Michael Porter On How To Marry Strategy & Operational Effectiveness
The Harvard management guru argues that operations & strategy must fit to create a sustainable competitive advantage.
For almost two decades, managers have been learning to play by a new set of rules. Companies must be flexible to respond rapidly to competitive and market changes. They must benchmark continuously to achieve best practice. They must outsource aggressively to gain efficiencies. . . Positioning — once the heart of strategy — is rejected as too static for today’s dynamic markets and changing technologies. According to the new dogma, rivals can quickly copy any market position, and competitive advantage is, at best, temporary. . . But those beliefs are dangerous half-truths, and they are leading more and more companies down the path of mutually destructive competition.
Distinguishing Between Operational Effectiveness and Strategy
Operational effectiveness and strategy are both essential to superior performance, which is the primary goal of any enterprise. But they work in very different ways. . . Operational effectiveness (OE) means performing similar activities better than rivals perform them. Operational effectiveness includes but is not limited to efficiency. It refers to any number of practices that allow a company to better utilize its inputs by, for example, reducing defects in products or developing better products faster. In contrast, strategic positioning means performing different activities from rivals or performing similar activities in different ways. . . Constant improvement in operational effectiveness is necessary to achieve superior profitability. However, it is not usually sufficient. Few companies have competed successfully on the basis of operational effectiveness over an extended period, and staying ahead of rivals gets harder every day.
Strategy is the creation of a unique and valuable position, involving a different set of activities. If there were only one ideal position, there would be no need for strategy. Companies would face a simple imperative — win the race to discover and preempt it. The essence of strategic positioning is to choose activities that are different from rivals’. If the same set of activities were best to produce all varieties, meet all needs, and access all customers, companies could easily shift among them and operational effectiveness would determine performance.
Developing Strategic Fit Across Activities
Strategic positions emerge from distinct sources, which often overlap. First, positioning can be based on producing a subset of an industry’s products or services. I call this variety-based positioning. . . A second basis for positioning is that of serving the needs of a particular customer group. I call this needs-based positioning. . . The third basis for positioning is that of segmenting customers who are accessible in different ways. I call this access-based positioning. . . Positioning choices determine not only which activities a company will perform and how it will configure individual activities but also how activities relate to one another. While operational effectiveness is about achieving excellence in individual activities, strategy is about combining activities.
Fit Sustains Competitive Advantage
The importance of fit among functional policies is one of the oldest ideas in strategy. Gradually, however, it has been supplanted on the management agenda. Rather than seeing the company as a whole, managers have turned to core competencies, critical resources, and key success factors. In fact, fit is a far more central component of competitive advantage than most realize. Strategic fit among many activities is fundamental not only to competitive advantage but also to the sustainability of that advantage. It is harder for a rival to match an array of interlocked activities than it is merely to imitate a particular sales-force approach, match a process technology, or replicate a set of product features. Positions built on activity systems are more sustainable than those built on individual activities.
Finally, fit among a company’s activities creates pressures and incentives to improve operational effectiveness, which makes imitation even harder. Fit means that poor performance in one activity will degrade the performance in others, so that weaknesses are exposed and more prone to get attention. Conversely, improvements in one activity will pay dividends in others. Companies with strong fit among their activities are rarely inviting targets. Their superiority in strategy and in execution only compounds their advantages and raises the hurdle for imitators.
What is Strategy?
Strategy is creating fit among a company’s activities. The success of a strategy depends on doing many things well — not just a few — and integrating among them. If there is no fit among activities, there is no distinctive strategy and little sustainability. Management reverts to the simpler task of overseeing independent functions, and operational effectiveness determines a company’s relative performance.
Improving operational effectiveness is a necessary part of management, but it is not strategy. In confusing the two, managers have unintentionally backed into a way of thinking about competition that is driving many industries toward competitive convergence, which is in no one’s best interest and is not inevitable.
Both Strategy and Operational Effectiveness Are Critical to Success
Managers must clearly distinguish operational effectiveness from strategy. Both are essential, but the two agendas are different. The operational agenda involves continual improvement everywhere there are no trade-offs. Failure to do this creates vulnerability even for companies with a good strategy. The operational agenda is the proper place for constant change, flexibility, and relentless efforts to achieve best practice. In contrast, the strategic agenda is the right place for defining a unique position, making clear trade-offs, & tightening fit. It involves the continual search for ways to reinforce & extend the company’s position.
