the longer term. It further reduces import costs substantially. Currently
fertilizer import alone accounts for nearly four percent of the value of total imports.
(ii) Industries producing intermediate and capital goods. Lack of investment

coordination created a structural imbalance (imbalance among consumption, intermediate
and capital goods supply). While intermediate inputs supplying firms are few, capital
goods industries are largely lacking. This resulted in heavy dependency on imports for
intermediate and capital goods. Some of the intermediate inputs, such as chemicals, are
so critical that lack of them could significantly retard production. Therefore, industries
which produce critical intermediate inputs and capital goods should be given due priority
for promotion. Such industries, with relatively high potential linkages, include basic
chemicals, iron & steel, cutlery & hand tools, basic and general purpose machinery,
paints, varnishes and mastics, etc.
Promoting such industries will significantly induce more new entrants through the
forward and backward linkages effect, thereby expanding the sector, and hence creating
more employment. Since such industries lie at the center of the linkages, they have strong
spillover effects setting the required technological and quality standards.
Except fuel and spare parts, the remaining import demand of the sector constitutes

intermediate inputs. Promoting industries with high linkages, therefore, will substantially
reduce the import demand of the sector as a whole. This leads to a structural change
towards a more independent and internally vibrant manufacturing sector.
(iii) Import cost reducing and export promoting industries. A major challenge of
industrialization at least at the initial stage, is the massive import demand, which far
exceeds export earnings. Therefore, promoting both import substituting (or import cost
reducing) and exporting activities is not only complementary and reinforcing, but also
necessary.
Though most manufacturing industries use imported inputs, the import demand of some
industries is relatively much larger than others. In most cases, the demand of such
industries would be met if the internal structural problem of the sector is resolved, i.e., if
the capacity of intermediate goods producing industries is augmented substantially. There
are, however, industries with relatively weak linkages but high import demand. Industries
such as battery manufacturing, basic iron and steel, etc. are largely import intensive.
Therefore, establishments producing inputs to industries such as metal casting foundries,
iron bar and iron sheet industries, chemical industries, etc., have to be the focal point for
promotion.
Promoting export oriented industries is a well recognized strategy. Ethiopian

manufacturing is least known for its export performance. Currently, export is literally a
single industry's affair - that of the leather tanning. Other industries making limited
export effort include sugar, textile, meat and fruits processing. Most of these export
oriented industries are natural-resource-based agro industries, hence exploiting the
existing comparative advantage of the country. Capitalizing on this natural resource
potential, promoting such agro-based exporting industries is obviously justifiable.
Export promotion, however, should not be limited to these industries alone. Export
diversification is essentially a key strategy. Even more important is exporting of
intermediate inputs, though the short term prospect, at least in large scale, is limited.

Despite this, export promotion should be open equally to all industries capable of making
the effort.
(iv) Efficient and innovative firms: irrespective of the above categorization, there are
firms which emerge efficient and innovative on their own effort. Such firms could be
exemplary, and their experience could be diffused to other firms if supported and
promoted to expand their scope and scale of activities. From time to time, a number of
such innovative firms have emerged in the manufacturing sector. For instance, successful
ventures such as manufacturing of elevators through reverse engineering and adaptation,
truck and trailers manufacturing, building a water based machine cooling system in a
plastic products manufacturing enterprise, and the like have been witnessed. [UNCTAD,
2000] There are also related ventures in experimenting with alternative sources of energy,
such as solar energy. Recently emerging enterprises engaged in electronics industry, such
as computer assembly, TV assembly have to be encouraged to move into manufacturing
of parts. For instance, the lack of policy to support and encourage the few auto
assembling firms to move into higher value added manufacturing stages, has left this
industry in limbo with little technology transfer to other industries. Also, the high-tech
skill said to be the mark of Ethiopian Airline is confined within itself without any spill
over effect to other industries for decades. Hence, encouraging and promoting such
enterprises so that they could expand and extend their activities to manufacturing would
allow other industries/firms to benefit from their innovative experiences.
(V) Strategic industries: the relatively cheap and reliable supply of agricultural
products, which make up the bulk of the raw material inputs for agro-based industries,
such as leather, textile, sugar, meat, fruits and vegetables processing industries, along
with cheap and trainable labor, provide the static comparative advantage of the
manufacturing sector. However, industrialization, in the main, is creating a long-term
dynamic comparative advantage, i.e., building technological capability - expanding
technologically leading industries and creating technically skilled labor force. Promoting
strategic industries which could generate technological externalities to all other industries
is the central long-term strategy of industrialization.

