ESRC lecture 1994 – Is There a Competitive Advantage of Nations?

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Competitive advantage is based, not on doing what others already do well, but on doing what others cannot do as well. Not only is this true for individuals and for firms, but for countries as well.

Is There a Competitive Advantage of Nations?

Professor John Kay

Our dissatisfaction with Britain’s industrial performance begins when we compare ourselves with our principal competitors. The quality of our manufactured goods is lower than that of Japan. Our record of innovation cannot match that of the United States. The skills of our designers are often outstripped by those of Italy. Our levels of scientific and technical education are lower than those of Germany. The job of research is to find out why these things are so; the job of government is to put them right.

Tonight I want to propose a rather different perspective. When I view my own personal performance, I find the outlook equally depressing. I cannot bat as well as Brian Lara. I cannot write as felicitously as Tom Stoppard. I am not as handsome as Hugh Grant. You may feel that I should spend more time in the nets, improve my writing style, and spruce up my image, and indeed I should perhaps do all these things. But the solution I have found is a rather different one. I know I cannot match Lara’s cover drive, but when it comes to calculating a demand elasticity I know that I can beat Lara ninety-nine times out of a hundred. Let Lara face the bowling, while I deal with the economics.

Competitive advantage is based, not on doing what others already do well, but on doing what others cannot do as well. We know that this is true for us as individuals. We can see – with greater difficulty – that this is true for firms; that real corporate success is based on distinctive capabilities, not on imitating the successful. What I wish to argue tonight is that the same is true for countries. It follows that the focus of industrial policy should not be on what we do worse than other people but on what we do better.

The fifth ESRC annual lecture 1994

Is there a competitive advantage of nations?

In a question that echoes Mrs Thatcher’s assertion that there is no such thing as society, we might ask whether there is such a thing as a national economy, or national competitiveness. Can there be a competitive advantage of nations, as distinct from a competitive advantage of individuals or firms?

The evidence that there is indeed a competitive advantage of nations seems all around us. The camera you use and the audio equipment you listen to were almost certainly made in Japan. The aeroplane in which you fly is far more likely to have been built in the United States than in any other country, and the same is true of the software you use and the movies you watch. The largest world insurance market is in London, and if you go behind the scenes at a grand prix you will discover that the skills that put Formula One motor cars on the track are mostly British. I have a German kitchen and an Italian bathroom, and I bet that so do many of you.

A striking feature of all these industries is that I can predict the country of origin with much more certainty than the manufacturer. Japan dominates sales of cameras, but there are many Japanese camera manufacturers. The software industry is fiercely competitive, but most of these competitors are US firms. When you buy your German kitchen, Poggenpohl and Bulthaup will eagerly seek your custom. Competitive advantages in these industries seem to be as much with countries as with firms.

Now the theory of international trade we learn in beginning economics did indeed focus on the nation as the unit. Portugal was sunny and England wet, so the former country sold its wine for the latter’s textiles. But the theory of comparative advantage, in which world trade reflects these differential endowments of natural resources, seems almost irrelevant in the context of twentieth century trade. While comparative advantage still explains Saudi oil and Colombian coffee, most trade today is in manufactured goods between countries whose resource endowments are apparently similar. It is not clear what natural resources are necessary, or useful, in writing software or building kitchens. The Heckscher-Ohlin theory sought to revive the theory of comparative advantage by emphasising differences in the availability of capital and labour. Capital rich countries would sell capital-intensive goods in return for labour-intensive ones. But does writing an insurance policy use more or less capital than making a camera? It depends on how you write the policy or make the camera, and successful firms in the same country do so in a range of different ways.

Modern trade theory is rather different. It stresses the imperfection of competition and the ubiquity of scale economies. But these factors, at best, explain the fact of trade rather than its structure. Why does Japan export cameras and the United States aeroplanes, and not the other way around? Home market bias, the design of products to meet particular national preferences, is part of that story – Germany makes a recognisable style of limousine because these are cars that Germans aspire to drive. Japanese tourists do like to take photographs, and the British are prone to worry about unanticipated events. But there is more to Japanese strength in optics and Britain’s leadership in insurance than that.

Who are Us?

