commercial economics market system - demand, supply, prices the market system demand, supply and...

Commercial Economics Market System - Demand, Supply, Prices

The Market System The Market System

Demand, Supply and Price Determination


2March-April 2008

The Market System Individual and Market Demand

The Market System Individual and Market Demand

Market consists of:– Consumers - create a demand

for a product

Demand– the amount consumers desire

to purchase at various prices– Not what they will buy, but

what they would like to buy!

Effective demand – must be willing AND able to pay

Market demand – consists of the sum of all individual demand schedules in the market

Represented by a demand curve

At higher prices, consumers generally willing to purchase less than at lower prices

Demand curve – negative slope, downward sloping from left to right


3March-April 2008

The Demand CurveThe Demand Curve

Price (£)

Quantity Demanded (000s)

Demand

£10

£5

100 150

The demand curve slopes downwards from left to right (a negative slope) indicating an inverse relationship between price and the quantity demanded. Demand will be higher at lower prices than at higher prices. As price falls, demand rises. As price rises, demand falls.


4March-April 2008

The Demand Curve 2 The Demand Curve 3The Demand Curve 2 The Demand Curve 3

The level of demand – – determines where on the graph

it sits Low demand –

– nearer the origin High demand –

– further from the origin (assuming same scale)

Dependent on a variety of factors

Demand curve moves in response to changing factors

Factors influencing demandD = f (Pn,Pn…Pn-1, Y, T, P, A, E)

Where: Pn = Price Pn…Pn-1 = Prices of other

goods – substitutes and complements

Y = Incomes – the level and distribution of income

T = Tastes and fashions P = The level and structure of

the population A = Advertising E = Expectations of

consumers


5March-April 2008

The Demand Curve 4 The Demand Curve 5The Demand Curve 4 The Demand Curve 5

Changes in any of the factors other than price causes the demand curve to shift either:

Left (Less demanded at each price) or

Right (More demanded at each price)

Price (£)

Quantity Demanded (000s)

Demand

£10

100

D1

D2

10 200

Changes in any of the factors affecting demand other than price cause the entire demand curve to shift to the left (less demanded at each price) or to the right (more demanded at each price).


6March-April 2008

The Supply CurveThe Supply Curve

Factors influencing supply: S = f (Pn, Pn..Pn-1,H, N,F1..Fm,E,Sp)

Where: Pn = Price Pn..Pn-1 = Profitability of other goods in

production and prices of goods in joint supply

H = Technology N = Natural shocks F1..Fm = Costs of production

E = Expectations of producers Sp = Social factors

Changes in any of the factors OTHER than price cause a shift in the supply curve

A shift in supply to the left – the amount producers offer for sale at every price will be less

A shift in supply to the right – the amount producers wish to sell at every price increases

HINT: Be careful to not confuse supply going ‘up’ and ‘down’ with the direction of the shift!


7March-April 2008

The Supply CurveThe Supply Curve

Price £

Quantity Bought and Sold (000s)

Supply

£3

200

£7

800

The supply curve slopes upwards from left to right indicating a positive relationship between supply and price. As price rises, it encourages producers to offer more for sale whereas a fall in price would lead to the quantity supplied to fall.


8March-April 2008

The Supply Curve

Price £


Supply

£4

400

S1

100

S2

900

Changes in any of the factors affecting supply other than price will cause the entire supply curve to shift. A shift to the left results in a lower supply at each price; a shift to the right indicates a greater supply at each price.


9March-April 2008

The MarketThe Market

Price (£)


S

D

£5

600

D1

300

Surplus

£3

450

A shift in the demand curve to the left will reduce the demand to 300 from 500 at a price of £5. Suppliers do not have the information or time to adjust supply immediately and still offer 600 for sale at £5. This results in a market surplus (S > D)

In an attempt to get rid of surplus stock, producers will accept lower prices. Lower prices in turn attract some consumers to buy. The process continues until the surplus disappears and equilibrium is once again reached.


10March-April 2008

The Market

Price (£)


S

D

£5

600

S1

100

Shortage

£8

350

A shift in the supply curve to the left would lead to less products being available for sale at every price. Suppliers would only be able to offer 100 units for sale at a price of £5 but consumers still desire to purchase 600. This creates a market shortage. (S < D)

The shortage in the market would drive up prices as some consumers are prepared to pay more. The price will continue to rise until the shortage has been competed away and a new equilibrium position has been reached.


11March-April 2008

Context of business Theories of price & competition The Entrepreneurial

Role

Context of business Theories of price & competition The Entrepreneurial

Role

Manager’s most immediate concern is own market & competition

But macroeconomic performance sets context for own market

– Most markets rise & fall with general economic conditions

Some exceptions—e.g., liquidators do well in slumps!

“Boom” or “slump” conditions thus affect profitability

Ability to foresee switch from one extreme to other also extremely important

– Hence economists being paid to “forecast” So can you rely upon economists to predict

the behavior of the macro economy?

Superficially, microeconomics a settled field

– Micro-economics = Neoclassical economics

In depth, many possible approaches

– Empirical: data contradicts neoclassical assumptions

– Theoretical: Schumpeter & evolutionary views of behavior of firms

– Analytic: multi-agent modeling of behavior of firms & consumers

A much more complex mosaic than “supply & demand”


12March-April 2008

… Acknowledged debate… Acknowledged debate

Essentially “port” of micro framework to macro economy

– Micro: “intersecting demand & supply curves explain everything”

– Macro: “intersecting AD & AS curves explain everything” But as we’ve seen…

– Micro analysis has real flaws

– Macro… Similar problems BUT some debate over “elasticity” of curves…

– “Flexibility of wages & prices

– Flexibility of aggregate supply

– Role of expectations in working of market”


13March-April 2008

Flexibility of wages & pricesFlexibility of wages & prices

High flexibility: quick adjustment from one equilibrium to another:

P

GDP

AD1

AS

AD2

Y1 Y2

P 1

P 2 “Instantaneous” movement, system always in equilibrium

Low flexibility: slow adjustment from one equilibrium to another:

Potential for out of equilibrium effects: “disequilibrium unemployment”

P,GDP


14March-April 2008

… Acknowledged debate… Acknowledged debate

Flexibility of aggregate supply– “… flexible … aggregate supply does not respond … to changes in aggregate demand.

Aggregate supply … depends on the quantity and productivity of factors of production, not on the level of aggregate demand. An expansion of aggregate demand will merely lead to (demand-pull) inflation…

– If the government, therefore, wants to expand aggregate supply and get more rapid economic growth… it should concentrate directly on supply by encouraging enterprise and competition, and generally by encouraging markets to operate more freely…. supply-side economics.

– Other … argue that rises in aggregate demand will cause aggregate supply to rise… However, these conditions will not be achieved, they argue, if the government pursues a non-interventionist, laissez-faire policy. The government instead must seek to control aggregate demand, to ensure that it continues to grow, and at a steady, nonfluctuating rate.” (383)


15March-April 2008

More … Acknowledged debateMore … Acknowledged debate

Role of expectations in working of market– “Some economists argue that people's [price change expectations] adjust rapidly

… If aggregate demand expands … people will expect higher prices… all firms

will raise their prices in response to the demand increase… price rises will fully choke off the extra demand… no increase in sales, … output and employment.

… increased aggregate demand merely fuels inflation…– Others believe that the formation of expectations is more complex … If there is a

lot of slack in the economy—if unemployment is very high and there are many idle resources…—then output and employment may quickly rise…” (384)


16March-April 2008

Keynes “general theory”, according to HicksKeynes “general theory”, according to Hicks

The combination: an upward-sloping LM curve:

Md2 (Y2)

Md1 (Y1)

i

M

i

GDP=YY1 Y2

Exogenous Ms The LM curve

• LM curve thus shows all combinations of output and interest rate that give equilibrium in money market: demand for money equals supply…


17March-April 2008


Next, the IS curve:– Investment demand a negative function of i [I=I(i)]

Lower interest rate makes more projects NPV positive Investment rises as interest rate falls

– Savings supply a positive function of Income [S=S(Y)] Savings a residual after consumption Savings rise as income rise


18March-April 2008


S=S(Y)

Savings a function of

income

I=I(i)

Investment a function of

interest rate

S

Y (income) Y (income)

Y (income)

Y(output)

i i

I (Investment)

The IS curve

Multiplier

IS curve thus shows all points where goods market is in equilibrium

Investment = Savings

– So consumption = output of consumer goods


19March-April 2008

Keynes “general theory”, according to HicksThe product: IS-LM analysis

LM

IS

i

Y (GDP)

LM curve shows all points for money market equilibrium

– Money demand equals money supply

IS curve shows all points for goods market equilibrium

– Investment=Savings

– Demand for goods equals supply

Intersection shows overall economy equilibrium


20March-April 2008

“IS-LM: An Explanation”“IS-LM: An Explanation”

In 1979/80, Hicks commented that– “The IS-LM diagram, which is widely, though not universally,

accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.”

