Sample text for The competitive advantage of nations : with a new introduction / Michael E. Porter.


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Chapter 1

The Need for a New Paradigm

Why do some nations succeed and others fail in international competition? This question is perhaps the most frequently asked economic question of our times. Competitiveness has become one of the central preoccupations of government and industry in every nation. The United States is an obvious example, with its growing public debate about the apparently greater economic success of other trading nations. But intense debate about competitiveness is also taking place today in such "success story" nations as Japan and Korea. Socialist countries such as the Soviet Union and others in Eastern Europe and Asia are also asking this question as they fundamentally reappraise their economic systems.

Yet although the question is frequently asked, it is the wrong question if the aim is to best expose the underpinnings of economic prosperity for either firms or nations. We must focus instead on another, much narrower one. This is: why does a nation become the home base for successful international competitors in an industry? Or, to put it somewhat differently, why are firms based in a particular nation able to create and sustain competitive advantage against the world's best competitors in a particular field? And why is one nation often the home for so many of an industry's world leaders?

How can we explain why Germany is the home base for so many of the world's leading makers of printing presses, luxury cars, and chemicals? Why is tiny Switzerland the home base for international leaders in pharmaceuticals, chocolate, and trading? Why are leaders in heavy trucks and mining equipment based in Sweden? Why has America produced the preeminent international competitors in personal computers, software, credit cards, and movies? Why are Italian firms so strong in ceramic tiles, ski boots, packaging machinery, and factory automation equipment? What makes Japanese firms so dominant in consumer electronics, cameras, robotics, and facsimile machines?

The answers are obviously of central concern to firms that must compete in increasingly international markets. A firm must understand what it is about its home nation that is most crucial in determining its ability, or inability, to create and sustain competitive advantage in international terms. But the same question will prove to be a decisive one for national economic prosperity as well. As we will see, a nation's standard of living in the long term depends on its ability to attain a high and rising level of productivity in the industries in which its firms compete. This rests on the capacity of its firms to achieve improving quality or greater efficiency. The influence of the home nation on the pursuit of competitive advantage in particular fields is of central importance to the level and rate of productivity growth achievable.

But we lack a convincing explanation of the influence of the nation. The long-dominant paradigm for why nations succeed internationally in particular industries is showing signs of strain. There is an extensive history of theories to explain the patterns of nations' exports and imports, dating back to the work of Adam Smith and David Ricardo in the eighteenth century. It has become generally recognized, however, that these theories have grown inadequate to the task. Changes in the nature of international competition, among them the rise of the multinational corporation that not only exports but competes abroad via foreign subsidiaries, have weakened the traditional explanations for why and where a nation exports. While new rationales have been proposed, none is sufficient to explain why firms based in particular nations are able to compete successfully, through both exporting and foreign investment, in particular industries. Nor can they explain why a nation's firms are able to sustain their competitive positions over considerable periods of time.

Explaining the role played by a nation's economic environment, institutions, and policies in the competitive success of its finns in particular industries is the subject of this book. It seeks to isolate the competitive advantage of a nation, that is, the national attributes that foster competitive advantage in an industry. Drawing on my study of ten nations and the detailed histories of over one hundred industries, I will present in Part I a theory of the competitive advantage of nations in particular fields. In Part II, I will illustrate how the theory can be employed to explain the competitive success of particular nations in a number of individual industries. In Part III, I will use the theory to shed light on the overall patterns of industry success and failure in the economies of the nations we studied and how the patterns have been changing. This will serve as the basis for presenting a framework to explain how entire national economies advance in competitive terms. Finally, in Part IV, I will develop the implications of my theory for both company strategy and government policy, The book concludes with a chapter entitled "National Agendas," which illustrates how the theory can be used to identify some of the most important issues that will shape future economic progress in each of the nations I studied.

Before presenting my theory, however, I must explain why efforts to explain the competitiveness of an entire nation have been unconvincing, and why attempting to do so is tackling the wrong question. I must demonstrate that understanding the reasons for the ability of the nation's firms to create and sustain competitive advantage in particular industries is addressing the right question, not only for informing company strategy but also for achieving national economic goals. I must also describe why there is a growing consensus that the dominant paradigm used to date to explain international success in particular industries is inadequate, and why even recent efforts to modify it still do not address some of the most central questions. Finally, I will describe the study that was conducted so, that the reader will understand the factual foundations of what follows.

