least likely to occur for developing country producers. In addition, a more dynamic approach suggests that chain governance is not given forever and may change
because(Humphrey & Schmitz, 2002b): (a) power relationships may evolve when existing producers, or their spin offs, acquire new capabilities;(b) establishing and maintaining quasi-hierarchical governance is costly for the lead firm and leads to inflexibility because of transaction specific investments; and (c) firms and cluster soften do not operate only in one chain but simultaneously in several types of chains, and they may apply competencies learned in one chain to supply other chains. In sum, both modes of organizing production, that is, the cluster and the value chain, offer interesting opportunities for the upgrading and modernization of local
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firms, and are not mutually exclusive alternatives. However, in order to assess their potential contribution to local SMEs’ innovation and upgrading, we need to understand their organization of inter firm linkages and their internal governance. Furthermore, as we explain in the following section, the nature of their dominant specialization also plays a role and affects SMEs’ upgrading prospects.
3. THE SECTORAL DIMENSION OFSMEs’ UPGRADING (a) The concept of upgrading
The concept of upgrading—making better products, making them more efficiently, or moving in to more skilled activities—has often been used in studies on competitiveness (Kaplinsky,2001; Porter, 1990), and is relevant here.
Following this approach, upgrading is decisively related to innovation. Here we
define upgrading as innovating to increase value added. 7 Enterprises achieve this in
various ways, such as, for example, by entering higher unit value market niches or
new sectors, or by undertaking new productive (or service) functions. The concept of
upgrading may be effectively described for enterprises working within a value chain,
where four types of upgrading are singled out (Humphrey & Schmitz, 2000):
—Process upgrading is transforming inputs into outputs more efficiently by reorganizing the production system or introducing superior technology ., footwear producers in the Sinos Valley; Schmitz, 1999b).
—Product upgrading is moving into more sophisticated product lines in terms of increased unit values ., the apparel commodity chain in Asia upgrading from discount chains to department stores; Gereffi,1999).
—Functional upgrading is acquiring new, superior functions in the chain, such as design or marketing or abandoning existing low-value added functions to focus on higher value added activities ., Torreon’s blue jeans industry upgrading from maquila to ‘‘full-package’’ manufacturing; Bair&Gereffi, 2001). —Inter sectoral upgrading is applying the competence acquired in a particular
function to move into a new sector. For instance, in Taiwan, competence in producing
TVs was used to make monitors and then to move into the computer sector (Guerrieri
& Pietrobelli,2004; Humphrey & Schmitz,2002b). In sum, upgrading within a value
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chain implies going up on the value ladder, moving away from activities in which competitionis of the ‘‘low road’’ type and entry barriers are low.
Our focus on upgrading requires moving a step forward and away from Ricardo’s static concept of ‘‘Comparative Advantage’’ (CA). While CA registers ex-post gaps in relative productivity which determine international trade flows, success in firmlevel upgrading enables the dynamic acquisition of competitiveness in new market niches, sectors or phases of the productive chain (Lall, 2001; Pietrobelli, 1997). In sum, the logic goes from innovation, to upgrading, to the acquisition of firm-level competitiveness., competitive advantage). 8
In this paper, we argue that the concept of competitive advantage increasingly matters. In the theory of comparative advantage, what matters is relative productivity,
determining different patterns of inter industry specialization. Within such a theoretical approach, with perfectly competitive markets, firms need to target only
production efficiency. In fact, this is not enough, and competitive advantage is the
relevant concept to analyze SMEs’ performance because of (i) the existence of forms
of imperfect competition in domestic and international markets and (ii) the presence
of different degrees of (dynamic) externalities in different subsect or sand stages of the value chain.
More specifically, in non perfectly competitive market rents and niches of ‘‘extra-
normal’’ profits often emerge, and this explains the efforts to enter selectively specific
segments rather than simply focusing on efficiency improvements, regardless of the
prevailing productive specialization (as advocated by the theory of CA). Moreover,
different stages in the value chain offer different scope for dynamic externalities.
Thus, for example, in traditional manufacturing, the stages of design, product
innovation, marketing, and distribution may all foster competitiveness increases in
related activities and sectors. The advantage of functional upgrading is in reducing the
fragility and vulnerability of an enterprise’s productive specialization. Competition
from new entrants—., firms from developing countries with lower production costs,
crowding out incumbents—is stronger in the manufacturing phases of the value chain
than in other more knowledge and organization-intensive phases ., product design
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