Such industries involve electrical and electronics, chemical, iron casting foundries, iron
sheet, iron bar, aluminum manufacturing, machinery manufacturing, precision
instruments, and other engineering industries. In Ethiopia, however, strategic industries
are largely missing and they have to be created, nurtured and developed through new
investment. This should be primarily the focus area for public investment as well as FDI.
The categories outlined above are quite broad. A large number of industries and firms fall
under these categories. But as intervention resources are limited only a few activities
should be promoted at anyone time. This implies that there is a need for further
prioritizing industries and firms. For instance, even after selecting chemical industries, it
may be necessary to identify further a few relatively more important chemicals for
promotion in the first phase, to be followed by others at a latter phase. Drawing such
priorities requires more detailed studies of each industry identified for promotion.
However, it should be underlined that promoting a single industry has practical

limitations and could be less beneficial than promoting a group of closely linked
industries. In practice the latter is advantageous and often preferable. This is so
particularly when an industry has both forward and backward linkages.
Moreover, promotional activity is not passive. It is rather, a very active exercise. It

requires aggressively challenging industries/firms to improve, actively move to a higher
stage, to be competitive and become more professional in return for active support or else
face the consequences.
4. Promotional measures
Now that the industries to be promoted are identified, what is the role of the state in
promoting the industries? What are the measures that the state could undertake in the
Ethiopian context? It should be underlined that intervention should be comprehensive.
There is little outcome if investment is encouraged while ignoring marketing activities; it
is also less useful to upgrade the hardware technology of plants while the skill of workers
remain rudimentary. So interventions, or promotional measures must be undertaken in all
markets, including product market, input market, capital market, technology market, skill

market and foreign direct investment. Moreover, interventions in all markets should be
closely coordinated. One without the other may be ineffective even counterproductive.
Moreover, as noted above, interventions could simultaneously involve broader and linked
group of industries or selectively, a single industry, firm, or product.
A number of measures are identified below. While some of these have common features
for many developing economies undertaking industrial policy, others are specific to the
Ethiopian manufacturing sector.
4.1 Identify the specific problems constraints of and criteria selected industries
Survey results have indicated that most firms have little idea about the internal critical
problems of their plants or firms, particularly technical aspects. They have little
information or knowledge outside their own firm. The same is true with respect to the
new technology on the market, productivity levels of sisterly firms in other countries or at
international level, new management techniques, labor skills, new product qualities and
mixes of improved raw materials to improve product quality, etc. Lack of such
knowledge leads managers to think that their main problem is lack of market and
shortage of raw material. So, identifying the major problems and critical constraints of
selected industries and firms is precisely the initial major undertaking of the
industrialization process.
This requires establishing teams of experts which form the nucleus of the office which
will run the industrialization process (for details see below under institutional
requirement). Such teams should be composed of versed experts in each industrial
activity, involving largely engineers in various fields (chemical, electrical, mechanical,
and hydraulic, etc.), industrial chemists, production managers (in textiles, leather,
foundries, etc.), economists, etc. It is these teams of experts which will visit each firm,
identify their problems with respect to technological status, labor skill, product quality,
managerial techniques, etc., and recommend what specific promotional measures should
be undertaken, what instruments to use, what incentives to provide, for how long and to
what extent, etc. It is these teams which will recommend the type of technology, the size
of the firm, labor skill, product quality, etc., for new investment in a specific industry. In

short, these teams involving experts of international standard with full information access
to and knowledge of manufacturing technology will lead the industrialization process in
the country.
Once detailed recommendations are in place, promotional measures appropriate for each
industry/firm could be outlined or planned. Leaving such specific promotional measures
to be determined by final studies, relatively broad promotional measures which could be
undertaken in the context of the Ethiopian manufacturing sector are identified below
under each market.
4.2 Product market