There is a more fundamental problem if national competitive advantage is to be explained by scale economies. Most scale economies arise at the level of the individual firm. America’s leading position in aircraft manufacture is in large measure the product of the leading position of Boeing, and that position is in turn the product of that firm’s economies of scale and experience. These are the competitive advantages of Boeing. The Coca-Cola corporation earns considerable returns from the exploitation of its powerful brand. It is based in Atlanta, its shareholders are mostly American, and it pays substantial taxes to the US government. In these ways it makes a major contribution to the wealth and welfare of the United States. Yet it is stretching language to call Coca-Cola an American competitive advantage.

This distinction between those competitive advantages which appear to belong to a particular firm – such as those of Boeing or Coca-Cola or Reuters or Glaxo – and those which seem to be characteristic of many firms in the same location – such as those of German kitchen manufacturers, Japanese optical companies, or Italian tie makers – has a variety of important implications. It does seem that the competitive strengths we associate with the United States and Britain are often the assets of particular firms, while those of countries such as Germany, Italy or Japan are more often recognisable as national competitive advantages. I shall suggest below why this may be so. It may also be one reason why the profitability of American and British firms is very much higher than those of Japanese or German firms even though the competitive performance of Japan or Germany may be superior. Anglo-American competitive advantages earn returns for British and American firms; Japanese and German competitive advantages earn returns for whole economies.

This relationship between national and firm competitive advantage raises another fundamental issue. If the City of London retains a pre-eminent position in the world financial services market, but many of its firms are foreign owned, is the competitive advantage ours, or theirs? Should we care if a new British motor car industry, under Japanese ownership, rises from the ashes of the old; or if British Aerospace exploits its technical capabilities by manufacturing in Taiwan? In a world of multinational firms and multinational production, where is competitive advantage located? Robert Reich, now President Clinton’s Labor Secretary, posed the question for Americans in the stark, if ungrammatical, phrase, “Who are us?”? Reich’s question deserves an answer; it is important in itself and also bears directly on the definition of national competitive advantage.

The answer is that we own those factors from which we earn and we earn from those factors which we own. If firms in London locate, and pay, to exploit the skills they find there, we need not care whether they trade as Morgan Grenfell or Deutsche Bank, as Brown Shipley or as Goldman Sachs. We should judge Japanese car manufacturers in direct proportion to the value they add in the UK. And if offshore manufacturing maximises the value of British Aerospace’s research capabilities, then that is what “us” should do. In each case, the question is how much economic rent, or added value, is established here.

Sources of Competitive Advantage

A strictly national competitive advantage would be derived from a scarce factor whose availability coincided with the boundaries of a nation. There are some, but few, economically important resources which are exactly aligned with national borders. Language frontiers broadly follow political frontiers, so the English language helps Britain and America to have competitive advantage in broadcasting, films, publishing and a range of associated industries, such as graphic design and sound mixing equipment. Time zones are national, and that gives Europe some advantages in financial services. Legal systems, fiscal rules, and regulatory regimes also coincide with national boundaries. Britain and the United States derive competitive advantage from the widespread adoption of their legal jurisdictions. Some small countries – Panama in shipping, Monaco in gaming, Switzerland in banking – derive competitive advantage through attractive regulation (regulation which is attractive, in the main, for its absence). But all these factors are minor in relation to the aggregate of world trade. What we recognise as national competitive advantages are mostly not advantages of countries as such. They are the product of factors which are located within particular countries. The observation is not that firms necessarily gain competitive advantage in fitted kitchens by locating in Germany; it is that many German firms in that industry appear to have competitive advantages.

That theory of comparative advantage explained trade by reference to the physical location of scarce natural resources. But the most successful economies of the post- war era, like Germany and Japan, are countries singularly devoid of any natural resources at all. Indeed, the belief that these countries could only prosper if they secured access to natural resources proved perhaps the most costly and damaging misconception in world history. If we are here tonight to justify the role of analysis, research and education in the social sciences, then we need do no more than observe that two world wars were substantially the product of elementary misunderstanding of the relationships between physical resources and economic power. But if popular discourse is not yet free of that misunderstanding, it is a misunderstanding which is much less prevalent than it was.

