Commercial Economics Market System - The Market System Demand, Supply and Price Determination
Commercial Economics Market System - Demand, Supply, Prices
The Market System The Market System
Demand, Supply and Price Determination
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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.
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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).
Commercial Economics Market System - Demand, Supply, Prices
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!
Commercial Economics Market System - Demand, Supply, Prices
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.
Commercial Economics Market System - Demand, Supply, Prices
8March-April 2008
The Supply Curve
Price £
Quantity Bought and Sold (000s)
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.
Commercial Economics Market System - Demand, Supply, Prices
9March-April 2008
The MarketThe Market
Price (£)
Quantity Bought and Sold (000s)
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.
Commercial Economics Market System - Demand, Supply, Prices
10March-April 2008
The Market
Price (£)
Quantity Bought and Sold (000s)
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.
Commercial Economics Market System - Demand, Supply, Prices
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”
Commercial Economics Market System - Demand, Supply, Prices
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”
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
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…
Commercial Economics Market System - Demand, Supply, Prices
17March-April 2008
Keynes “general theory”, according to HicksKeynes “general theory”, according to Hicks
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
Commercial Economics Market System - Demand, Supply, Prices
18March-April 2008
Keynes “general theory”, according to HicksKeynes “general theory”, according to Hicks
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
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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).
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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.])
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
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
Commercial Economics Market System - Demand, Supply, Prices
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:
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
30March-April 2008
Post Keynesian Price TheoryPost Keynesian Price Theory
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:
Commercial Economics Market System - Demand, Supply, Prices
31March-April 2008
Post Keynesian Price TheoryPost Keynesian Price Theory
“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
Commercial Economics Market System - Demand, Supply, Prices
32March-April 2008
Post Keynesian Price TheoryPost Keynesian Price Theory
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
Commercial Economics Market System - Demand, Supply, Prices
33March-April 2008
Post Keynesian Price TheoryPost Keynesian Price Theory
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
Commercial Economics Market System - Demand, Supply, Prices
34March-April 2008
Post Keynesian Price TheoryPost Keynesian Price Theory
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:
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
37March-April 2008
New productsNew products
“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)
Commercial Economics Market System - Demand, Supply, Prices
38March-April 2008
New productsNew products
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
Commercial Economics Market System - Demand, Supply, Prices
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”
Commercial Economics Market System - Demand, Supply, Prices
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)
Commercial Economics Market System - Demand, Supply, Prices
41March-April 2008
Competitive AdvantageCompetitive Advantage
Focus not on “natural endowment” (comparative advantage) & broadly defined industries (labour-intensive, capital intensive) but
– Innovation & very specific industries Luxury cars (Germany) Ski boots (Italy) Mobile phones (Finland!)
Porter’s theory aware of recent economic trends:
– “The long-dominant paradigm … is inadequate… the rise of the multinational corporation … [has] weakened the traditional
explanations of why and where a nation exports…” (2) Porter instead “seeks to isolate … the national attributes that foster
competitive advantage in an industry…” (3)
Commercial Economics Market System - Demand, Supply, Prices
42March-April 2008
Competitive AdvantageCompetitive Advantage
Dismisses other conventional explanations for trade– Good macroeconomic policies?
“Nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy & Korea), appreciating currencies (Germany & Switzerland), and high interest rates (Italy & Korea)…” (3)
– Cheap 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.”
Commercial Economics Market System - Demand, Supply, Prices
43March-April 2008
Competitive AdvantageCompetitive Advantage
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)
Commercial Economics Market System - Demand, Supply, Prices
44March-April 2008
Competitive AdvantageCompetitive Advantage
Rejects comparative advantage:– “the assumptions underlying factor comparative advantage … are
unrealistic in many industries.– The standard theory assumes that there are no economies of scale,
that technologies everywhere are identical, that products are undifferentiated, and that the pool of national factors is fixed.” (12)
(same reservations as early Samuelson—last week)– “The theory … is also frustrating for firms because … [it] assumes
away a role for firm strategy, such as improving technology or differentiating products … most managers exposed to the theory find that it assumes away what they find to be most important and provides little guidance for appropriate company strategy.” (12-13)
Commercial Economics Market System - Demand, Supply, Prices
45March-April 2008
Competitive AdvantageCompetitive Advantage
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:
Commercial Economics Market System - Demand, Supply, Prices
46March-April 2008
Competitive AdvantageCompetitive Advantage
“firms can and do choose strategies that differ… successful international competitors often compete with global strategies
in which trade and foreign investment are integrated…” (19) “a nation’s firms gain competitive advantage in all its forms, not only the
limited types of factor-based advantage contemplated in the theory of comparative advantage…” (20)
Acknowledges inspiration by Schumpeter but he “stopped short of answering the question … Why do some firms, based in some nations, innovate more than others?” (20)
Theory developed by empirical research:– 10 countries examined at deep industry level: Denmark (5.1 million people in
1987); Germany (61m); Italy 57; Japan 122; Korea 42; Singapore 2.6; Sweden 8.4; Switzerland 6.5; UK 57; USA 244 m
Commercial Economics Market System - Demand, Supply, Prices
47March-April 2008
Competitive AdvantageCompetitive Advantage
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
Commercial Economics Market System - Demand, Supply, Prices
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:
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“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)
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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)
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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
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Combination of cost & differentiation give different forms of competitive advantage:
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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)
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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)
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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)
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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
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“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)
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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: