Michael Porter (1990),20a Harvard business professor, believes that standard classical theories on comparative advantage are inadequate. He studied 100 firms in ten developed nations to learn if a nation’s dominance in an industry can be explained more adequately by variables other than the factors of production on which the theories of comparative advantage and the H-O theory are based.
According to Porter, a nation attains a competitive advantage if its firms are competitive. Firms become competitive through innovation. Innovation can include technical improvements to the product or to the production process. He proposed a model that provides conditions that have to be met for a firm to be internationally competitive and successful. This model
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Exhibit 3.3
Porter’s Diamond
Firm strategy, structure, and rivalry
Factor conditions Demand conditions
Related and supporting industries
focuses on four primary conditions that he arranged in a diamond-shaped diagram—Exhibit 3.3—(hence the name “Porter’s diamond”). These four key elements to international entrepreneurial success are:
• Factor conditions (i.e., the nation’s position in factors of production, such as skilled labor and infrastructure)
• Demand conditions (i.e., sophisticated customers in home market)
• Related and supporting industries (i.e., the importance of clustering)
• Firm strategy, structure, and rivalry (i.e., conditions for organization of companies, and the nature of domestic rivalry).
Factor Conditions
Factor conditions refer to inputs used as factors of production—such as labor, land, natural resources, capital, and infrastructure. This sounds sim- ilar to standard economic theory, but Porter argues that the “key” factors of production (or specialized factors) are created, not inherited. Specialized factors of production are skilled labor, capital, and infrastructure. Further- more, “nonkey” factors or general use factors, such as unskilled labor and raw materials, can be obtained by any company and, hence, do not gener- ate sustained competitive advantage. However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate and even- tually this leads to a competitive advantage, because if other firms can- not easily duplicate these factors, they are valuable. Porter argues that a
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lack of resources often actually helps countries to become competitive (call it selected factor disadvantage); thus, abundance generates waste and scarcity generates an innovative mindset. Such countries are forced to innovate to overcome their problem of scarce resources. How true is this? Switzerland was the first country to experience labor shortages. They abandoned labor- intensive watches and concentrated on innovative/high-end watches. Japan has high-priced land so its factory space is at a premium. This lead to just- in-time inventory techniques—Japanese firms cannot have a lot of stock taking up space, so to cope with the potential of not having goods around when they need it, they innovated traditional inventory techniques. Sweden has a short building season and high construction costs. These two things combined created a need for prefabricated houses. In several Middle East- ern countries, due to the climatic conditions—lots of sun, limited rain fall, scarcity of water—the need to use solar energy for heating up water became a necessity.
Demand Conditions
Porter states that a sophisticated domestic market is an important element in producing competitiveness. Firms that face a sophisticated domestic mar- ket are likely to sell superior products because the market demands high quality and a close proximity to such consumers enables the firm to bet- ter understand the needs and desires of the customers (this same argument can be used to explain the first stage of the IPLC theory when a prod- uct is just initially being developed; after it has been perfected, it does not have to be so close to the discriminating consumers). If the nation’s discriminating values spread to other countries, the local firms become competitive in the global market. One example is the French wine indus- try. The French are sophisticated wine consumers. These consumers force, help, and expect French wineries to produce high-quality wines. The Italian consumers are sophisticated in terms of leather products; thus they force, help, and expect the Italian leather industry to produce high-quality leather products.
Related and Supporting Industries
Porter continues with his theory by stating that a set of strongly related and supporting industries is important for firms to be competitive. This includes suppliers and related industries. This usually occurs at a regional level as opposed to a national level. Examples include Silicon Valley in the United States, Detroit (for the auto industry), and Italy (leather shoes and other leather goods industry). The phenomenon of competitors (and upstream and/or downstream industries) locating in the same area is known as clustering or agglomeration. What are the advantages and disadvantages
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of locating within a cluster? Some advantages to locating close to your rivals may be:
• Potential technology knowledge spillovers
• An association of a region on the part of consumers with a product and high quality and therefore some market power
• An association of a region on the part of applicable labor force.
Some disadvantages to locating close to your rivals are:
• Potential poaching of your employees by rival companies
• Obvious increase in competition possibly decreasing markups.
Firm Strategy, Structure, and Rivalry
1. Strategy
(a) Capital Markets: Domestic capital markets affect the strategy of firms. Some countries’ capital markets have a long-run outlook, while others have a short-run outlook. Industries vary in how long the long run is. Countries with a short-run outlook (like the United States) will tend to be more competitive in indus- tries where investment is short-term (like the computer industry).
Countries with a long-run outlook (like Switzerland) will tend to be more competitive in industries where investment is long-term (like the pharmaceutical industry).
(b) Individuals’ Career Choices: Individuals base their career deci- sions on opportunities and prestige. A country will be competi- tive in an industry whose key personnel hold positions that are considered prestigious.
2. Structure
Porter argues that the best management styles vary among industries.
Some countries may be oriented toward a particular style of manage- ment. Those countries will tend to be more competitive in industries for which that style of management is suited. For example, Germany tends to have a hierarchical management structure comprising man- agers with strong technical backgrounds and Italy has smaller, family- run firms.