Historically, the concentration of industry in particular locations was often explained by access to natural resources. What is interesting is not just that these natural resources have become very much less significant elements in production, but that geographical concentration has often long outlasted the natural resources concerned. Firms located in the Ruhr to access its coal and steel; the coal and steel are no longer there but the firms are. Film studios went to Los Angeles in the 1920s to benefit from the natural light of southern California. This no longer matters, and few films are now shot in California, but Hollywood is still the centre of the world film industry. And London is still the world’s shipping market even though we no longer have a great navy or a substantial merchant marine.

Now there is something surprising at work here. Where geographical concentration is not the result of shared access to physical resources, it might instead have been the product of the costs of transport and communication. Once, physical proximity was critical to supplier relationships. The Fisher body plant was located on the opposite side of the road to the Morris assembly line even though it was owned by a separate company. But as obstacles to trade and transport costs have fallen, and data transmission has become cheap and instantaneous, location would seem to matter less and less. Today we take it for granted that cars will be put together from components manufactured in different locations around the world. It was once true that a strong national firm in one industry would confer competitive advantages on many related businesses within the same country. With a great merchant marine went a strong ship building industry and a powerful position in steel production. Italian success in domestic appliances was associated with Fiat’s achievements in small motors. With firms increasingly free to seek preferred partners on a global basis these sources of national competitive advantage are steadily eroding.

Yet geographical concentration remains important. One recent study of the evolution of financial services wrote of “the end of geography”, suggesting that location had become irrelevant. Appropriately enough, he was the chief economist of American Express Bank. Yet the more striking observation is that geography has not ended. Traders now operate on screens, rather than in a physical market; but the screens are mostly to be found within a few hundred yards of each other. Financial information can be sent immediately around the world, and is; yet the financial services industry remains concentrated in tiny areas of East London and Lower Manhattan.

Relationships and Networking

And the same is true of manufacturing. Observers of the rise of Toyota from second line manufacturer of sewing machines to dominance of the world automobile industry in a period of forty years have emphasised the role of Toyota’s keiretsu – the integrated but nevertheless independent group of suppliers which underpins Toyota’s exceptional reputation for reliability, their pioneering of just-in-time inventory management, and their shortening of the traditional model cycle. Most of the firms involved are not only based in Japan; they are located close to Toyota’s main assembly plant in Nagoya. But this need for physical proximity is not directed at reducing transport costs. Ford of Europe makes bodies in one country and engines in another without suffering any serious cost penalty. So what is the purpose of this continuing geographical concentration? Its purpose is to cement the relationship between Toyota management and the executives of other members of the keiretsu. That keiretsu involves a complex structure of implicit contracts – long-lasting understandings whose context is not, and cannot be written down. The nature of these relationships enables Toyota to be confident in the quality of its suppliers’ parts, unconcerned about its potential vulnerability to component shortages, and ready to share proprietary knowledge in order to accelerate design and retooling.

Toyota illustrates well why some competitive advantages will continue to be associated with particular geographical locations. Despite the internationalisation of markets, despite air travel, despite information technology, there are still things that are done best by people who find themselves frequently in the same room. The most important of these are the transfer of skills and knowledge and the development of trust between individuals. It is in success in creating networks which facilitate these exchanges that many competitive advantages in today’s world depend.

Why learning and trust require physical proximity is a matter for psychologists rather than economists. Yet it remains true that distance learning – even for material that has been completely mastered and communicated many times before – is but a shadow of a classroom experience, and that video conferencing has made a negligible dent on the market for world air travel. Effective communication depends on non-verbal, possibly even non-visual, cues. The barely perceptible hesitation introduced by a satellite link invites misunderstanding when we are used to interpreting hesitation in other ways. Shared experiences and values are a central element in developing trust. The linking of social and commercial relationships increases the penalties for opportunistic behaviour. That is why the lunch room is a central facility of the City of London and extensive entertainment an integral part of Japanese business culture.