Promotional measures in the product market are related to investment, production, and
marketing.
In the area of investment:
• Coordinating investment and production horizontally and vertically. This creates
interdependency and close structural linkage between domestic industries thereby
reducing external dependency. As such,
it economizes scarce investible/capital resources;
it reduces unnecessary or wasteful competition; and
it creates markets through increasing linkages.
• Targeting products (hence firms/industries) and actively seeking for investors.
• Setting the minimum optimal size of firms for new investment which would enable
them to be internationally competitive.
In marketing:
• Maintaining a higher tariff margin to limit the volume of imports for targeted
products, to provide space or learning period (improving the practice of application of
new technology, capability/skill build up, improving marketing techniques, etc) to new
investments as well operating industries selected for promotion, particularly industries
such as chemical, machinery, iron and steel, and other engineering industries
• Reservation of markets (such as government purchase) for targeted export or other
products
• Providing a computerized databank on foreign markets, buyers and suppliers, and on

supply potentials of Ethiopia. The Ethiopian Export Promotion Agency could handle such
activities. The government can as well implement this through private organizations such
as Ethiopian and Addis Ababa Chambers of Commerce by providing financial support.
• Targeting exports. To further augment exports, the government can set export targets
for firms, not only for those identified above as exporting industries, but also any firm, in
return for a favorable price and guaranteed sales/market domestically or any other
incentive as discussed below, including subsidy.
4.3 Input market

Intervention in the input market encourages the development of firms/industries through
enriching their linkage on the input side. The following interventions are relevant.
• Promoting subcontracting to encourage specialization and structural linkages between
industries. For instance, auto assembly industries have no local content, despite the fact
there are vehicle body manufacturing firms, battery assemblers, etc. There is a need to
make a study in this connection and promote the activity.
• Providing industrial infrastructure to ease supply side constraints. The recent attempt
to locate an industrial site with better infrastructural facilities for new investment is
commendable. However, it is also important to provide infrastructural priorities for the
already established firms such as energy and communication lines. It may as well involve
support for relocation, to newly identified industrial sites, wherever it is initiated.
4.4 Capital markets

The critical role of capital/financial markets in promoting industrialization is well known.
In this respect, apart from the general measures of strengthening financial institutions,
both private and public, further effort would be required to cater the large financial
resource that industrialization demands. In the Ethiopian context this may include
establishing various financial institutions including the following.
• Reorienting the functions of the Commercial Bank of Ethiopia to provide the
required finance for targeted/selected industries.
• Establishing an industrial development fund. This is not new for Ethiopia, as the
Development Bank of Ethiopia has been providing a similar service to the industrial
sector

• Establishing specialized funds such as science and technology promotion fund,

technical assistance fund, etc.
• Establishing and encouraging, long term capital markets, venture capital
companies, credit guarantee companies, and related specialized financial
institutions.
In line with this, the government can facilitate finance for targeted activities using
different financial mechanisms.
• Targeted industries may benefit from direct credit from state owned banks or
government guaranteed private, local or even foreign banks.
• Special credit scheme for selected industries and activities. Investments in targeted
industries, such as strategic industries, have to benefit from special long term credit
schemes, including credit subsidy, longer grace period, etc.
• Finance linked to specific performance criteria. Targeted performances, such as
export, productivity improvement, adopting new technology, positive externalities,
etc., could benefit from priorities in financial credit at favorable terms.
• Provision of matching grants. Large capital and technology requiring investments,
targeted by the state, may benefit from matching grants.
4.5 Technology market
Promoting technology is the core strategy of an industrial policy. In the Ethiopian
context, it is even critical. However, intervening in the technology market is also most
challenging and expensive. Apart form the general provisions of technology
infrastructure, such as metrology, standards, quality and testing; the government should
promote technology using diverse schemes as outlined below.
• The government should have a mechanism to support all forms of foreign
technology transfer to Ethiopia. In other words, it should help firms locate, purchase,
and adopt new foreign technology. It should provide technical advice and guidance in
terms of identifying appropriate technologies in all industries. The choice of labor
intensive type technology should be weighted against possible efficiency (hence
competitiveness) tradeoff, which could come with high-tech capital intensive technology
types. Moreover, the rise in wages (including environmental issues) may necessitate,
even in the medium term, moving out of labor to capital intensive type industries.