– saw two key problems with IS-LM as an interpretation of Keynes

– 2nd problem was time-period of model: Hicks’s used a week, Keynes used “a ‘short-period’, a term with connotations

derived from Marshall; we shall not go far wrong if we think of it as a year” (Hicks 1980).


21March-April 2008

“IS-LM: An Explanation”“IS-LM: An Explanation”

Not unreasonable to hold expectations constant for a week–and therefore ignore them.

But keeping expectations constant over a year in an IS-LM model does not make sense, because

– “for the purpose of generating an LM curve, which is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.” (Hicks OREF)

I.e., why hold money for precautions/speculation, if expectations were constant?

Can’t validly derive LM curve, because transactions are only reason for holding money when expectations constant


22March-April 2008

Macroeconomics: what the debate ignoresMacroeconomics: what the debate ignores

Empirical record hardly indicates “equilibrium”:

USA Unemployment Rate

0%

2%

4%

6%

8%

10%

12%

4801

4908

5103

5210

5405

5512

5707

5902

6009

6204

6311

6506

6701

6808

7003

7110

7305

7412

7607

7802

7909

8104

8211

8406

8601

8708

8903

9010

9205

9312

9507

Years

Rate

Trend

USA Inflation

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96

Year

CP

I In

dex

CPI Change

Trend

There is a “disequilibrium” interpretation too:– Schumpeter and cycles– Minsky’s “Financial Instability Hypothesis”

But first, empirical investigation of cycles in USA data… next week


23March-April 2008

Other theories of pricingOther theories of pricing

If rising costs of production & falling don’t determine how much firms produce, what does?

– According to some economists, things conventional (neoclassical) theory of firm omits:

Product differentiation

– Theory assumes firms compete only on price Uncertainty

– Theory assumes costs, demand, etc., known by firms

– Also probably no “one size fits all” pricing model Different price models needed for different

– Industries (Ag & Mining vs.. Manufacturing)

– Products (established vs.. new)

– Uses (consumables vs. assets [houses, shares, etc.])


24March-April 2008

Manufacturing: Operation within capacityManufacturing: Operation within capacity

Alternative theories of manufacturing pricing emphasize:

– Uncertainty Can’t know future Excess capacity gives room to react to unforeseeable events

– Rivalry with other producers Output not homogeneous Firms compete on product differentiation Try to “steal” market share from competitors by non-price competition Extra sales profitable because

– “Marginal revenue” high: Price doesn’t have to drop when non-price competition expands sales

– “Marginal cost” low & fixed costs high


25March-April 2008

Alternative models of firm behaviorAlternative models of firm behavior

In manufacturing– Few very large firms– Differentiated products: quality and feature variation– Competition mainly on product development, marketing, services

(availability, after-sales support)– Price “banding”: price reflects quality so market segmented

Product diversity & non-price competition limit output, not costs Income distribution also limits potential sales

– Main problem not producing with “DMP”, but selling output given constrained effective demand


26March-April 2008

Alternative models of firm behaviorAlternative models of firm behavior

Conventional economic supply & demand model based on small, “price taking” firms

Model doesn’t fit data; any alternative model must!– Basic fact: wide dispersion of firm sizes, but– Most industries dominated by few large firms– E.g., US industry aggregate data:

Let’s break that down by percentages:

Employer Firms, Establishments, Employment, Payroll, and Receipts by Receipts Size of Firm and Major Industry, 1997Receipt Size of Firm (in millions of dollars)

Total <1 1 - 2.9 3 - 4.9 <5 5 - 7.49 7.5 - 99.9 100+Firms (000s) 5,542 4,497 633 151 5,281 81 167 13Establishments (000s) 6,895 4,541 722 208 5,472 132 486 805Employment (000s) 105,299 18,524 11,497 5,178 35,200 3,956 21,166 44,977Annual Payroll 3,047,907 324,234 281,025 141,584 746,843 112,920 644,174 1,543,970Est. Receipts 18,242,633 1,162,508 1,059,896 577,315 2,799,719 492,532 3,554,561 11,395,820

(Source: USA Office of Advocacy for Small Firms)


27March-April 2008

Galbraith & Institutional AnalysisGalbraith & Institutional Analysis

One alternative: “Institutional economics” view Focuses on institutions of society Sees dominant institution as large manufacturing firm

– Some competition good & necessary Restrains prices (e.g., Goodyear’s experience) Encourages innovation (Apple v IBM v Dell)

– But small firms/“competitive industries” not automatically superior to concentrated industries

