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Firm growth: what kind?

May 24, 2012

WHILE talking to an owner of a large retail store — and trying to understand why the owner had not gone for more stores across the country — he mentioned that the latest addition to the products they offered was tailored shalwar-kameez suits for men but that these were under their own brand.

This was interesting because the retail brand was now branching into products of its own — extending their brand to products rather than just being in the service of retailing. So I asked a bit more about the shalwar-kameez: who tailored it for them and why.

The owner said they had set up a tailoring unit and were doing the tailoring themselves. This was surprising. The store had a brand name in retailing; why were they integrating backwards into manufacturing when another expansion option was in retailing where they had a reputation and, more importantly, the expertise?

The owner said he could not find outfits that would give him the quality he required, invest in quality assurance mechanisms, manage delivery on his preferred time schedule and be responsive to his needs/requirements. So he set up his own unit.

The decision to bring something into the boundaries of a firm as opposed to keeping it out, with a vendor and/or partner, is not a trivial one for firms. Or should not be a trivial one. Economic theory suggests that only those processes will be within the boundary that are considered to be crucial for the functioning/growth of the firm and others can be left out, especially if the cost of doing it outside is lower than within the firm.

In our example, if a specialised tailoring outfit could be contracted, on a long-term basis, it would have saved the retailer capital, effort and time, besides allowing him to benefit from the specialisation of the contracted firm. But, given the problems of contract enforceability, especially in the informal sector where most tailoring outfits are based, he had to bring the tailoring unit into his firm. Has this hurt his growth? Is this symptomatic and do many firms in Pakistan face similar issues?

Alerted to this issue, I have kept an eye on similar problems when talking to business owners from other areas too. Talking to another retail chain store, and curious as to why they only had four stores in one city and not more, I found that the owner felt that since he had only four sons he could only expand to four stores. And the issue had to do with trust in professional management: he did not think long-term employment contracts could solve his problem due to issues of enforceability.

A vendor of one of the automobile manufacturers in the country said that he had to make even his own nuts and bolts and sometimes carry out alterations to his machines himself as he, a vendor, could not get specialised vendors for work he wanted to subcontract. The market for the work he wanted was not large enough and was very specialised so it was not really possible for subcontractors to develop.

However, when I asked him if, with the other vendors in the market, the size for the automobile parts market was not large enough, he said that it was. But due to issues of secrecy and lack of contract enforceability, the market for subcontracting could not develop. The vendor was certain that not only was the quality of their product good enough for the car manufacturer in the country they could compete with vendors in Japan for the Japanese parts market too, but for lack of support in terms of specialised subcontractors and the high transaction costs in organising exports.

A manufacturer and retailer of confectioneries mentioned that he could not get ghee and milk of the quality needed from local manufacturers and so he was in the process of attempting backward integration and developing a dairy company. He said that the existing players in the milk market were either too small to cater for his demand or they were too large and would not take his requirement seriously.

With his expertise in retailing sweets and his brand established, is backward integration into a dairy company the best way to expand business? He felt that it was. And given the choices he had, it must have been. But if the market outside was more developed, if long-term contracting was possible and contract enforceability was not an issue, the optimal choice might have been different.

Is this constrained optimisation of backward integration limiting the growth of the firm in a more desirable direction: that of having more retail outlets for the sweets, more variety of sweets and exploring the export market for sweets?.

For all of these cases the entrepreneurs are clearly responding to the environment they are facing and so their choice might be optimal, given the constraints, but it will have an impact on their growth path and cumulatively determine the growth of their industries and the country.

If the constraints they face are such that they are pushed in the direction of choices that are not where their comparative advantage and their specialisation and/or brand advantage should take them, it will have a growth consequence for them and for all, and it will not be globally optimal. It is not clear to me how widespread this phenomenon is, though it seemed to crop up in almost all sectors we had conversations in.

It will take more empirical work to establish this more rigorously and thoroughly. There are multiple factors that are leading to the situation, varying with industry, and requiring detailed exploration but it does seem that a number of them might be linked to poor contract enforceability; an important basis for the development/functioning of markets.

Most economic thinking/debate in Pakistan is about the macro picture: inflation, deficit, foreign exchange, debt, default and growth. Important as these debates are, the micro issues are where the rubber meets the road. If they are not looked at, in industrial and competition policy say, we will not be able to meet sustainability, development and growth targets.

The writer is senior adviser, Pakistan at Open Society Foundations, associate professor of economics, LUMS, and a visiting fellow at IDEAS, Lahore.