Managerial Economics

Lecture Thirteen: Alternative perspectives on globalisation

Recap
Theory of comparative advantage Appeals to economists because
Fits within age-old paradigm of specialisation Consistent with usual static equilibrium method

But fails as empirical model (a flop)

Some better recent results really test absolute advantage because drop factor price equalization Dynamic model & analysis rejects zero tariff bias

This week: alternative (you guessed it!) Schumpeterian theory Porters Competitive Advantage of Nations

Competitive Advantage
Direct attack on relevance of conventional economics: Why do some nations succeed and others fail in international competition? This question is perhaps the most frequently asked of our times Yet it is the wrong question We must focus instead on another, much narrower one why does a nation become the home base for successful international competitors in an industry?... why is one nation often the home for so many of an industrys world leaders?
How can we explain why Germany is the home base for so many of the worlds leading makers of printing presses, luxury cars, & chemicals? Why is tiny Switzerland the home base for international leaders in pharmaceuticals, chocolate? (1)

Competitive Advantage
Focus not on natural endowment (comparative advantage) & broadly defined industries (labourintensive, capital intensive) but Innovation & very specific industries
Luxury cars (Germany) Ski boots (Italy) Mobile phones (Finland!)

Porters theory aware of recent economic trends: The long-dominant paradigm is inadequate
the rise of the multinational corporation [has] weakened the traditional explanations of why and where a nation exports (2)

Porter instead seeks to isolate the national attributes that foster competitive advantage in an industry (3)

Competitive Advantage
Dismisses other conventional explanations for trade Good macroeconomic policies?

Cheap labour?

Nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy & Korea), appreciating currencies (Germany & Switzerland), and high interest rates (Italy & Korea) (3) The ability to compete despite paying high wages would seem to represent a far more desirable national target. Even 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 (4) has occurred only in a subset of industries, and is far from universally successful even in Japan and Korea.

Natural resources?

Government intervention?

Competitive Advantage
Management style? What is celebrated as good management practice in one industry would be disastrous in another. (4) Labour relations? (An Australian favourite) Unions are very powerful in Germany and Sweden, with representation by law in management (Germany) and on boards of directors (Sweden) both nations contain some of the most internationally preeminent firms and industries of any country. (5) Rejects characterisation of nations as competitive We must abandon the whole notion of a competitive nation And focus instead on specific industries and industry segments (9)

Competitive Advantage
Rejects comparative advantage: the assumptions underlying factor comparative advantage are unrealistic in many industries. The standard theory assumes that there are no economies of scale, that technologies everywhere are identical, that products are undifferentiated, and that the pool of national factors is fixed. (12)
(same reservations as early Samuelsonlast week)

The theory is also frustrating for firms because [it] assumes away a role for firm strategy, such as improving technology or differentiating products most managers exposed to the theory find that it assumes away what they find to be most important and provides little guidance for appropriate company strategy. (12-13)

Competitive Advantage
Old theory wrongly emphasises country & factors New theory emphasises companies BUT still has clear role for countries: the leaders in particular industries tend to be concentrated in a few nations Competitive advantage is created and sustained through a highly localised process While globalization of competition might appear to make the nation less important, instead it seems to make it more so. (19) Basic elements of theory turn false comparative advantage theory on its head:

Competitive Advantage
firms can and do choose strategies that differ successful international competitors often compete with global strategies in which trade and foreign investment are integrated (19) a nations firms gain competitive advantage in all its forms, not only the limited types of factor-based advantage contemplated in the theory of comparative advantage (20) Acknowledges inspiration by Schumpeter but he stopped short of answering the question Why do some firms, based in some nations, innovate more than others? (20) Theory developed by empirical research: 10 countries examined at deep industry level: Denmark (5.1 million people in 1987); Germany (61m); Italy 57; Japan 122; Korea 42; Singapore 2.6; Sweden 8.4; Switzerland 6.5; UK 57; USA 244 m

Competitive Advantage
Statistical technique used to select industries/firms in which each country was outstanding competitor in 1985 > 100 industries selected
From obvious (Japan semiconductors) To obscure (British biscuits) Industry classifications show how specific capital is Machines essential for one industry useless in another Key point in critique of neoclassical concept of factor of production & ease of movement from one industry to another

The complete list by country:

Competitive Advantage
DENMARK agricultural machinery building maintenance services consultancy engineering dairy products food additives furniture industrial enzymes pharmaceuticals specialty electronics telecommunications equipment waste treatment equipment
ITALY ceramic tiles dance club and theater equipment domestic appliances engineering/construction factory automation equipment footwear packaging and filling equipment ski boots wool fabrics