Strategic continuity does not imply a static view of competition. A company must continually improve its operational effectiveness and actively try to shift the productivity frontier; at the same time, there needs to be ongoing effort to extend its uniqueness while strengthening the fit among its activities. Strategic continuity makes an organization’s improvements more effective.
This report is excerpted from What Is Strategy? by Michael E. Porter, Harvard Business Review, Volume 74, Number 6, pp 61 – 78.
Michael E Porter
The Competitive Advantage of Nations and Regions
Michael E. Porter continues to extend his study first reported in The Competitive Advantage of Nations. Porter has published books and studies of other countries, states, and cities, including Canada, New Zealand, Portugal, the Commonwealth of Massachusetts, and India. A book on Japan (with visiting professor Hirotaka Takeuchi), tentatively titled The Two Japans, is expected to be completed in 1999.
Porter is extending his microeconomics-based theory of competitiveness in a variety of ways. He is exploring the shifting role of various microeconomic influences as a nation’s economy becomes more advanced, and the relationship between macroeconomic conditions and microeconomic conditions in development.
Porter’s examination of the problems of early-stage economic development includes research with Pankaj Ghemawat on India, as well as studies on Central American, South American, and Asian countries.
Porter is also conducting statistical research on the microeconomic foundations of economic development. An initial paper The Microeconomic Foundations of Economic Development (in The Global Competitiveness Report 1998, Geneva, Switzerland: World Economic Forum, 1998) examines the role of microeconomic variables in explaining per capita income differences among 52 countries. A paper with Mariko Sakakibara (UCLA) examines the link between domestic rivalry and international competitive success in a sample of Japanese industries.
Porter is also conducting research into appropriate forms of economic cooperation within regions (including countries), for which a major project involving the presidents of seven Central American nations is serving as a laboratory.
Clusters and Competition
Porter is conducting ongoing research on the theory of clusters, or geographic concentrations of interconnected companies and institutions in a particular field. This work includes further development of cluster theory and its implications for management and public policy (see On Competition, Boston: Harvard Business School Press, 1998 and Clusters and the New Economics of Competition, Harvard Business Review, November-December 1998). Porter is also conducting statistical research on the incidence, growth, and decline of clusters in the U.S. economy. With Claas van der Linde of St. Gallen University in Switzerland, he is also conducting a meta-study of clusters drawn from almost 350 known studies of individual clusters.
National Innovative Capacity and the Ideas Production Function
Joint research with Scott Stern (MIT) is exploring the determinants of innovative capacity across countries using time series/cross-section data (Measuring the Ideas Production Function: Evidence from International Patent Output, draft working paper, July 1998). Using international patenting as a weighting variable, Porter and Stern have devised an index of national innovation capacity. The data has also been employed to directly estimate critical parameters of the ideas production function, a central element in economic growth theory.
Sustainable Inner-City Economic Development
Michael E. Porter is using the framework he developed in The Competitive Advantage of Nations to examine the economic development problems in distressed inner-city areas. He seeks to understand the potential of inner-city businesses, government policies, and private-sector initiatives to contribute to sustainable economic development. Porter’s project has yielded a series of articles (see The Competitive Advantage of the Inner City, Harvard Business Review, May-June 1995) and led to the development of a private-sector organization called the Initiative for a Competitive Inner City, which is catalyzing inner-city development efforts across the nation.
Environmental Policy and Competitiveness
Michael E. Porter has been exploring (with Claas van der Linde of St. Gallen University, Switzerland) the relationship between environmental regulation, industry competition, and international competitiveness. He finds that many forms of environmental pollution reflect inefficient resource utilization and poorly developed technology, suggesting that better environmental performance is often consistent with enhanced competitiveness. This perspective recasts the role of governmental regulation, highlighting the importance of regulatory and corporate approaches that foster innovation and improve resource productivity rather than simply abate or prevent pollution
Capital Markets, Investment, and Competition
Michael E. Porter’s research into issues of capital allocation, first published in the report Capital Choices, is the basis for continuing research that examines how U.S. capital markets distort competitive behavior and investment. A report to the Competitiveness Policy Council, Lifting All Boats, contains recent research and policy recommendations.