Too small scale of operation Inability to plan for technology/market Institutionally inferior to large firms because less effective

manager of vagaries of market


28March-April 2008

Galbraith & Institutional AnalysisGalbraith & Institutional Analysis

Focus of Galbraith’s “institutional” analysis of firms:– “Nothing so characterizes the industrial system as the scale of the

modern corporate enterprise. In 1969, the five largest industrial corporations, with combined assets of $59 billion, had just under 11 per cent of all assets used in manufacturing. The 50 largest manufacturing corporations had 38 per cent of all assets. The 500 largest had 74 per cent…” (89)

Companies achieve scale because it facilitates planning of technology, and “control” of the market:


29March-April 2008

Post Keynesian Price TheoryPost Keynesian Price Theory

Prices set by markup on input costs:– “[P]rice is set by adding together direct material and labor costs per

unit output, plus overhead costs determined at standard volume output, plus a predetermined (conventional) profit margin. Because the pricing procedure is not explicitly designed to maximize profits, the full cost price is no a profit maximizing price or, in fact, a price that maximizes anything. Rather the pricing procedure is designed to enable the firm to reproduce itself and grow.” (Lee 1984: 1108)


30March-April 2008


View of firms costs:– Based on empirical

data;– High fixed costs– Constant variable costs– Costs fall to full capacity– Planned output within

capacity:A

ndre

ws 1

950

: 6

1 Emphasis on realism

– Post Keynesians often stunned that model not accepted by economists:


31March-April 2008


“Granted that the principle is so generally adhered to in manufacture, the mystery is that it has not yet emerged as a postulate of economic analysis. It should obviously be an accepted principle in pricing-theory. Those economists who have thought about it have been too concerned with trying to explain it on the basis of the existing theory, instead of accepting it… Scientific method would suggest that the right thing to do at the existing state of knowledge would be at least to accept the principle as a basis for further theory in its own field—the analysis of price-policy.” (Andrews 1950: 82)

Main danger for firm is that target sales will not be met

– If sales below target then costs (including debt servicing) can exceed revenue

– Sales above target greatly increase profit


32March-April 2008


Main focus of competition between firms then non-price– Attempt to alter profile of demand towards own product and away

from competitors Hence advertising, marketing, etc.

– Attempt to lower/control costs & increase quality Research & development key focus of firm

Non-manufacturing prices quite different– Minerals, foodstuffs etc. subject to very different dynamics

Products much more homogeneous than manufactures Supply less under control of producer (esp. agriculture) Often more difficult to stockpile Productive capacity more difficult to alter


33March-April 2008


As a result, manufacturing prices “administered” while minerals/agriculture “market”

Administered:– Price set by firm on target output costs plus markup– Changed rarely– Changes in demand met by changes in output– Increase in output can allow drop in markup

Market– Price set by some market mechanism, mainly demand-determined– Changed often– Changes in demand initially met by change in price– Change in supply only after sustained change in demand– Prices will rise & fall with the trade cycle


34March-April 2008


In PK theory, volatile market prices tend to rise in boom, fall in slump relative to stable administered prices

Distinction between “administered” and “market” prices set by frequency of price changes– 1935 study (Means)– “Administered” < 3 changes/year or less– “Market” ≈ 1 change/month or more– On this basis, following classification of administered vs.

market prices by industry:


35March-April 2008

Summing up alternativesSumming up alternatives

Some guidance from Post Keynesians & Sraffians re pricing for managers– “Supply & demand” can’t explain 95% of prices– In general, prices set by markup on costs– Markup constrained by

Competitive pressures Productivity of industry

– Minerals/agriculture largely demand-determined prices

But theories don’t explain all prices– Pricing theory for new products– Pricing theory for assets (Finance section of subject)


36March-April 2008

New productsNew products

Doesn’t fit Post Keynesian or Sraffian models because– Both refer to established products– Sraffian (in particular) considers equilibrium positions

Can’t fit into neoclassical model either– Model flawed for all products– More importantly, even if model was OK

Model fits equilibrium only when new products are “disequilibrium” phenomena

– In equilibrium, profits are zero– Best understood by “Austrian” school of economics

– In particular, Joseph Schumpeter: “in an exchange economy … the prices of all products must, under free competition, be equal to the prices of the services of labor and nature embodied in them…” (30)


37March-April 2008


“The businessman considers as his costs those sums of money which he must pay to other individuals, in order to procure his wares or the means of producing them, that is his expenses of production. We complete his calculation in that we also include in costs the money value of his personal efforts. Then costs are in their essence price totals of the services of labor and of nature. And these price totals must always equal the receipts obtained for the products. To this extent, therefore, production must flow on essentially profitless.” (31)

But profit the driving motive of production in capitalist economy!