Direct support should be provided to strengthen targeted technology imports to reduce

prices and strengthen the position of local buyers through different transfer agreements
such as purchase of equipment by itself or with know how and technology assistance,
contracts for blue prints and patents, hiring consultants, etc.
In this regard the government should compile a database on sources and prices of
technology supply
• Special incentives to firms to develop indigenous own product development
capability through reverse engineering and adaptation.
• Hiring of foreign experts to help industrial technology development. The success
of a vehicle body manufacturing enterprise here in Ethiopia by hiring an expatriate
knowledgeable in the field is exemplary. The government should encourage
employment of technology skilled expatriates through tax exemptions, remittances
and other incentives.
• Direct support for research at firm/industry level no matter how preliminary it is.
Also establishing and sponsoring basic R&D on industrial related initiatives.
• Engaging in joint venture with foreign firms to acquire difficult and complex
technologies.
• Supporting updating, automation, renovation and modernization of existing
technology
• Technical support and extension services. This is to overcome informational,
technical, equipment, and other handicaps of industries. This would in turn enable
industries to undertake consultancy and feasibility studies, product development and
design, quality and productivity improvement and acquire modern marketing
techniques. To implement this, a mechanism for diffusing new technologies,
management techniques and skills to micro and small scale firms has to be installed.
The government should provide training, information, advice on automation, arranges
visits to plants to identify technological problems, prepare trade fairs, etc. This requires a
well organized center, which should be regularly involved in these activities.
The institutional demand to provide such support services is challenging. Though the
currently existing institutions such as Science and Technology Institute, Micro
Enterprises Development Institute, etc., could be restructured to provide the required

services, various specialized additional institutes and centers in collaboration with the
private sector and foreign technical assistance should be established.
4.6 Skill market

Building industrial technological capability is not just adopting advanced hardware
technology, but also developing highly skilled labor. In fact the latter is a prerequisite.
Provision of formal higher education by itself may not be adequate, even if it is of high
standard. Of course, basic and high standard educational background is essential.
However, much emphasis should go for specialized technical skill training. In this regard
much effort would be required, as creating a pool of skilled labor force by itself is today a
prerequisite to attract foreign direct investment. Promotional measures may include the
following:
• Expand and strengthen the comprehensive or technical secondary education
system to create workers with basic technical skills.
• Provide more specialized technical training on different categories of industrial
technology.
• Provide special incentives for selected skills to reverse brain drain. It is extremely
important to provide due attention to higher education graduates in engineering
technology and natural sciences.
• Give pre-employment technical skill training for school leavers.
• Arrange customized courses for workers based on the demand and tailored' to the
needs of industries.
• Provide on the job training on workplaces using actual work machines and
equipment to directly enhance relevant skills in improving productivity, quality,
product design, marketing etc. And also, directly support (financial or professional)
firms/industries to provide on the job training.
To cater for this, specialized institutes and training centers are required, such as for
instance, special industrial technology training institute. However, the institutional
demand can as well be met by guiding and promoting private sector investment, which is
currently deployed in less useful and quick profit earning training activities.

4.7 Foreign direct investment

Attracting FDI may be desirable, but admittedly, it is a difficult task. The requirement for
FDI is not only economic. It demands, among other things the existence of political
stability and a conducive economic environment. The latter implies good infrastructure,
skilled labor, efficient economic governance, highly competitive and attractive
incentives, etc. However, success in this field does not always come on the cheap when
seen from the perspective of long term development and industrialization. It is not always
the case that the interests of host countries and investors coincide. Particularly, while
large investment in technologically leading strategic industries, whose benefit accrues in
the longer term, is badly needed by developing countries, including Ethiopia, the
preference of FDI is in quick and highly profitable natural resource-based industrial
activities. So, there is a need to balance or reconcile diverging interests.
In the Ethiopian context, primarily, government has to provide the essential