KOREA apparel automobiles construction footwear pianos semiconductors shipbuilding steel travel goods video and audio recording tape wigs

GERMANY automobiles chemicals cutlery eyeglass frames harvesting/threshing combines optical instruments packaging, bottling equipment pens and pencils printing presses rubber, plastic working machinery X-ray apparatus

SINGAPORE airlines apparel beverages ship repair trading

SWITZERLAND banking chocolate confectionery dyestuffs fire protection equipment freight forwarding hearing aids heating controls insurance marine engines paper product manufacturing machinery pharmaceuticals surveying equipment textile machinery trading watches

SWEDEN car carriers communication products for handicapped persons environmental control equipment heavy trucks mining equipment teller-operated cash dispensers newsprint refrigerated shipping rock drills semihard wood flooring

UNITED STATES advertising agricultural chemicals commercial aircraft* commercial refrigeration and air-conditioning computer software construction equipment detergents engineering/construction motion pictures patient monitoring equipment syringes waste management services

JAPAN air-conditioning machinery home audio equipment car audio carbon fibers continuous synthetic weaves facsimile forklift trucks microwave and satellite communications equipment musical instruments optical elements and instruments robotics semiconductors sewing machines shipbuilding tires for trucks and buses trucks typewriters videocassette recorders watches

 Historical study of industry undertaken Global history as well as specific to successful country
In printing presses we sought to understand why Germany and Switzerland had sustained advantage but also why the United States had lost ground and Japan was gaining. (28)

Found country far from relevant scale of analysis:

Competitive Advantage
Successful firms are frequently concentrated in particular cities or states within a nation. In the United States many of the nations leading real estate developers are based in Houston, Texas; oil & gas equipment suppliers in Houston; hospital management chains in Nashville; carpet producers in Dalton, Georgia; Something about these locations provides a fertile environment for firms in these particular industries. (29)

Competitive Advantage
Narrow and meaningful definition of industry used: Many discussions of competition employ overly broad definitions such as banking, chemicals, or machinery. These are not strategically meaningful industries because both the nature of competition and the sources of competitive advantage vary a great deal within them. Machinery, for example, is not one industry but dozens of strategically distinct industries such as weaving machinery, rubber processing equipment, and printing machinery each with its own unique requirements for competitive success. (34)

Competitive Advantage
Delineates 5 forces shaping an industry: The threat of new entrants; The threat of substitute products or services; The bargaining power of suppliers; The bargaining power of buyers; and The rivalry among existing competitors (35) Two basic determinants of competitive advantage: lower cost and differentiation (37)

3rd important factor is competitive scopehow broad industry is & how much of it firm covers

It is difficult, though not impossible, to be both lowercost and differentiated relative to competitors. (38) Any successful strategy, however, must pay close attention to both types of advantage while maintaining a clear commitment to superiority on one. (38)

Competitive Advantage
Combination of cost & differentiation give different forms of competitive advantage:

Competitive Advantage
Innovation crucial First mover advantage can last well past short run
German and Swiss dye companies (Bayer, Hoecsht, BASF, Sandoz, Ciba-Geigy) have sustained their positions as international leaders since before World War I (47) Early movers gain advantages such as being first to reap economies of scale, reducing costs through cumulative learning (47)

Schumpeters assumption confirmed: Often, innovators are outsiders to existing industry. (48) Also larger companies were often supplanted by smaller ones (49)

Competitive Advantage
4 key determinants of Competitive Advantage: Factor conditions
Only one considered by comparative advantage Concerns innovation as well as endowment

Demand conditions Related & supporting industries Firm strategy, structure, and rivalry. (71)

Competitive Advantage
Porters National Diamond Advantages throughout the diamond are necessary for achieving and sustaining competitive success [but]
Advantage in every determinant is not a prerequisite (73)

Competitive Advantage
Factors matter but may enhance CA through their absence: an abundance of factors may undermine instead of enhance competitive advantage. Selective disadvantages in factors, through influencing strategy and innovation, often contribute to sustained competitive success. (74) Opposite of economic theory belief Second factor also important for Dutch flowers: Home demand Quality more important than quantity
Discerning consumers drive product innovation Gives example of Hollands advantage in flowers despite its cold, grey climate