– Yes, but not in equilibrium (argues Schumpeter)


38March-April 2008


Schumpeter builds model of economic development that– Uses neoclassical as description of equilibrium– Adds process of qualitative change– Explains profit as outcome of one of 5 types of qualitative change caused by

entrepreneurial activity “(1) The introduction of a new good … (2) The introduction of a new method of production… (3) The opening of a new market… (4) The conquest of a new source of supply of raw materials or half-

manufactured goods… (5) The carrying out of the new organization of any industry” (66)

– Explains introduction (& pricing) of new products In doing so, overturns many conventional economic beliefs not as false,

but as only applying in equilibrium


39March-April 2008

Alternative perspectives on globalizationAlternative perspectives on globalization

Theory of comparative advantage– Appeals to economists because

Fits within age-old paradigm of specialization 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

– Porter’s “Competitive Advantage of Nations”


40March-April 2008

Competitive AdvantageCompetitive 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)


41March-April 2008


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)


42March-April 2008


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 labor? “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.”


43March-April 2008


Management style?

– “What is celebrated as good management practice in one industry would be disastrous in another.” (4)

Labor relations? (An Australian favorite…)

– “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 characterization of nations as competitive

– “We must abandon the whole notion of a ‘competitive nation’…”

– And focus instead on “specific industries and industry segments…” (9)


44March-April 2008


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)


45March-April 2008


Old theory wrongly emphasizes country & factors New theory emphasizes 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 localized 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:


46March-April 2008


“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


47March-April 2008


SWEDENcar carrierscommunication products for handicapped personsenvironmental control equipmentheavy trucksmining equipment

teller-operated cash dispensersnewsprintrefrigerated shippingrock drillssemihard wood flooring

UNITED STATESadvertisingagricultural chemicalscommercial aircraft*commercial refrigeration and air-conditioningcomputer software

construction equipmentdetergentsengineering/constructionmotion picturespatient monitoring equipmentsyringeswaste management services

KOREAapparelautomobilesconstructionfootwearpianos

semiconductorsshipbuildingsteeltravel goodsvideo and audio recording tapewigs

SINGAPOREairlinesapparelbeveragesship repairtrading

SWITZERLANDbankingchocolateconfectionerydyestuffsfire protection equipment

freight forwardinghearing aidsheating controlsinsurancemarine enginespaper product manufacturing machinerypharmaceuticals

surveying equipmenttextile machinery

tradingwatches

DENMARKagricultural machinerybuilding maintenance servicesconsultancy engineeringdairy productsfood additives

furnitureindustrial enzymespharmaceuticalsspecialty electronicstelecommunications equipmentwaste treatment equipment

ITALYceramic tilesdance club and theater equipmentdomestic appliancesengineering/constructionfactory automation equipment

footwearpackaging and filling equipmentski bootswool fabrics

GERMANYautomobileschemicalscutleryeyeglass framesharvesting/threshing combines

optical instrumentspackaging, bottling equipmentpens and pencilsprinting pressesrubber, plastic working machineryX-ray apparatus

JAPANair-conditioningmachineryhome audio equipmentcar audiocarbon fibers

continuous synthetic weavesfacsimileforklift trucksmicrowave and satellite communications equipmentmusical instrumentsoptical elements and instrumentsrobotics

semiconductorssewing machinesshipbuildingtires for trucks and buses

truckstypewritersvideocassette recorderswatches


48March-April 2008

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:


49March-April 2008


“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)


50March-April 2008


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)


51March-April 2008

Competitive AdvantageCompetitive 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


52March-April 2008


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


53March-April 2008


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)


54March-April 2008


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)


55March-April 2008


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)


56March-April 2008


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


57March-April 2008


“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)


58March-April 2008


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…


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– Competitive advantage in suppliers means spin-offs 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…


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Competitive advantage in related industries

TABLE 3-1 Internationally Competitive Related IndustriesNation Industry Related IndustryDenmark Dairy products, brewing Industrial enzymesGermany Chemicals Printing inkItaly Lighting FurnitureJapan Cameras CopiersKorea VCRs VideotapeSingapore Port services Ship repairSweden Automobiles TrucksSwitzerland Pharmaceuticals FlavoringsUnited Kingdom Engines Lubricants, antiknock preparationsUnited States Electronic test and measuring equipment Patient monitoring equipment


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“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)


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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)


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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


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Geographic clustering also strikingly obvious:

Clustering of internationally competitive industries in Italy:


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

commercial economics market system - demand, supply, prices the market system demand, supply and...

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