CONFLICTING EXPLANATIONS

There has been no shortage of explanations for why some nations are competitive and others are not. Yet these explanations are often conflicting, and there is no generally accepted theory. It is far from clear what the term "competitive" means when referring to a nation. This is a major part of the difficulty, as we will see. That there has been intense debate in many nations about whether they have a competitiveness problem in the first place is a sure sign that the subject is not completely understood.

Some see national competitiveness as a macroeconomic phenomenon, driven by such variables as exchange rates, interest rates, and government deficits. But nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy, and Korea), appreciating currencies (Germany and Switzerland), and high interest rates (Italy and Korea).

Others argue that competitiveness is a function of cheap and abundant labor. Yet nations such as Germany, Switzerland, and Sweden have prospered despite high wages and long periods of labor shortage. Japan, with an economy supposedly built on cheap, abundant labor, has also experienced pressing labor shortages. Its firms have succeeded internationally in many industries only after automating away much of the labor content. The ability to compete despite paying high wages would seem to represent a far more desirable national target.

Another view is that competitiveness depends on possessing bountiful natural resources. Recently, however, the most successful trading nations, among them Germany, Japan, Switzerland, Italy, and Korea, have been countries with limited natural resources that must import most raw materials. It is also interesting to note that within nations such as Korea, the United Kingdom, and Germany, it is the resource-poor regions that are prospering relative to the resource-rich ones.

More recently, many have argued that competitiveness is most strongly influenced by government policy. This view identifies targeting, protection, export promotion, and subsidies as the keys to international success. Evidence is drawn from the study of a few nations (notably Japan and Korea) and a few large, highly visible industries such as automobiles, steel, shipbuilding, and semiconductors. Yet such a decisive role for government policy in competitiveness is not confirmed by a broader survey of experience. Many observers would consider government policy toward industry in Italy, for example, to have been largely ineffectual in much of the postwar period, but Italy has seen a rise in world export share second only to Japan along with a rapidly rising standard of living.

Significant government policy intervention has occurred in only a subset of industries, and it is far from universally successful even in Japan and Korea. In Japan, for example, government's role in such important industries as facsimile, copiers, robotics, and advanced materials has been modest, and such frequently cited examples of successful Japanese policy as sewing machines, steel, and shipbuilding are now dated. Conversely, sustained targeting by Japan of industries such as aircraft (first targeted in 1971) and software (1978) has failed to yield meaningful international positions. Aggressive Korean targeting in large, important sectors such as chemicals and machinery has also failed to lead to significant market positions. Looking across nations, the industries in which government has been most heavily involved have, for the most part, been unsuccessful in international terms. Government is indeed an actor in international competition, but rarely does it have the starting role.

A final popular explanation for national competitiveness is differences in management practices, including labor-management relations. Japanese management has been particularly celebrated in the 1980s, just as American management was in the 1950s and 1960s. The problem with this explanation, however, is that different industries require different approaches to management. What is celebrated as good management practice in one industry would be disastrous in another. The small, private, and loosely organized family firms that populate the Italian footwear, textile, and jewelry industries, for example, are hotbeds of innovation and dynamism. Each industry has produced a positive trade balance for Italy in excess of $1 billion annually. However, these same structures and practices would be a disaster in a German chemical or automobile company, a Swiss pharmaceutical producer, or an American commercial aircraft manufacturer. American-style management, with all the flaws now attributed to it, produces highly competitive firms in such industries as software, medical equipment, consumer packaged goods, and business services. Japanese-style management, for all its strengths, has produced little international success in large portions of the economy such as chemicals, consumer packaged goods, or services.

Nor is it possible to generalize about labor-management relations. Unions are very powerful in Germany and Sweden, with representation by law in management (Germany) and on boards of directors (Sweden). Despite the view by some that powerful unions undermine competitive advantage, however, both nations have prospered and contain some of the most internationally preeminent firms and industries of any country.

Clearly, none of these explanations for national competitiveness, any more than a variety of others that have been put forward, is fully satisfactory. None is sufficient by itself in rationalizing the competitive position of a nation's industries. Each contains some truth but will not stand up to close scrutiny. A broader and more complex set of forces seems to be at work.

The numerous and conflicting explanations for competitiveness highlight an even more fundamental problem. That is, just what is a "competitive" nation in the first place? While the term is frequently used, it is unusually ill defined. Is a "competitive" nation one in which every firm or industry is competitive? If so, no nation comes close to qualifying. Even Japan, as we will see, has large sectors of its economy that fall far behind the world's best competititors. Is a "competitive" nation one whose exchange rate makes its goods price competitive in international markets? But surely most would agree that nations such as Germany and Japan, that have experienced sustained periods of a strong currency and upward pressure on foreign prices, have enjoyed remarkable gains in standard of living in the postwar period. The ability of a nation's industry to command high prices in foreign markets would seem to be a more desirable national target.