3. Rivalry
Porter states that intense competition spurs innovation. Competi- tion is particularly fierce in Japan, where many companies com- pete vigorously in most industries. International competition is not as intense and motivating. With international competition, there are
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enough differences between companies and their environments to pro- vide handy excuses to managers who were outperformed by their competitors.
The Diamond as a System: Overall, Porter’s theory states that if the ele- ments in the diamond are increasingly present, trade increases. Furthermore, these elements in the diamond constitute a system and are self-reinforcing.
Domestic rivalry for final goods stimulates the emergence of an indus- try that provides specialized intermediate goods. Keen domestic competi- tion leads to more sophisticated consumers who come to expect upgrading and innovation. The diamond promotes clustering. Porter emphasizes the role of chance in the model. Random events can either benefit or harm a firm’s competitive position. These can be anything like major technologi- cal breakthroughs or inventions, acts of war and destruction, or dramatic shifts in exchange rates. One might wonder how agglomeration becomes self-reinforcing.
• When there is a large industry presence in an area, it will increase the supply of specific factors (i.e., workers with industry-specific training) since they will tend to get higher returns and will face less risk of losing employment.
• Upstream firms (i.e., those that supply intermediate inputs) will invest in the area. They will also wish to save on transport costs, tariffs, interfirm communication costs, inventories, and so on.
• Downstream firms (i.e., those that use the industry’s product as an input) will also invest in the area. This causes additional savings of the type listed before.
• Attracted by the good set of specific factors, upstream and downstream firms, producers in related industries (i.e., those that use similar inputs or whose goods are purchased by the same set of customers) will also invest. This will trigger subsequent rounds of investment.
Implications for Governments: The government plays an important role in Porter’s diamond model. Like everybody else, Porter argues that there are some things that governments do that they shouldn’t and other things that they do not do but should.
He says, “Government’s proper role as a pusher and challenger is to encourage or even push firms to raise their aspirations and move to a higher level of competitive prowess even though this may be an unsettling and even unpleasant process.”21
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Governments can influence all four of Porter’s determinants through a variety of actions such as:
• subsidies to firms, either directly (money) or indirectly (through infrastructure)
• tax codes applicable to corporation, business, or property ownership
• educational policies that affect the skill level of workers
• establishment of technical standards and product standards, including environmental regulations
• government’s purchase of goods and services
• antitrust regulation.
Moreover, Porter has emphasized the role of chance in the model. Ran- dom events can either benefit or harm a firm’s competitive position. Typi- cally, such events are:
• major technological breakthroughs or inventions
• political decisions by foreign governments
• acts of war and destruction
• dramatic shifts in exchange rates
• sudden price shocks affecting input goods (such as the oil price shock in the early 1970s)
• sudden surges or drops in world demand or sudden shifts in consumer preferences.
Although Porter’s diamond theory is renowned, it has been criticized on the following points:
1. It focuses too strongly on developed economies.
2. The government’s role can be both positive and negative. Even well- intentioned government actions can occasionally fail by cushioning domestic industries and making them less internationally competitive.
3. Chance is difficult to predict. Situations can change very quickly and unexpectedly.
4. Porter says that firms, not countries, compete in international markets.
This means that national comparative advantage must be understood at the level of a firm rather than at the level of a country.
5. Porter describes four distinct stages of national competitive development:
• Factor-driven (e.g., Singapore)
• Investment-driven (e.g., Korea)
• Innovation-driven (e.g., Japan, Italy, Sweden)
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• Wealth-driven (e.g., Great Britain, with the United States and Germany somewhere between innovation-driven and wealth- driven), which is characterized by decline.
6. Porter argues that only outward foreign direct investment (FDI) is valuable in creating competitive advantage and inbound FDI does not increase domestic competition significantly because the domestic firms lack the capability to defend their own markets and face a process of market share erosion and decline. However, there seems to be little empirical evidence to support this claim.
7. Porter contends that reliance on natural resources alone is insufficient.
Canada is an example that does not fit this description, as is apparent by the success of Canadian MNCs like Alcan and Norando.
8. The Porter model does not adequately address the role of MNCs.
There seems to be ample evidence that the diamond is influenced by factors outside the home country.
It is obvious that Porter’s diamond model continued on Ricardo’s and H-O’s theories but a final criticism is that Porter’s evidence is anecdotal and there is no empirical proof as yet.22
The following questions were posed to Mr. Bill Bogle, the chief operating officer of Genesis Machinery Products, Inc., during an interview:
What products are you trading and with which countries? What criteria have you used in exporting to the countries you are exporting to and what steps have you taken in becoming familiar with these countries? Do you import? If yes, what and from where?
Our company manufactures capital equipment used in the manufacturing of injectable drugs. We export our product to Europe, South America, Asia, as well as Canada, Mexico and the Caribbean. Our primary export customers tend to be the large pharmaceutical companies or their foreign affiliates. Since the majority of our equipment is used in a highly regulated industry, the technical require- ments usually take precedence to other commercial concerns and we tend to achieve our best results with those customer facilities that are running high-speed operations. We are currently designing new equipment that will be available in November of this year and that takes our same high speed technology and applies it to less complicated machines with lower output so that we can target host country national companies predominantly in Asia but also in other markets.
