February 29th, 2012 The Diamond Model
The Diamond model of Michael Porter for the Competitive Advantage of Nations offers a model that can help understand the competitive position of a nation in global competition. This model can also be used for other major geographic regions.
Traditionally, economic theory mentions the following factors for comparative advantage for regions or countries:
C. Natural resources (minerals, energy)
D. Labor, and
E. Local population size.
Because these factor endowments can hardly be influenced, this fits in a rather passive (inherited) view towards national economic opportunity.
Porter says sustained industrial growth has hardly ever been built on above mentioned basic inherited factors. Abundance of such factors may actually undermine competitive advantage! He introduced a concept of "clusters," or groups of interconnected firms, suppliers, related industries, and institutions that arise in particular locations.
As a rule Competitive Advantage of nations has been the outcome of 4 interlinked advanced factors and activities in and between companies in these clusters. These can be influenced in a pro-active way by government.
These interlinked advanced factors for Competitive Advantage for countries or regions in Porters Diamond framework are:
1. Firm Strategy, Structure and Rivalry (The world is dominated by dynamic conditions, and it is direct competition that impels firms to work for increases in productivity and innovation)
2. Demand Conditions (The more demanding the customers in an economy, the greater the pressure facing firms to constantly improve their competitiveness via innovative products, through high quality, etc)
3. Related Supporting Industries (Spatial proximity of upstream or downstream industries facilitates the exchange of information and promotes a continuous exchange of ideas and innovations)
4. Factor Conditions (Contrary to conventional wisdom, 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. "Non-key" factors or general use factors, such as unskilled labor and raw materials, can be obtained by any company and, hence, do not generate sustained competitive advantage. However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate. This leads to a competitive advantage, because if other firms cannot easily duplicate these factors, they are valuable).
The role of government in Porter's Diamond Model is "acting as a catalyst and challenger; it is to encourage – or even push – companies to raise their aspirations and move to higher levels of competitive performance. They must encourage companies to raise their performance, stimulate early demand for advanced products, focus on specialized factor creation and to stimulate local rivalry by limiting direct cooperation and enforcing anti-trust regulations.
Porter introduced this model in his book: The Competitive Advantage of Nations, after having done research in ten leading trading nations. The book was the first theory of competitiveness based on the causes of the productivity with which companies compete instead of traditional comparative advantages such as natural resources and pools of labor. This book is considered required reading for government economic strategists and is also highly recommended for corporate strategist taking an interest in the macro-economic environment of corporations.
Overview of The Competitive Advantage of Nations (The Diamond Model)
- Porter is a famous Harvard business professor. He conducted a comprehensive study of 10 nations to learn what leads to success. Recently his company was commissioned to study Canada in a report called "Canada at the Crossroads".
- Porter believes standard classical theories on comparative advantage are inadequate (or even wrong).
- 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.
The Diamond – Four Determinants of National Competitive Advantage
Four attributes of a nation comprise Michael Porter's "Diamond" of national advantage. They are:
1. Factor conditions (i.e. the nation's position in factors of production, such as skilled labour and infrastructure),
2. Demand conditions (i.e. sophisticated customers in home market),
3. Related and supporting industries, and
4. Firm strategy, structure and rivalry (i.e. conditions for organization of companies, and the nature of domestic rivalry).
Factor conditions refers to inputs used as factors of production – such as labour, land, natural resources, capital and infrastructure. This sounds similar 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 labour, capital and infrastructure.
"Non-key" factors or general use factors, such as unskilled labour and raw materials, can be obtained by any company and, hence, do not generate sustained competitive advantage. However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate. This leads to a competitive advantage, because if other firms cannot easily duplicate these factors, they are valuable.
Porter argues that a lack of resources often actually helps countries to become competitive (call it selected factor disadvantage). 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 labour shortages. They abandoned labour-intensive watches and concentrated on innovative/high-end watches.
Japan has high priced land and so its factory space is at a premium. This lead to just-in-time inventory techniques (Japanese firms canï¿½t have a lot of stock taking up space, so to cope with the potential of not have 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 pre-fabricated houses.
Michael Porter argues that a sophisticated domestic market is an important element to producing competitiveness. Firms that face a sophisticated domestic market are likely to sell superior products because the market demands high quality and a close proximity to such consumers enables the firm to better 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 product is just initially being developed and after it has been perfected, it doesn't have to be so close to the discriminating consumers).
If the nation's discriminating values spread to other countries, then the local firms will be competitive in the global market.
One example is the French wine industry. The French are sophisticated wine consumers. These consumers force and help French wineries to produce high quality wines. Can you think of other examples? Or counter-examples?
Related and Supporting Industries
Porter also argues that a set of strong related and supporting industries is important to the competitiveness of firms. 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 U.S., Detroit (for the auto industry) and Italy (leather-shoes-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 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, or
- an association of a region on the part of applicable labour force.
Some disadvantages to locating close to your rivals are:
- potential poaching of your employees by rival companies and
- obvious increase in competition possibly decreasing mark-ups.
Firm Strategy, Structure and Rivalry
- Capital Markets
Domestic capital markets affect the strategy of firms. Some countriesï¿½ 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 U.S.) will tend to be more competitive in industries 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).
- Individuals Career Choices
Individuals base their career decisions on opportunities and prestige. A country will be competitive in an industry whose key personnel hold positions that are considered prestigious.
Does this appear to hold in the U.S. and Canada? What are the most prestigious occupations? What about Asia? What about developing countries?
Porter argues that the best management styles vary among industries. Some countries may be oriented toward a particular style of management. Those countries will tend to be more competitive in industries for which that style of management is suited.
For example, Germany tends to have hierarchical management structures composed of managers with strong technical backgrounds and Italy has smaller, family-run firms.
Porter argues that intense competition spurs innovation. Competition is particularly fierce in Japan, where many companies compete vigorously in most industries.
International competition is not as intense and motivating. With international competition, there are enough differences between companies and their environments to provide handy excuses to managers who were outperformed by their competitors.
The Diamond as a System
- The points on the diamond constitute a system and are self-reinforcing.
- Domestic rivalry for final goods stimulates the emergence of an industry that provides specialized intermediate goods. Keen domestic competition leads to more sophisticated consumers who come to expect upgrading and innovation. The diamond promotes clustering.
- Porter provides a somewhat detailed example to illustrate the system. The example is the ceramic tile industry in Italy.
- 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 technological 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 (ie: workers with industry-specific training) since they will tend to get higher returns and less risk of losing employment.
- At the same time, upstream firms (ie: those who supply intermediate inputs) will invest in the area. They will also wish to save on transport costs, tariffs, inter-firm communication costs, inventories, etc.
- At the same time, downstream firms (ie: those use our industry's product as an input) will also invest in the area. This causes additional savings of the type listed before.
- Finally, attracted by the good set of specific factors, upstream and downstream firms, producers in related industries (ie: those who 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 of The Competitive Advantage of Nations 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, "Governments proper role is as a catalyst and challenger; it is to encourage – or even push – companies to raise their aspirations and move to higher levels of competitive performance"
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.
- They should focus on specialized factor creation. (How can they do this?)
- They should enforce tough standards. (This prescription may seem counterintuitive. What is his rationale? Maybe to establish high technical and product standards including environmental regulations.)
The problem, of course, is through these actions, it becomes clear which industries they are choosing to help innovate. What methods do they use to choose? What happens if they pick the wrong industries?
Criticisms about The Diamond Model
Although Porter theory is renowned, it has a number of critics. Porter developed this paper based on case studies and these tend to only apply to developed economies.
Porter argues that only outward-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 that claim.
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.