Tacit Knowledge and Flexible Response

Locally concentrated networks are characteristic features of the Italian industrial organisation of northern Italy – the knitwear producers of Carpi, the shoemakers of Varese, the metal workers of Lumezzane. Although these groupings are based on small firms, with production facilities sometimes still attached to houses, they are not cottage industries in any pejorative sense of that term. Their technology is as advanced as any in the world, and levels of investment are high. The competitive strength of each firm within the network derives from the knowledge base to which all contribute and have access – “The mysteries of the trade are in the air”, as Marshall noted of similar concentrations a century ago. Their competitive performance also benefits from the capacity of flexible structures, based on trust, to respond more rapidly and more effectively to changing conditions than can either monolithic corporations or individual proprietors. For those who equate competitive advantage with size and scale and see these as the prerogative of multinational companies, the structure of Italian industry, in which its large firms are subsidised by the more vibrant small business sector of the economy, provides a powerful antidote.

In financial services the competitive advantage of London has long rested on access to shared knowledge and on trust relationships between participants. Trading floors, and the Room at Lloyd’s, are physical manifestations of the advantages of casual proximity in developing tacit knowledge. The traders who chose “My word is my bond” as the motto of the Stock Exchange clearly thought they were making an important statement about London’s competitive position. This was supported by the homogeneity of background and the rigid values established by the English class system and the English school system.

Tacit knowledge need not be industry specific. Italian – and to a degree European – pre-eminence in design rests ultimately on a skill base that dates back to the Renaissance. It is a casual – but undeniable – observation that quite average French or Italian women have a sense of style in dress that the typical American tourist on the Rue du Faubourg-St-Honore or the Via Veneto conspicuously lacks. The mechanisms by which that style is acquired are complex – they are “in the air” – but the fact has consequences for the competitive position of French and Italian firms that extends well beyond the field of haute couture.

The most important of such non-specific skill bases lies in scientific and technical training. The levels of scientific education and achievement in British universities are as high as any in the world, and this is reflected in the success of British firms in industries that depend on elite science, like pharmaceuticals and certain areas of defence electronics. Once the product is designed it has, for practical purposes, been made. Britain’s dominance of technical support for Formula One motor racing stands in stark contrast to its competitive failure in volume car production. Where – particularly – Germany and Japan stand out is in the technical capabilities of workers further down the ability spectrum. The manufacture of fitted kitchens, precision optical equipment, or computer aided machine tools requires little in the way of the kind of science that wins Nobel prizes, but it does require a production line workforce with quantitative skills.

National Culture and Competitive Advantage

Social institutions which support trust relationships and the development of tacit knowledge have major advantages. But this is not a wholly one-sided story. Although the advantages of collaborative and cooperative activities are obvious, tacit knowledge can often be conservative and constraining, and networks of relationships nepotistic and corrupt. What makes Italian and Japanese business strong is not so different from what makes Italian and Japanese politics rotten. The most striking comparison is that between Japan and the United States. In one country, business emphasises consensus and shared knowledge; in the other information is an individual property and bargains are struck, enforced and disputed in precise legal form.

The United States is a country founded by immigrants, many of whom were throwing off the constraints imposed by the values and social structures of the countries from which they came. (That tourist with ill-fitting pants is probably of European descent.) That history has contributed to its strongly individualistic ethos and helped to lay the foundations for the most innovative and entrepreneurial society the world has known. These attributes are translated into the competitive advantages of US firms. It is this capacity for innovation and individual entrepreneurship which explains why the United States dominates in pharmaceuticals and in computer software.

Even in industries where market leadership has subsequently been ceded to firms in other countries, like semiconductors or VCR’s, the product is often based on an initial American innovation. The difficulty of appropriating innovations fully for the benefit of innovating firms is a problem for the US economy, but the innovative environment which these spillovers foster is the most important of American competitive advantages.

Societies which rely less on trust relationships between individuals have greater need of public forms of quality certification. So most of the world’s great brands originate in the United States, and they help to sell products as different as hamburgers and legal and accounting services around the world. It is a direct result of the different nature of the two societies that the competitive strength of the individualistic United States is substantially founded on the competitive advantage of American firms while the competitive strengths of Japanese firms are substantially founded on the competitive advantage of the collectivist Japanese nation.

So political and cultural history exerts a continuing influence on economic performance. A clearer appreciation of that might make us more cautious in the models of reform we urge on the countries of Eastern Europe. The most unbridled forms of individualism – as in Nigeria – are not a recipe for economic success, and individualism in the United States is mediated by a complex collectivism reflected in intense patriotism and an unusually rich variety of voluntarist institutions from churches to charities to country clubs. There are dangers in the breakdown of established structures of relationships, however debased, in conditions where there is nothing to take their place.