Is a "competitive" nation one with a large positive balance of trade? Switzerland has roughly balanced trade and Italy has had a chronic trade deficit, but both nations have enjoyed strongly rising national income. Conversely, many poor nations have balanced trade but scarcely represent the sorts of economies most nations aspire to Is a "competitive" nation one with a rising share of world exports? A rising share is often associated with growing prosperity, but nations with stable or slowly falling world export shares have experienced strong per capita income growth so that world export share clearly does not tell the whole story. Is a "competitive" nation one that can create jobs? Clearly, the ability to do so is important, but the type of jobs, not merely the employment of citizens at low wages, seems more significant for national income. Finally, is a "competitive" nation one whose unit labor costs are low? Low unit labor costs can be achieved through low wages such as those in India or Mexico, but this hardly seems an attractive industrial model. Each of these measures says something about a nation's industry, but none relates clearly to national economic prosperity.

ASKING THE RIGHT QUESTION

The search for a convincing explanation of both national and firm prosperity must begin by asking the right question. We must abandon the whole notion of a "competitive nation" as a term having much meaning for economic prosperity. The principal economic goal of a nation is to produce a high and rising standard of living for its citizens. The ability to do so depends not on the amorphous notion of "competitiveness" but on the productivity with which a nation's resources (labor and capital) are employed. Productivity is the value of the output produced by a unit of labor or capital. It depends on both the quality and features of products (which determine the prices they can command) and the efficiency with which they are produced.

Productivity is the prime determinant in the long run of a nation's standard of living, for it is the root cause of national per capita income. The productivity of human resources determines their wages, while the productivity with which capital is employed determines the return it earns for its holders. High productivity not only supports high levels of income but allows citizens the option of choosing more leisure instead of long working hours. It also creates the national income that is taxed to pay for public services which again boosts the standard of living The capacity to be highly productive also allows a nation's firms to meet stringent social standards which improve the standard of living, such as in health and safety, equal opportunity, and environmental impact.

The only meaningful concept of competitiveness at the national level is national productivity. A rising standard of living depends on the capacity of a nation's firms to achieve high levels of productivity and to increase productivity over time. Our task is to understand why this occurs. Sustained productivity growth requires that an economy continually upgrade itself. A nation's firms must relentlessly improve productivity in existing industries by raising product quality, adding desirable features, improving product technology, or boosting production efficiency. Germany has enjoyed rising productivity for many decades, for example, because its firms have been able to produce increasingly differentiated products and introduce rising levels of automation to boost the output per worker. A nation's firms must also develop the capabilities required to compete in more and more sophisticated industry segments, where productivity is generally higher. At the same time, an upgrading economy is one which has the capability of competing successfully in entirely new and sophisticated industries. Doing so absorbs human resources freed up in the process of improving productivity in existing fields. All this should make it clear why cheap labor and a "favorable" exchange rate are not meaningful definitions of competitiveness. The aim is to support high wages and command premium prices in international markets.

If there were no international competition, the level of productivity attainable in a nation's economy would be largely independent of what was taking place in other nations. International trade and foreign investment, however, provide both the opportunity to boost the level of national productivity and a threat to increasing or even maintaining it. International trade allows a nation to raise its productivity by eliminating the need to produce all goods and services within the nation itself. A nation can thereby specialize in those industries and segments in which its firms are relatively more productive and import those products and services where its firms are less productive than foreign rivals, in this way raising the average productivity level in the economy. Imports, then, as well as exports are integral to productivity growth.

Establishment of foreign subsidiaries by a nation's firms can also raise national productivity, provided it involves shifting less productive activities to other nations or performing selected activities abroad (such as service or modifying the product to address local needs) that support greater penetration of foreign markets. A nation's firms can thus increase exports and earn foreign profits that flow back to the nation to boost national income. An example is the move in the last decade of less sophisticated electronics assembly activities by Japanese firms first to Korea, Taiwan, and Hong Kong, and now to Malaysia and Thailand.