infrastructure and institutional requirements for FDI. Moreover, on top of the
general facilitation of investors, guarantees and arbitration, government can employ the
following promotional measures.
• Encourage FDI in areas where domestic investment is weak. When FDI moves into
areas with relatively better comparative advantage, such as in resource-based
industries, which can easily be managed by domestic investors, such advantages must
be compensated by a parallel investment in strategic industries.
• Promote FDI in export-activities, particularly in non natural-resource-based
industries.
• Provide generous incentives for FDI with greater externalities in technology and
skill transfer, including design knowledge. In this regard, the government can give
due priority and an all round support to proven foreign investors, such as the
MIDROCK and sisterly groups so that they can move to high-tech strategic
industries.
• Encourage subcontracting and significant local content in all FDI operation.
• Encourage existing foreign investments engaged in simple assembly activities, such
as in auto assembly, to move into manufacturing.

• Encourage FDI in joint venture activity, particularly in advanced technology

oriented industries.
• Target and encourage lower-tier foreign companies, particularly those from newly
industrializing economies.
5. Incentive instruments
It should be underlined that as the objective of industrial policy is not to maintain
inefficient firms, incentives have to be selective, goal specific, measured in
magnitude, limited in time, and performance based. Moreover, the incentive scheme
should also be differentiated based on the importance of activities to be promoted. For
instance, investing on a strategic industry, say chemical or metal casting, may be given
higher priority than investing in footwear. Hence the incentive for the former should be
more rewarding than the latter.
Apart from the specific incentives stated above under each market, the remaining
instruments are quite diverse and commonly applicable in each market intervention. A
number of instruments could be employed simultaneously or separately. For instance, a
new investment in say strategic industries may receive subsidized credit as well as tax
exemption for some time. The instruments include:
• Taxes (direct and indirect): tax exemption, tax holiday, tax credit, tax
reduction/deduction,
• Accelerated depreciation
• Finance: Grants, direct credit, credit priority, low interest credit, long term credit,
prolonged grace period.
• Foreign exchange priority
• Priority in infrastructure provision
• Import duty exemption or reduction
• Subsidies
• Free or favorable provision of land
• Reduced electricity charges
• Reduced domestic air cargo charges

• Employing government procurement to encourage new investment or expansion of

selected/targeted products
6. Measures of control
As noted above, promoting industries with a package of rewards should necessarily be
based on achievements which are specified, limited in time, and measured to outcome. As
promotional programs involve costs and risks, firms are required to share at least some of
the costs and risks commensurate with the benefits they receive. As the overarching
objective of industrial policy is to develop an industrial sector which is productive and
efficient, hence competitive, the benefit basically accrues to firms themselves. Hence
sharing the costs and risks is not only logical but also inevitable as the alternative in
today's competitive environment is to close down, i.e., go out of business eventually.
Control measures or performance requirements could be varied depending on the

importance of the industry/commodity targeted for promotion. Requirements may
include, among others, the following.
• Level of productivity and efficiency: An outstanding problem of most firms is low

productivity and efficiency, which results in lack of competitiveness and loss of
demand even in the domestic market. This is a challenge for nearly all firms.
Therefore, targeted firms would be required to improve their efficiency significantly,
if they have to benefit from promotional incentives.
• Product quality: Irrespective the price level, product quality is the primary
prerequisite, particularly for export products. Exporting industries may be required to
improve their quality to benefit from the incentive schemes.
• Level of production: Despite their productivity or efficiency levels, some industries
producing critical products and currently of high import content, such as specific
chemical industries, may be required to expand their capacity and volume of
production first, and then move to meeting productivity and efficiency criteria.
• Investment: As noted above, Ethiopia's manufacturing sector is quite dwarf. A great
deal of the industrialization program would only come through new investments,
particularly in strategic industries. Therefore, new investments in targeted industries