It is easier to destroy trust relationships than to create them. So whatever the commercial advantages of these structures, they are under constant pressure from those who identify immediate gains from more opportunistic behaviour. In the banking industry, for example, many established relationships were fractured in pursuit of the supposed advantages of a more performance-oriented, transaction-driven, culture. Even if the mistakes are now evident, the pieces cannot easily be put together again. Is it possible, then, that the competitive advantages of the Far East nations are essentially transitory? Do we see today a short interval in which the institutions of contemporary capitalism coincide with the collectivist values of more traditional feudal systems, before one inevitably drives out the other?

It certainly is possible that this is what we see, and the rigid conventions of Japanese firm structure and labour markets are under increasing pressure. Yet we can look to the successful maintenance of relationship structures over decades if not centuries in Switzerland and in parts of Italy and Germany as evidence that such national competitive advantages can be sustained.

Patterns of Trade and Competitiveness

A country’s international competitiveness depends, therefore, on three things. The first is the strength of the competitive advantage of its individual firms. This is the benefit the United States derives from the fact that Coca-Cola, Merck and Microsoft – all among the most profitable firms in the world – are American owned and managed, have a bias, although by no means an overwhelming one, in favour of conducting their business within the United States, and pays tax there.

Second, international competitiveness may be derived from access to scarce resources which are available within a country, but not to those outside it. Once, as we have seen, these were natural resources. Today, I have suggested, such strategic assets are more likely to be intangible; the English language, the European time zone. Such national competitive advantages exist – although they matter for small countries like Switzerland, Saudi Arabia or Singapore.

But mostly, national competitive advantages lie in supportive networks of firms and activities, and are based on those things which such networks typically facilitate – speed and flexibility of response, and the construction of a base of tacit knowledge, which may be industry-specific – Japanese capabilities in optics – or more general – German craft skills.

I believe an appreciation of these trends largely explains why it is that the growth of international trade among developed countries has led ultimately to widening income differentials and to higher levels of unemployment everywhere. Widening markets increases the rewards for those – individuals, firms, or groups of individuals or firms within nations – who have truly distinctive capabilities. Pavarotti, Microsoft, Italian knitwear producers earn more by displaying their talents on a wider stage; while widening markets equally bids down the earnings of those – individuals, firms or groups of firms – who have nothing distinctive to offer.

The history of the last forty years has been one characterised at first by attempts to resist these changes. Governments tried vainly to arrest the decline of firms which had no competitive advantages – indeed, often whole industries in which no firms had any marked competitive advantages, such as steel, automobiles or airlines. They absorbed low-skilled workers into the public sector. Ultimately, unwilling or unable to bear the costs of these policies, they allowed unemployment to be the consequence.

Establishing National Competitive Advantages

This account of the dependence of competitive advantage on history makes clear that establishing national competitive advantages is no easy task. Indeed, it is self-evident that the process of creation must be hard, since if it were otherwise there could be no enduring source of competitive advantage. There can be no general recipes for competitive success – for individuals, firms or countries – since if there were their general adoption would defeat their object. It is almost impossible to implant trust where it does not already exist. The process of developing skills and shared knowledge is inhibited by the limitations on the ability of individuals to communicate, or teach, more than they themselves already know. The unflattering comparison of British and German technical education is hardly new, for example; but to recognise the problem is, as history has shown, only the smallest of steps towards a solution.

Yet it is not impossible to build national competitive advantages. The evolution of Singapore as a financial services centre has illustrated the creation of trust through austere communal discipline and the stimulation of shared knowledge through a powerful collective ethos. Korean industry has been encouraged to develop in ways that mimic the networking structures of Japan. Policies can change the skill bases of populations, but there is no escaping the slowness of the process.

Let me now turn to some policy implications of what I have been saying. If there is one issue in industrial policy on which everyone is in agreement, it is that governments should not pick winners, and that the attempt to do so are responsible for many of our past failures. You will understand by now that I completely disagree; I think that picking winners is exactly what the government should do. The past problem was not that we picked winners – no one could describe an industrial policy focused on Leyland and on expanding steel output, on Magnox reactors and on Concorde, as one of picking winners. We picked things that were losers but that we would have liked to be winners.

