Managerial Economics: Managerial Economics Lecture Thirteen: Alternative perspectives on globalisation


Recap: 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 Porter’s “Competitive Advantage of Nations”


Competitive Advantage: 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 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, & chemicals? Why is tiny Switzerland the home base for international leaders in pharmaceuticals, chocolate…?” (1)


Competitive Advantage: Competitive Advantage Focus not on “natural endowment” (comparative advantage) & broadly defined industries (labour-intensive, capital intensive) but Innovation & very specific industries Luxury cars (Germany) Ski boots (Italy) Mobile phones (Finland!) Porter’s 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: Competitive Advantage Dismisses other conventional explanations for trade Good macroeconomic policies? “Nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy & Korea), appreciating currencies (Germany & Switzerland), and high interest rates (Italy & Korea)…” (3) Cheap labour? “The ability to compete despite paying high wages would seem to represent a far more desirable national target.” Natural resources? 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) Government intervention? “has occurred only in a subset of industries, and is far from universally successful even in Japan and Korea.”


Competitive Advantage: 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: 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 Samuelson—last 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: 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: 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 nation’s 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: 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: Competitive Advantage


Slide12: 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: Competitive Advantage “Successful firms are frequently concentrated in particular cities or states within a nation. In the United States … many of the nation’s 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: 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: 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) “It is difficult, though not impossible, to be both lower-cost 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) 3rd important factor is “competitive scope”—how broad industry is & how much of it firm covers


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


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) Schumpeter’s assumption confirmed: “Often, innovators are ‘outsiders’ … to existing industry.” (48) Also… “larger companies were often supplanted by smaller ones…” (49)


Competitive Advantage: 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: Competitive Advantage Porter’s “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: 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 Gives example of Holland’s advantage in flowers “despite its cold, grey climate”… Second factor also important for Dutch flowers: Home demand Quality more important than quantity Discerning consumers drive product innovation


Competitive Advantage: 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 product’s 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: 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: Competitive Advantage A more disaggregated view…


Competitive Advantage: 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 world’s jewelry-making machinery.” (101) Related industries give strength to each other…


Competitive Advantage: Competitive Advantage Competitive advantage in related industries


Competitive Advantage: 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: 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: Competitive Advantage National goals Short term focus of US firms—advantage in accounting Long term focus of German/Japanese—advantage 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: Competitive Advantage Japan in particular has large number of internationally competitive firms in different industries:


Competitive Advantage: 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: 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


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


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


Competitive Advantage: 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: Integrating Managerial Economics We’ve covered a fair bit of territory… Theory & empirics of… Firm Market Economy Finance Trade In all areas Data doesn’t support conventional economic beliefs Dominant theories have “obvious” flaws But alternative theories exist…


The Firm: The Firm Conventional Theory Production subject to diminishing marginal productivity Firm’s internal structure “black box” Firm’s 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: 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: 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: The Market Empirical Evidence Most industries characterised by “power law” distribution of firm sizes Some very large; many very small; no “average” size Competitive outcomes (falling price, rising quality & diversity) independent of number of firms in industry Alternative Theory Evolutionary: process of dynamic selection. Varying products increases survival chances of firms Varying consumer interaction alters environment Multi-agent modeling can capture essential features of process Diversity of firm behavior rather than homogeneity Power-law distribution of firm sizes rather than non-existent neoclassical taxonomy of “PC”, monopoly, oligopoly


The Economy: The Economy Conventional Theory Equilibrium processes Keynesian/Neoclassical dispute over tendency to full employment Both agree real wages have to fall in boom (diminishing marginal productivity) Exogenous money, causation from base money supply to credit money to economic activity Empirical Evidence Disequilibrium the rule: all variables cyclical Real wages rise, prices (relatively) fall during boom (no DMP) Credit money drives economy, base money reacts afterwards Rising debt levels since WWII


The Economy: The Economy Alternative Theory Schumpeter’s vision: Underlying disequilibrium dynamics reflect entrepreneurial search for profit Credit essential to entrepreneurial process and endogenous to economy Debt & entrepreneurial activity co-extensive Minsky’s 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 anti-cyclical spending


The Finance Sector: 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 / Tsallis’s “q”—”non-extensive statistical mechanics” / minority game


The Finance Sector: 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: 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: 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: 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