to benefit from generous support and incentives would be the major requirement.
• Targeted level of export: In newly industrializing economies, targeting export has
been used as an effective mechanism for not only increasing export earnings, but also
improving efficiency. In the Ethiopian context too, export targeting could be used as a
prerequisite for benefiting a significant state support.
• Introducing new technology: Technology heavily influences levels of productivity
and efficiency. It is likely that existing firms have to update their technology to
improve their efficiency. Therefore, benefiting from the incentive package may
require introducing new technology.
Again, at anyone period, requirements could be: one or more depending on the
importance of the industry. For instance, a firm may be required to increase its volume of
production as well as export. On the other hand, a strategic firm may first be required to
increase production to fill the gap in import shortage (foreign exchange saving) and may
later be required to increase its productivity level.
7. Institutional requirement
Industrialization requires a great deal of organizational, informational, skill and financial
resources. A successful industrial policy demands the existence of such capability. As
noted earlier, leading the industrialization program should be the prime responsibility of
the government. The leading role of the government is not contestable as it is the only
institution which has the prerogative to formulate and implement national policy.
Moreover, no other institution has a nationwide structure and capability to undertake such
a long term program
Perhaps the major challenge in this undertaking is the institutional demand. Primarily a
central organ/office to coordinate and lead the program at the apex has to be in place.
This office, as noted above, must be composed of all stakeholders, including the
government, the private sector, labor organizations, civic society, etc, not only for the
sake of transparency, but also for addressing the common interest of all stakeholders
which is critical for the success of the program. It is this central organ which will
establish the structure of the office and pool together the required human resource for

designing, administering and implementing the program. The task of the latter is very
challenging as it has to draw a coherent and detailed action plan and also organize
various required institutions. Financial, technical/technological, educational, marketing
institutions, investment promoting institutions and centers for intervention in different
markets need to be established. Such institutions demand a large amount of resources,
both financial (including foreign exchange) and human. The demand for both financial
and human resources is challenging as it requires experts in varying fields, including
engineers (chemical, electrical, mechanical, etc) , statisticians, industrial experts,
management experts, economists, financial experts, marketing experts, etc, to design,
administer, and monitor the program (i.e., to identify priorities, specify promotional
measures and incentives, confirm performances, etc.). Establishing such institutions
requires a priori study and as industrialization is a long and painstaking process, it is
important that such institutions and staff be permanently assigned to maintain the
sustainability of the program.
However, because of the challenge and complexity of industrial policy, some question the
capability of governments to successfully undertake such a program. For instance, the
World Bank argues that developing country governments are intrinsically unable to act in
the national interest, for various reasons including lack of acquiring enough information
to select better than the market, lack of skill to design and implement detailed and
complex industrial policy, the tendency to gravitate towards sectional interest rather than
national interest, corrupt practices, etc. [Chang, 1999; WB, 1993]5.
It is true that developing countries, including Ethiopia face some of these shortcomings
and constraints. Hence, there is a need for a careful preparation to overcome such
shortcomings. In the Ethiopian context, with respect to the information gap on markets,
factor conditions, technology, skill requirements and organizational heeds, the experience
of industrialized countries could serve as an initial source of information to make
selective decisions. Second, the government can utilize its offices abroad, embassies,
consulates, etc, as a source of information. In this connection, NGOs can also be viable
sources as they have access to external information, outside Ethiopia. Third, private
5
Ibid , page 307

sector associations, such as the Chambers of Commerce, Ethiopian Manufacturing

Industries Association and specialized trade associations (Leather tanning, coffee export,
etc) along with trade unions, and professional associations, are all valuable sources of
information. Also, Ethiopian nationals living al1road could serve as reliable sources.
The lack of skill to design and implement such a complex program is a serious
shortcoming. This can be mitigated initially by training staff and hiring skilled and
experienced experts from countries which have undertaken an industrialization program.
Moreover, experience, along with on the job training, is the best medium for acquiring
further skills.
A major challenge also arises from sectional interest (noted above in this section) and
corrupt bureaucratic practices. While it is relatively easy to reduce rampant corruption at
the lower tiers of government - through supervision and incentives- it is more difficult at
higher levels. Today Ethiopia is not free from this problem. As noted above, this is the
underlying reason for organizing a leadership entrusted with managing such a program
composed of different stake holders. The involvement of all stakeholders will discipline
the state and make it accountable to the public, hence improving the quality and outcome
of government interventions. Disciplined and competent bureaucracy to avoid rent
seeking practices is a prerequisite. Certainly, a corrupt government should not be
entrusted with undertaking detailed industrial policy. Transparency in the implementation
of the program is one instrument to mitigate the potential abuse of such a program.
8. Integrating macro and sectoral policies with industrial policy framework