Next, we should not focus our attention on those areas of economic activity which others already do well. There is a complex series of issues here. The trade liberalisation of recent decades has been heavily focused on semi-sophisticated manufactured goods. So much so, in fact, that we have come to take for granted that this is what trade and competitiveness is about; cameras and textile machinery, cars and audio equipment. Now these are, as it happens, areas in which Britain and British firms have relatively few competitive advantages. We are much further from free trade in basic manufactures, where protectionism and subsidy is rife, or at the most sophisticated levels, where public purchasing dominates; in agriculture, where we have retreated from free trade when liberalisation has been happening elsewhere; and, most importantly for Britain, in business and financial services, where different national standards are entrenched and where entry barriers and cartels abound.

We supported a world trading order which directed liberalisation at areas in which we enjoyed no particular competitive advantage, and joined a European Union with essentially the same characteristics. The results were massively beneficial to British consumers, but not at all beneficial to British producers. One response is, indeed, to focus on improving our performance in those areas where others enjoy these competitive advantages. But, for the reasons I have explained, this strategy is not likely to be successful nor likely to be rewarding if it were successful.

An alternative is to focus on those areas in which Britain and British firms have real competitive advantages. Let me give some examples. I have already noted that Britain’s greatest strategic asset is the English language. It feeds directly into British competitive advantages in publishing – traditional and electronic, all kinds of audio-visual media, and tertiary education. I find it difficult to see that considerations of international competitiveness have played any role in policy for these areas; certainly a negligible one relative to more important concerns, such as anti-intellectualism, cost minimisation, and a belief that the BBC is insufficiently deferential to politicians.

Let us take pharmaceuticals. This is another industry of undoubted British competitive advantage. Two of the principal members of the European Union – France and Italy – have clear policies of promoting indigenous clones of established products and buying international drugs only at low prices. If we are to make ourselves unpopular with our European partners, I would rather do it on this issue than by being rude about the Belgian Prime Minister.

Britain has the best located of the world’s international airports, and an airline which is a few years ahead of others in realising that it is almost as important to please passengers as to please politicians. Yet it is only within the last few months that British Airways has been able to make any flights which do not start or end in the UK, and that represents a tiny fraction of its business. Contrast that with the trade liberalisation we have seen for manufactured goods.

In all these areas, government is not creating competitive advantage; it is promoting opportunities to exploit competitive advantages that already exist. My account of the origins of national competitive advantages, which emphasises the importance of history and the role of supportive relationships between firms and the creation of collective knowledge bases, makes clear how a government role in the development of competitive advantage can only be marginal, indirect and long term. But it can exist.

Take insurance, for example. If there is any British industry where government intervention and support would have been justified it is not, in my judgement, steel or shipbuilding or cars or biotechnology; it is insurance. We have real competitive advantages here; yet they have been seriously eroded by a combination of weak management and personal aggrandisement. I am not just talking about Lloyd’s, although the problems of Lloyd’s have made the issues particularly visible. The industry is starting to get its act together, with more effective management and improving standards of training and competence; these are precisely the sorts of issues with which a sympathetically critical government can help.

Or look at retailing. This is again a British winner; it is not, however, yet an international industry, and it will become one only slowly. Once we understand how national competitive advantages are created, we can see a role for government in encouraging the sharing of the costs of learning and the results of experience; precisely the role, in fact, that the Japanese government has played in relation to many Japanese export industries.

I have argued tonight that there are such things as national competitive advantages, which are based in the specific and unique business histories of individual countries; and that for these reasons attempts to imitate the competitive advantages of others are doomed to failure. I have argued that the past failure of British industrial policy was not that we tried to pick winners, but that we did not; that our measures were based on a vision of what we would like to be rather than an analysis of what we are. I have attempted to describe a real and constructive role of industrial policy.

There is not much comfort in my analysis for those individuals who have few distinctive capabilities to offer in the labour market, or those firms which have few distinctive capabilities to offer their customers. We should not have expected that a policy aimed at enhancing competitiveness would.

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