Competitive Advantage
Nations gain competitive advantage where the home demand gives local firms a clearer or earlier picture of buyer needs if home buyers pressure local firms to innovate faster (86) A products fundamental or core design nearly always reflects home market needs. (87) small nations can be competitive in segments which represent an important share of local demand but a smaller share of demand elsewhere, even if the absolute size of the segment is greater in other nations. (88)

Competitive Advantage
Related & supporting industries Suppliers assist process of

innovation and upgrading

Suppliers help firms perceive new methods and opportunities to apply new technology. (103)

The full pattern of interlinking industries is very complex

Competitive Advantage
A more disaggregated view

Competitive Advantage
Competitive advantage in suppliers means spinoffs from one industry can be means to develop new ones Italian world leadership in gold and silver jewelry has been sustained because other Italian firms produce two-thirds of the worlds jewelry-making machinery. (101) Related industries give strength to each other

Competitive Advantage
Competitive advantage in related industries
TABLE 3-1 Internationally Competitive Related Industries

Nation Denmark Germany Italy Japan Korea Singapore Sweden Switzerland United Kingdom United States

Industry Dairy products, brewing Chemicals Lighting Cameras VCRs Port services Automobiles Pharmaceuticals Engines Electronic test and measuring equipment

Related Industry Industrial enzymes Printing ink Furniture Copiers Videotape Ship repair Trucks Flavorings Lubricants, antiknock preparations Patient monitoring equipment

Competitive Advantage
Japan's strength in long-filament synthetic textile fibers reflects a long tradition of success in silk, as does a leading export position in silk-like continuous synthetic weaves, woven from long-filament synthetic fibers. Carbon fibers employ technology closely related to synthetic filament fibers and many of the same competitors participate in both. Also, while not overall leaders in textile machines, Japanese firms are leaders in water jet weaving machines, used to weave long-filament synthetic fibers into synthetic weaves. Such groups of linked competitive industries in a nation are common. (105)

Competitive Advantage
Firm strategy structure & rivalry No one management system is universally appropriate But character of national management structure needs to suit needs of industry.
Nations will tend to succeed where the management practices and modes of organization favored by the national environment are well suited to the industries sources of competitive advantage. Italian firms are world leaders in a range of fragmented industries operating in small niches In Germany the engineering and technical background of many senior executives produces a strong inclination towards methodical product and process improvement (108)

Competitive Advantage
National goals Short term focus of US firmsadvantage in accounting Long term focus of German/Japaneseadvantage in engineering Domestic rivalry Desire to beat own national competitors often drives innovation
Italian supercars; Japanese electronics; US software, computers With little domestic rivalry, firms are more content to rely on the home market. (119)

Competitive Advantage
Japan in particular has large number of internationally competitive firms in different industries:
TABLE 3-2 Estimated Number of Japanese Rivals in Selected Industries, 1987 Air conditioners 13 Motorcycles 4 Audio equipment 25 Musical instruments 4 Automobiles 9 Personal computers 16 Cameras 15 Semiconductors 34 Car audio 12 Sewing machines 20 Carbon fibers 7 Shipbuilding 33 Construction equipment 15 Steel 5 Copiers 14 Synthetic fibers 8 Facsimile machines 10 Television sets 15 Lift trucks 8 Truck and bus tires 5 Machine tools 112 Trucks 11 Mainframe computers 6 Typewriters 14 Microwave equipment 5 Videocassette recorders 10

Competitive Advantage
National competitive advantage therefore tends to occur in clusters Geographic clusters: Many of the Italian jewelry firms, for example, are located around two towns, Arezzo and Valenca Po (120) Industry clusters
Related industries and supplier-buyer chains

Competitive Advantage
The individual determinants that define the national environment are mutually dependent because the effect of one often depends on the state of the others (129)

Example of clustering: Denmark

Competitive Advantage

Competitive Advantage
Geographic clustering also strikingly obvious: Clustering of internationally competitive industries in Italy:

Competitive Advantage
Interactions in the Diamond for Italian Ski Boot industry:

Competitive Advantage
Not so much a model in economic sense More description of process But better guide to feasible policy than comparative advantage Industry policy promoted over free trade obsession:
Identify present clusters Expect innovation in areas where domestic demand is an important share of local demand but a smaller share of demand elsewhere Obvious examples for Australia solar energy water conservation (if only government policy helped!)