No nation can be competitive in (and be a net exporter of) everything. A nation's pool of human and other resources is necessarily limited. The ideal is that these resources be deployed in the most productive uses possible. The export success of those industries with a competitive advantage will push up the costs of labor, inputs, and capital in the nation, making other industries uncompetitive. In Germany, Sweden, and Switzerland, for example, this process has led to a contraction of the apparel industry to those firms in specialized segments that can support very high wages. At the same time, the expanding exports of competitive industries put upward pressure on the exchange rate, making it more difficult for the relatively less productive industries in the nation to export. Even those nations with the highest standards of living have many industries in which local firms are uncompetitive.

The process of expanding exports from more productive industries, shifting less productive activities abroad through foreign investment, and importing goods and services in those industries where the nation is less productive, is a healthy one for national economic prosperity. In this way, international competition helps upgrade productivity over time. The process implies, however, that market positions in some segments and industries must necessarily be lost if a national economy is to progress. Employing subsidies, protection, or other forms of intervention to maintain such industries only slows down the upgrading of the economy and limits the nation's long-term standard of living.

While international trade and investment can lead to major improvements in national productivity, however, they may also threaten it. This is because exposure to international competition creates for each industry an absolute productivity standard necessary to meet foreign rivals, not only a relative productivity standard compared to other industries within its national economy. Even if an industry is relatively more productive than others in the economy, and can attract the necessary human and other resources, it will be unable to export (or even, in many cases, to sustain position against imports) unless it is also competitive with foreign rivals. The American automobile industry produces more output per man hour (and pays higher wages) than many other U.S. industries, for example, but America has experienced a growing trade deficit (and a loss of high-paying jobs) in automobiles because the level of productivity in the German and Japanese industries has been even higher. American productivity in producing automobiles has also not been sufficiently greater than that of Korean firms to offset lower Korean wages. Similar tests vis-à-vis foreign rivals must be met by more and more activities and industries.

If the industries that are losing position to foreign rivals are the relatively more productive ones in the economy, a nation's ability to sustain productivity growth is threatened. The same is true when activities involving high levels of productivity (such as sophisticated manufacturing) are transferred abroad through foreign investment because domestic productivity is insufficient to make performing them in the nation efficient, after taking foreign wages and other costs into account. Both limit productivity growth and result in downward pressure on wages. If enough of a nation's industries and activities within industries are affected, there may also be downward pressure on the value of a nation's currency. But devaluation, too, lowers the nation's standard of living by making imports more expensive and reducing the prices obtained for the nation's goods and services abroad. Understanding why nations can or cannot compete in sophisticated industries and activities involving high productivity, then, becomes central to understanding economic prosperity.

The preceding discussion should also make it clear why defining national competitiveness as achieving a trade surplus or balanced trade per se is inappropriate. The expansion of exports because of low wages and a weak currency, at the same time as the nation imports sophisticated goods that its firms cannot produce with sufficient productivity to compete with foreign rivals, may bring trade into balance or surplus but lowers the nation's standard of living. Instead, the ability to export many goods produced with high productivity, which allows the nation to import many goods involving lower productivity, is a more desirable target because it translates into higher national productivity. Japan, which exports many manufactured goods in which it has high productivity and imports raw materials and components involving less skilled labor and lower levels of technology, illustrates a nation where the mix of trade bolsters productivity. Similarly, it should be clear that defining national competitiveness in terms of jobs per se is misleading. It is high productivity jobs, not any jobs, that translate into high national income. What is important for economic prosperity is national productivity. The pursuit of competitiveness defined as a trade surplus, a cheap currency, or low unit labor costs contains many traps and pitfalls.

A rising national share of world exports is tied to living standards when rising exports from industries achieving high levels of productivity contribute to the growth of national productivity. A fall in overall world export share because of the inability to successfully increase exports from such industries, conversely, is a danger signal for a national economy. However, the particular mix of industries that are exporting is more important than a nation's average export share. A rising sophistication of exports can support productivity growth even if overall exports are growing slowly.

Seeking to explain "competitiveness" at the national level, then, is to answer the wrong question. What we must understand instead is the determinants of productivity and the rate of productivity growth. To find answers, we must focus not on the economy as a whole but on specific industries and industry segments. While efforts to explain aggregate productivity growth in entire economies have illuminated the importance of the quality of a nation's human resources and the need for improving technology, an examination at this level must by necessity focus on very broad and general determinants that are not sufficiently complete and operational to guide company strategy or public policy. It cannot address the central issue for our purposes here, which is why and how meaningful and commercially valuable skills and technology are created. This can only be fully understood at the level of particular industries. The human resources most decisive in modern international competition, for example, possess high levels of specialized skills in particular fields. These are not the result of the general educational system alone but of a process closely connected to competition in particular industries, just as is the development of commercially successful technology. It is the outcome of the thousands of struggles for competitive advantage against foreign rivals in particular segments and industries, in which products and processes are created and improved, that underpins the process of upgrading national productivity I have described.