Like most other businesses, our success depends upon the relationships that we have built over the years with companies and individuals that specialize in our industry. We are represented in many countries by people whose trust has been earned over time. The only way to effectively develop business in the countries in which we work is to go there and meet with people face to face on (Continued)
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their terms. To this end, I have done business personally visiting customers and representatives in twenty-eight countries.
Our experience with importation is much more limited but part of a critical element of our business plan. We are formalizing an agreement with an Italian company that has a testing technology that complements the work that we do in the industry. We will represent them in the US as well as provide service and spare parts for their equipment. This increases our contacts with the technical experts in our target industry as well as provides us with lucrative aftermarket income.
Source: Interview with Mr. Bill Bogle, Chief Operating Officer of Genesis Machinery Products, Inc., located in Exton, Pennsylvania. September 9, 2002.
Note: Genesis is the world’s leading manufacturer of capping equipment for pharmaceutical companies that are manufacturing injectable drugs.
Practical Tips
Both nations and individuals benefit from trade when they perceive an advan- tage in the production of some product or service. All nations have finite resources, whether natural or manufactured, such as capital, labor, and tech- nical ability. Nations can benefit when they put these resources to the most efficient use, and all nations do some things more efficiently than they do other things. Ideally, nations would produce only the goods that they can produce efficiently and import those they cannot produce efficiently from more efficient producers. This would benefit both nations.
Many nations have established agencies throughout their land to assist individual firms take the right steps in engaging in international trade. Such an agency is the Trade Information Center (TIC) in the United States. The TIC is a comprehensive resource for information on all US Federal Govern- ment export assistance programs. The center is operated by the International Trade Administration of the US Department of Commerce for the 20 federal agencies comprising the Trade Promotion Coordinating Committee (TPCC).
These agencies are responsible for managing the US Government’s export promotion programs and activities.
The TIC, the first stop for US exporters in the federal government, pro- vides, among other things, the following:
• Referrals and information on all US Federal Government export assis- tance programs. Interested parties can view the TIC’sExport Programs Guide: A Business Guide to Federal Export Assistance. This manuscript
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describes the resources available from the 20 federal agencies that help US companies develop their export potential.
• General export counseling. New-to-export firms should start with the TIC’s Frequently Asked Questions to find answers to the most com- monly asked exporting questions and links to the most-used resources.
Export America, another publication, publishes articles of interest writ- ten by international trade specialists.
• Sources of international market research and trade leads. The Internet Guide to Export Trade Leads, a list of web sites that provides trade lead information.
• Calendar of overseas and domestic trade events and activities. Interested firms can access the Commercial Service Calendar to learn about interna- tional trade events supported by one or more US government agencies.
• Sources of export finance. TheAlternative Trade Finance Guidecould be searched to view a state-by-state list of service providers nationwide, including those that specialize in meeting the unconventional needs of US exporters.
• Advice on export licenses and controls.
• Country-specific export counseling and assistance for Western Europe, Asia, the western hemisphere, Africa, and the Near East on commercial laws, regulations, business practices, distribution channels, business travel, and other market information.
• Import tariffs/taxes and customs procedures and assistance in overcom- ing commercial difficulties in doing business abroad.
Furthermore, there are agencies at the local, that is county, level where interested firms can obtain information on exporting. Such an agency is the Chester County International Trade Council (CCITC), in the county of Chester in the state of Pennsylvania, USA. Established in 1999, the CCITC is an economic development initiative of the Chester County Eco- nomic Development Council and serves as the Chester County “arm” of the Delaware River Port Authority’s (DRPA) Export Development initiative.
The CCITC receives funding from DRPA to deliver export assistance ser- vices to small to medium-sized companies located in Chester County. The CCITC is staffed by a program manager and an international trade specialist and receives guidance and expertise from its volunteer 33-member Advisory Board.
The mission of the CCITC is to contribute to the vitality of the regional economy by directly assisting businesses in international commerce. Its activ- ities and services are designed to facilitate the export sales of Chester County companies. Offered in partnership with DRPA, CCITC services are available to all Chester County companies and include:
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• individualized export/import counseling
• expertise and mentoring form the CCITC Advisory Board
• educational seminars and networking events
• in-depth marketing research
• market access grants (MAG) designed to subsidize business travel to develop new overseas markets
• official access point for Pennsylvania’s 17 Overseas Trade Offices, which provide customized services to PA companies
• recruitment, organization, and assistance with foreign trade show par- ticipation and in-bound trade and buying missions
• assistance with federal and state export financing programs
• videoconferencing equipment to facilitate business meetings with over- seas contacts
• access to pro bono legal consultation via the CCITC Advisory Board and the DRPA Legal Assistance Program.
Overall, the CCITC’s activities center around the goals of awareness raising, capacity building, and networking for local companies in order to facilitate increased trade activities, mainly, exports.