Chapter 4 Outline

National Competitive Advantage: Porter's Diamond

In 1990, Michael Porter of Harvard Business School published the results of an intensive research effort that attempted to determine why some nations succeed and others fail in international competition.²⁰ Porter and his team looked at 100 industries in 10 nations. The book that contains the results of this work, The Competitive Advantage of Nations, has made an important contribution to thinking about trade. Like the work of the new trade theorists, Porter's work was driven by a feeling that the existing theories of international trade told only part of the story. For Porter, the essential task was to explain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered easily by the Heckscher-Ohlin theory, and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. It is this puzzle that Porter tries to solve.

Porter's thesis is that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 4.6). These attributes are

• Factor endowments--a nation's position in factors of production such as skilled labor or the infrastructure necessary to compete in a given industry.

• Demand conditions--the nature of home demand for the industry's product or service.

• Relating and supporting industries--the presence or absence in a nation of supplier industries and related industries that are internationally competitive.

• Firm strategy, structure, and rivalry--the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.
  
  

Figure 4.6

Determinants of National Competitive Advantage: Porter's Diamond

Reprinted by permission of the Harvard Business Review. "The Competitive Advantage of Nations" by Michael E. Porter, March - April 1990, p. 77. Copyright © 1990 by the President and Fellows of Harvard College; all rights reserved.



Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues, favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them.

Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, create discontinuities that can unfreeze or reshape industry structure and provide the opportunity for one nation's firms to supplant another's. Government, by its choice of policies, can detract from or improve national advantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments.

Factor Endowments

Factor endowments lie at the center of the Heckscher-Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production in some detail. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., communications infrastructure, sophisticated and skilled labor, research facilities, and technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike basic factors (which are naturally endowed), advanced factors are a product of investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skills and knowledge of the population and by stimulating advanced research at higher education institutions, can upgrade a nation's advanced factors.

The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. The most obvious example of this phenomenon is Japan, a country that lacks much in the way of arable land or mineral deposits and yet through investment has built a substantial endowment of advanced factors. Porter notes that Japan's large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan's success in many manufacturing industries.

Demand Conditions

Porter emphasizes the role home demand plays in providing the impetus for upgrading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation's firms gain competitive advantage if their domestic consumers are sophisticated and demanding. Sophisticated and demanding consumers pressure local firms to meet high standards of product quality and to produce innovative products. Porter notes that Japan's sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models. A similar example can be found in the cellular phone equipment industry, where sophisticated and demanding local customers in Scandinavia helped push Nokia of Finland and Ericsson of Sweden to invest in cellular phone technology long before demand for cellular phones took off in other developed nations. As a result, Nokia and Ericsson, together with Motorola, are dominant players in the global cellular telephone equipment industry. The case of Nokia is detailed in the next Management Focus.

Related and Supporting Industries

The third broad attribute of national advantage in an industry is the presence of internationally competitive suppliers or related industries. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden's specialty steel industry. Technological leadership in the US semiconductor industry until the mid-1980s provided the basis for US success in personal computers and several other technically advanced electronic products. Similarly, Switzerland's success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry.

One consequence of this is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter's study. One such cluster is the German textile and apparel sector, which includes high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery.

Firm Strategy, Structure, and Rivalry

The fourth broad attribute of national competitive advantage in Porter's model is the strategy, structure, and rivalry of firms within a nation. Porter makes two important points here. His first is that nations are characterized by different "management ideologies," which either help them or do not help them to build national competitive advantage. For example, Porter notes the predominance of engineers on the top-management teams of German and Japanese firms. He attributes this to these firms' emphasis on improving manufacturing processes and product design. In contrast, Porter notes a predominance of people with finance backgrounds on the top-management teams of many US firms. He links this to the lack of attention by many US firms to improving manufacturing processes and product design, particularly during the 1970s and 80s. He also argues that the dominance of finance has led to a corresponding overemphasis on maximizing short-term financial returns. According to Porter, one consequence of these different management ideologies has been a relative loss of US competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry).

Porter's second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors. All of this helps to create world-class competitors. Porter cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.²¹

Strong domestic competition also stimulated the rise of Nokia of Finland to global preeminence in the market for cellular telephone equipment. For details, see the accompanying Management Focus.

Evaluating Porter's Theory

In sum, Porter's argument is that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to positively impact competitive performance (although there are some exceptions). Porter also contends that government can influence each of the four components of the diamond either positively or negatively. Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and the like. Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs. Government policy can influence supporting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.

If Porter is correct, we would expect his model to predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable. Is he correct? We do not yet know. Porter's theory is so new that it has not yet been subjected to independent empirical testing. Much about the theory rings true, but the same can be said for the new trade theory, the theory of comparative advantage, and the Heckscher-Ohlin theory. It may be that each of these theories explains something about the pattern of international trade. In many respects, these theories complement each other.