Competitive Advantage in Industries

Our central task, then, is to explain why firms based in a nation are able to compete successfully against foreign rivals in particular segments and industries. Competing internationally may involve exports and/or locating some company activities abroad. We are particularly concerned with the determinants of international success in relatively sophisticated industries and segments of industries involving complex technology and highly skilled human resources, which offer the potential for high levels of productivity as well as sustained productivity growth.

To achieve competitive success, firms from the nation must possess a competitive advantage in the form of either lower costs or differentiated products that command premium prices. To sustain advantage, firms must achieve more sophisticated competitive advantages over time, through providing higher-quality products and services or producing more efficiently. This translates directly into productivity growth.

When one looks closely at any national economy, there are striking differences in competitive success across industries. International advantage is often concentrated in narrowly defined industries and even particular industry segments. German exports of cars are heavily skewed toward high-performance cars, while Korean exports are all compacts and subcompacts. Denmark's modest share of world exports in vitamins consists of a substantial share in vitamins based on natural substances and virtually no position in synthetic vitamins. Japan's strong position in machinery comes mostly from general-purpose varieties, such as CNC machine tools, while Italy's is derived from often world-leading positions in highly specialized machines for particular end-user applications such as leather working or cigarette manufacturing. Increased trade has led to increased specialization in narrowly defined industries and in segments within industries. Were it not for protection, which sustains firms and entire national industries with no real competitive advantage, the differences among nations in competitive position would be even more apparent.

Moreover, in many industries and especially in distinct segments of industries, competitors with true international competitive advantage are based in only a few nations. The influence of the nation seems to apply to industries and segments, rather than to firms per se. Most successful national industries comprise groups of firms, not isolated participants, as my earlier examples illustrate. Leading international competitors are not only frequently located in the same nation but are often found in the same city or region within the nation. National positions in industries are often strikingly stable, stretching over many decades and, in some of our case studies, for over a century. Isolated successes can often be explained by different target segments, or by government subsidy or protection that means that the isolated national producer is not a real success at all (as in automobiles, aerospace, and telecommunications). Industries and segments of industries, then, will be the focus of our enquiry. Clearly, powerful influence of the nation is apparent in international competition in particular fields, which is important not only to firms but to national economic prosperity.

CLASSICAL RATIONALES FOR INDUSTRY SUCCESS

There is a long history of efforts to explain international success in industries in the form of international trade. The classical one is the theory of comparative advantage. Comparative advantage has a specific meaning to economists. Adam Smith is credited with the notion of absolute advantage, in which a nation exports an item if it is the world's low-cost producer. David Ricardo refined this notion to that of comparative advantage, recognizing that market forces will allocate a nation's resources to those industries where it is relatively most productive. This means that a nation might still import a good where it could be the low-cost producer if it is even more productive in producing other goods. As I have discussed, both absolute and relative advantage are necessary for trade.

In Ricardo's theory, trade was based on labor productivity differences between nations. He attributed these to unexplained differences in the environment or "climate" of nations that favored some industries. While Ricardo was on the right track, however, the focus of attention in trade theory shifted in other directions. The dominant version of comparative advantage theory, due initially to Heckscher and Ohlin, is based on the idea that nations all have equivalent technology but differ in their endowments of so-called factors of production such as land, labor, natural resources, and capital. Factors are nothing more than the basic inputs necessary for production. Nations gain factor-based comparative advantage in industries that make intensive use of the factors they possess in abundance. They export these goods, and import those for which they have a comparative factor disadvantage. Nations with abundant, low-cost labor such as Korea, for example, will export labor-intensive goods such as apparel and electronic assemblies. Nations with rich endowments of raw materials or arable land will export products that depend on them. Sweden's strong historical position in the steel industry, for example, developed because Swedish iron ore deposits have a very low content of phosphorous impurities, resulting in higher-quality steel from blast furnaces.

Comparative advantage based on factors of production has intuitive appeal, and national differences in factor costs have certainly played a role in determining trade patterns in many industries. This view has informed much government policy toward compe

Library of Congress subject headings for this publication: Industrial policy, Competition, International, International business enterprises, Strategic planning, Economic development, Industrial management