In order to respond effectively to market opportunities, micro and small enterprises (MSEs) and industries need to innovate to add value to products or services and to make production and marketing processes more efficient. These activities are known as upgrading. Firm-level upgrading can provide MSEs with higher returns and a steady, more secure income through the development of knowledge and the ability to respond to changing market conditions. Upgrading also leads to industry competitiveness and to national economic growth. Upgrading at the industry-level focuses on increasing the competitiveness of all activities involved in the production, processing, and/or marketing of a product or service and mitigating the constraints that influence value chain performance.
Upgrading is a multi-dimensional process that seeks to increase the economic competitiveness (profits, employment, skills) and/or social conditions (working conditions, low incomes, education system) of a firm or industry. Upgrading involves a learning process through which firms acquire knowledge and skills—often through their relationships with other enterprises in the value chain or through supporting markets—that can be translated into innovations or improvements that increase the value of their products or services. Upgrading is based on a firm’s capabilities—its internal capacity to learn and change from what it has done in the past, as well as to innovate and ensure continuous improvement in products and processes. Essential to upgrading are both the opportunity and ability to learn and the incentives for firms to invest in upgrading: if firms do not foresee viable benefits to investments, like higher incomes, secure markets or lower risks, they are unlikely to spend time or resources on upgrading.
The pursuit of upgrading provides many opportunities to firms that range from increased efficiency and output to access to new market channels and industry knowledge. There are five types of upgrading that firms undertake: process upgrading, product upgrading, functional upgrading, channel upgrading and intersectoral upgrading. The various types of upgrading are frequently connected. Read more on trajectories of upgrading.
A number of factors affect opportunities for upgrading, including:
- Access to investment capital and inputs
- Physical and social distance
- Trust between firms in a value chain
- Transmission of market information on end-market opportunities and characteristics
- The nature and dynamics of the relationships
- The power dynamics between firms
When MSE owners decide how to respond to upgrading opportunities, they may consider several relevant criteria, including profits, risks, time, sustainability, firm economic conditions, access to resources and social considerations.
MSE upgrading is most likely to occur when there are sufficient opportunities for entrepreneurs to learn about alternatives. MSEs tend to be risk averse and cannot afford to take a loss in anticipation of future benefits. The more firms can learn about upgrading opportunities, the better able they are to assess the current situation. MSEs rarely have complete information about the outcome of upgrading and do not know the exact value of future profits. Therefore, they must take this uncertainty into account and make upgrading decisions on the basis of risk-adjusted returns. Demonstration pilots can show the benefits of upgrading and convince producers to undertake sometimes costly, production, process and/or product changes. MSE upgrading is also most likely to occur when there are favorable structural elements—strong demand in end markets, a conducive business enabling environment, extensive linkages between firms and effective supporting markets.
Efforts to facilitate upgrading frequently arise from inter-firm linkages—where assistance is provided by lead firms via vertical relationships or through collective efficiencies realized through horizontal linkages. Furthermore, access to support services like information and communications technologies (ICT) can help MSEs strengthen these inter-firm relationships to improve their opportunities and incentives for upgrading.
- MSEs’ upgrading opportunities may be limited by their size—forming horizontal relationships among producer groups may provide the necessary scale to get on the radar screen of powerful lead firms or garner assistance from supporting markets.
- Strong vertical linkages facilitate upgrading. MSEs ability to upgrade is frequently limited by their availability of capital. In many cases, lead firms will provide the economic means required to improve the production capabilities of their suppliers. In other cases, MSEs are restricted by their limited knowledge of markets other than local markets. Lead firms also provide the means to acquire the market access and knowledge necessary to enter unfamiliar foreign markets.
- The business enabling environment can increase the availability of upgrading opportunities to MSEs by improving the determinants of upgrading such as infrastructure, establishing and providing easier access to supporting markets, improving producers’ knowledge of the costs and benefits associated with the different types of upgrading, and teaching the importance of forming strong horizontal and vertical linkages as well as fostering development of these linkages.
- Furthermore, herding all MSEs into a single market channel should be avoided--diversification of market channels helps MSEs manage risk and is a rational response to dynamic markets. For example, selling exclusively to the highest-priced market will not always maximize a firm’s risk-adjusted returns. Upgrading is not for everyone, and MSEs do not always benefit from upgrading—individual circumstances and risks may outweigh potential gains or the current situation may be acceptable for a firm’s aspirations.
- ↑ Explaining Concepts. A Guide for Value Chain Analysis and Upgrading,Herr, M.; Hultquist,I.;Rogovsky, N.;Pyke, F. ;(pp. EC-1-EC-23);Geneva, Switzerland: ILO, 2006