What can be inferred from the discussions is that, industrial policy is essentially a
development policy. What is perhaps unique is that, it places manufacturing at the center
of the development program. However, because of its linkages to all sectors of the
economy, it cannot stand on its own.
What this implies is that, sectoral as well as macro policies need to be consistent with the
industrial policy in place. If for instance, agricultural policy, such as land policy, is not
revised to allow massive agricultural inputs - fertilizers, insecticides, improved seeds,

improved farm implements, then, the industrial policy which accords priority to
industries producing agricultural inputs would be of no avail. Similarly, if macro policies,
such as financial policy, are not retuned to support targeted industries, then the success of
the industrialization program would be inevitably limited. If the energy policy does not
provide priority to targeted industries, then the industrialization program would be
adversely affected.
It is therefore, obvious that industrialization demands revising all relevant development

policies and programs to be consistent to the industrial policy in place.

1. Industrial policy is defined best as
A. The import controls to help the balance of payments and protect the domestic
firms from throat cut competition.
B. Government action which have direct effect on firms and industries through
determining the mechanisms of production and resource allocation.
C. The government intervention in the economy through general monetary an
fiscal policies to influence the actual allocation of resources among sectors of
production.
D. A deliberate government’s control over the income and prices to counter
inflation and increases in interest rate to control money supply.
E. All of the above.
2. Some economists argue that neoclassical economic theory is an inappropriate for the
prescription of industrial policy. Their rationalization is that:
A. Industrial policy depends on uncertainty and imperfect information.
B. Industrial policy does not require perfect knowledge about economic factors.
C. Industrial policy does not account for transaction cost and considers full
assignment well-defined property rights.
D. Any types of government interventions in industry will be efficient by providing
economic rationale for industrial policy.
E. Omniscient policy maker with privileged access to information secrets can
rescue optimality.
3. Industrial policy to correct only market failure is not sufficient condition to support
the government’s interference in the economy. Reason(s)
A. Government action uses scarce resources.
B. Intervention may take the form of transferring resources towards favoured areas.
C. The government may not know with certainty the most appropriate form of
intervention.
D. Government may find it difficult to identify cases for market failure.
E. Government intervention is unlikely to be warranted where few parties are
involved, property rights are clearly assigned and transaction costs are low.

F. All of the above.

4. The most politically acceptable industrial policies includes this/these intervention(s)
A. Directed at improving the dynamic performance of the economy.
B. Designed to discourage the working of market system.
C. Aimed at improving information flows, strengthening legal rights and
improving the frame work for their enforcements.
D. B and C
E. A and C
5. The desirable feature(s) of good industrial policy includes
A. The policy should be capable of performing sound in an environment where
transaction cost is norm.
B. The policy should not be able to perform well where economic agents lack
perfect knowledge.
C. The policy should not continually adapt to changes.
D. The opportunity cost of intervention should surpass any perceived potential
benefits.
E. All of the above.
6. One of the following is not true about laissez-faire approach industrial policy.
A. It believes in appropriate policies those aimed at strengthening and promoting
competitive.
B. It is established on the presumption that information flows are perfect.
C. It acknowledges the presence of transaction cost.
D. It holds that the market is a better judge of desirable action than government
agencies.
E. It rejects most types of intervention commonly pursued under the name of
industry policy.
7. Which of the following statement is incorrect about supportive approach industry
policy?
A. It argues for financial support to selected industries in order to promote
restructuring and protect external competition.
B. It argues for intervention to improve the allocation of resources and
enforcement of property right.
C. It recognizes the adoption of less desirable policies because of external
constraints.
D. It argues in favor of intervention to encourage entrepreneurship in order to
foster the process of economic change.
E. It believes in the underlying superiority of market forces.
F. It recognizes the presence of imperfect information.
8. The form of intervention which is designed to improve the speed at which market
operates with objective of prompting up the innovation process by providing financial
support to the most promising firms, markets or technologies is consistent with
A. Neutral industry policy.
B. Laissez-faire industrial policy.
C. Accelerative industry policy
D. Decelerative industry policy.