Integrating Managerial Economics

Weve covered a fair bit of territory Theory & empirics of
Firm Market Economy Finance Trade

In all areas
Data doesnt support conventional economic beliefs Dominant theories have obvious flaws But alternative theories exist

The Firm
Conventional Theory Production subject to diminishing marginal productivity Firms internal structure black box Firms objective profit maximisation Equates marginal cost to marginal revenue Empirical Evidence 89% (Blinder) to 95% (Eiteman) of firms have constant or falling marginal costs Prices via markup on average costs Marginal cost well below average Marginal considerations irrelevant Alternative Theory Conventional profit maximisation rule wrong for multi-firm industries Profit maximisation where marginal revenue exceeds marginal cost even with rising marginal cost

The Firm
Alternative Theory (cont.) Sraffa: well-designed factories mean factor proportions constant out to capacity
Constant marginal cost

Kornai: firms in dynamic industries

Growth & uncertainty make excess capacity sensible

Schumpeter: creative destruction

Entrepreneurs profit by revolutionising production Technical change drives costs down, diversity up

Combination means
Costs constant/falling Firms compete on product diversity/production innovation rather than just price

The Market
Conventional Theory Taxonomy of industry types
Competitive markets Many sellers, buyers Homogenous product Price equals marginal cost (with erroneous maths!) Monopoly Single seller Single product Price exceeds marginal cost Oligopoly Several sellers Compete with each other game theoretic style Welfare position between monopoly & PC

The Market
Empirical Evidence Most industries characterised by power law distribution of firm sizes

Competitive outcomes (falling price, rising quality & diversity) independent of number of firms in industry Alternative Theory Evolutionary: process of dynamic selection.
Multi-agent modeling can capture essential features of process
Diversity of firm behavior rather than homogeneity Power-law distribution of firm sizes rather than nonexistent neoclassical taxonomy of PC, monopoly, oligopoly Varying products increases survival chances of firms Varying consumer interaction alters environment

Some very large; many very small; no average size

The Economy
Conventional Theory Equilibrium processes Keynesian/Neoclassical dispute over tendency to full employment

Exogenous money, causation from base money supply to credit money to economic activity Empirical Evidence Disequilibrium the rule: all variables cyclical Credit money drives economy, base money reacts afterwards
Rising debt levels since WWII Real wages rise, prices (relatively) fall during boom (no DMP)

Both agree real wages have to fall in boom (diminishing marginal productivity)

The Economy
Alternative Theory Schumpeters vision:
Underlying disequilibrium dynamics reflect entrepreneurial search for profit Credit essential to entrepreneurial process and endogenous to economy Debt & entrepreneurial activity co-extensive

Minskys vision
Cyclical trend for debt over trade cycle Secular trend for debt/output levels to rise as memory of crisis recedes Potential for debt-deflation Big Government reduces likelihood of crisis by anticyclical spending

The Finance Sector

Conventional Theory Equilibrium process Investors balance risk vs return Empirical Evidence Far from equilibrium dynamics Fractal rather than efficient markets Beta is dead (and always was!) Market inefficient but still hard to predict Alternative Theory Sophisticated models from physicists:
Power law / Hurst exponent / Tsalliss qnonextensive statistical mechanics / minority game

The Finance Sector

Alternative Theory (cont.) Inefficient Markets Hypothesis
Non-institutional investors can construct low volatility & high return portfolios

Tendency of finance boom/bust cycle to drive economy

Argument for reform of asset markets

Trade & Global Economics

Conventional Theory Comparative advantage
Countries specialise where they have comparative advantage over rest of world, not absolute advantage Trade governed by relative factor abundance Free trade equalises wages & profits worldwide

Empirical Evidence Comparative Advantage a flop

Absolute advantage more relevant than comparative Factor abundance largely irrelevant to trade Innovation rules

Compounded by transnational corporations, outsourcing

Take advantage of absolute cost differences

Trade & Global Economics

Alternative Theory Role for industry promotion in development Success comes via competitive advantage
Not countries but firms, products, industry clusters

Where to from here? Other courses at UWS:

Behavioural Finance (myself & Craig Ellis) History of Economic Thought (James Farrell; sometimes also me) Political Economy Undergraduate (Neil Hart & others) Honours (myself & others)

Further reading

Building on Managerial Economics

Further reading All full readings from this course but especially: Schumpeter Theory of Economic Development Minsky John Maynard Keynes Ormerod Butterfly Economics Haugen The New Finance Peters The Fractal Markets Hypothesis Debunking Economics Book: via Zed Books, Pluto Press Website: www.debunking-economics.com Other critical resources PAECON movement: www.paecon.net