E. Supportive approach industry policy

9. All of the following are true about neutral industry policy: except
A. It is the pursuit of increased competition by the elimination of institutional
barriers which prevent the entry of new firms.
B. It is consistent with economic theories those explicitly recognize the presence of
transaction costs.
C. The government is responsible for picking ‘winner’ industries/firms.
D. The government creates an economic, social and political environment that is
conducive to efficiency and new initiatives.
E. The government is accountable for increasing labour mobility, improving long-
run employment prospectus and hence reduce resistance to change.
10. Which of the following is not true about the Ethiopian industrial sector?
A. It is dominated by production of consumer goods
B. It is characterized by the use of capital-intensive technology
C. It is dominated by production of capital goods
D. It is fully dependent upon imported capital goods
E. It has very low and declining productivity
F. It has very weak sectoral linkages and internally unbalanced structure
G. None of the above
1. Briefly discuss the policy forms and approaches (industrial policy taxonomy).
Substantiate your discussions with examples.
2. Mention and discuss the main problem of industrial sector in Ethiopia.
3. State the specific objectives of industrial policy in Ethiopia, and indicate
justifications for these objectives.
4. Mention some strategic industries for Ethiopia, and reason out why you
categorize them as strategic.
5. Explain the necessary institutional arrangements required for a successful
industrial policy in Ethiopia.
6. Briefly explain the neo-liberal policy prescription and show the limitation of
this school.
7. Discuss in detail the underlying features of structuralists’ perspectives on
industrialization.

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Industrial Economics - Theory and Policies Distance Learning material

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 1

Why do firms incur so much expenditure on advertising?

Objectives of the chapter

The objectives of this chapter are to:

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 2

Advertising is a mass paid communication, the ultimate purpose of which is to impart

Advertising is one of many forms of promotional activity. Instead of advertising, a firm

6.1 Why advertise?

In general, advertising is used to convey availability of a "product" (which can be a

(i) communicate information about a particular product, service, or brand (including

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 3

(ii) persuade people to buy the product, and

6.2 How much advertising?

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 4

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 5

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 6

6.3 Debates on advertising

Advertising is a prominent feature of modern economic life. Consumers encounter

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 7

However the traditional view of advertising is increasingly questioned. The alternative

The 'advertising as persuasion' view

Market Entry barriers:

Figure 6.2 ‘advertising as persuasion' view

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 8

The advertising as persuasion view implicitly assumes that advertising distorts

The 'advertising as information' view

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 9

knowledge is imperfect and uncertainty abounds, advertising plays an important part in

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 10

Advertising helps the competitive process: by supplementing other sources of

Advertising Consumers: Performance:

Market Entry barriers:

Figure 6.3 ‘The advertising as information’ view

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 11

Multiple Choice Questions

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 12

C. When knowledge is imperfect, consumers can improve their decisions by

Questions for Review and Discussion

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 13

INVENTION, INNOVATION AND DIFFUSION

Why organizations are spending more on research and development activities?

What determines innovation?

Is there any impact of invention and innovation on employment?

The reader will get acquainted with

The meaning of Invention, Innovation and Diffusion

The importance of Invention, Innovation and Diffusion in the performance of a

The diffusion of innovation.

The relation between Innovation and employment

The characteristics of firms and markets in the process of change

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 14

In the modern world,

An individual wants to be more creative,

A firm or corporation strives for the progressiveness of its business and

A government works for the collective security and welfare of masses.

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 15

What are the sources of innovation?

7.1 The process of innovation: Concepts and Relationships

Prepared by Jayamohan.M.K and Tadesse Demissie MU Department of Economics 16

2) The introduction of a new method of production, which need a discovery