Porter is engaged in a major new body of work on the theoretical foundations of competitive positioning and the underpinnings of sustainable competitive advantage. This research highlights the distinction between positioning and operational effectiveness; the fundamental role of differences in company activities in positioning; and the central importance of tradeoffs in delivering different types of customer benefit to the sustainability of differences in positioning; the role of fit among a firm’s activities (or activity systems); competitive advantage and sustainability; and the relationship between strategy, organizations, and incentives.
He is exploring his ideas in theoretical papers, mathematical models, and company studies. An early discussion of this body of work appears in What is Strategy?, Harvard Business Review, November-December 1996 and Activity Systems as Barriers to Imitation, Harvard Business School Working Paper #98-066.
Porter’s next book on strategy, focusing on these ideas, is nearing completion.
Michael Porter and Anita McGahan are completing a series of statistical papers on the sources of company and industry profitability. Based on large new database on the profitability of U.S. business segments between 1981 and 1994, their research examines topics such as the relative importance of industry; business segment positioning; corporate parent effects on superior or lagging profitability; the persistence of profit differences over time; and how high and low performers differ along such dimensions.
Last updated Wednesday, November 4, 1998
By Richard Pastore
For the full interview with Harvard Business School Professor Michael Porter, see the Oct. 1, 1995, issue of CIO.
Competitive advantage is one of the three golden aspirations of any ambitious CIO. Along with adding value and setting strategic agendas, creating competitive advantage remains a pipe dream for many a CIO. That’s because information systems departments are too often pigeonholed into an internally focused operational support mode. But it doesn’t have to be that way, says one of the most influential modern theorists in competitive strategy.
Michael E. Porter, the Roland E. Christensen professor of business administration at the Harvard Business School, wrote the landmark 1980 work, Competitive Strategy: Techniques for Analyzing Industries and Competitors. In that book, and in later works, Porter reconciled historical views on competitiveness and defined the concepts of unique positioning.
Porter’s more recent research has been a reaction to what he sees as the last decade’s worrisome infatuation with operational improvement efforts — something he contends does little to sustain competitive advantage. In effect, Porter tells CIO Managing Editor Richard Pastore, IS and the businesses it serves are both missing the strategic mark.
What concerns you most about the way companies today are looking at competitiveness?
As companies emerge from the last decade, many have been preoccupied with operational effectiveness — restructuring, reengineering and improving efficiencies. These improvements are a necessity in today’s competition, but they alone are not enough. They are approaching a point of diminishing returns. If companies are going to sustain competitive advantage, they can’t do it by being more efficient at running the business. They have to have a distinctive way of competing.
The necessity of carving out a distinctive competitive position is not understood as well as it needs to be today. In a lot of companies, there is a mistaken sense that there is only one right strategy for that industry, and if one company can be the first to discover and implement it, they’ll win. We’ve found from our research over the years that this way of thinking is ultimately self-destructive. If everybody’s racing to discover one right strategy, nobody wins.
What’s behind your new theory of complementary activity systems?
Rarely does sustainable advantage grow out of a single activity in a business. A company doesn’t get sustainable advantage simply because it has some unique product design or a unique sales force. Those kind of advantages tend to be visible targets to imitate. If it relies on one activity as its key strength, all its competitors are going to work very hard to match that–especially if it is dubbed a best practice against which everybody else is benchmarking.
Sustainable advantage comes from systems of activities that are complementary. These complementarities occur when performing one activity and gives a company not only an advantage in that activity, but it also provides benefits in other activities.
For example, if a company has a very good inventory management system, it can also offer faster delivery and do so cheaper than a company without the inventory management system. Companies with sustainable competitive advantage integrate lots of activities within the business: their marketing, service, designs, customer support. All those things are consistent, interconnected and mutually reinforcing.
As a result, competitors don’t have to match just one thing, they have to match the whole system. And until rivals achieve the whole system, they don’t get very many of the benefits. It’s like climbing a cliff; until you get to the top of the cliff, you can’t stand and begin to walk again.
Where does IT fit into these concepts? Can it promote the creation of these complementarities?
Yes. In many cases, achieving complimentarities across activities is heavily affected by information technology. A production process can benefit a company’s after-sales service if there is effective information exchange. If IS people need a new rallying cry for how to create competitive advantage, maybe it ought to be around the idea of tying activities together and achieving complementarities.
What can chief information officers specifically contribute toward competitive positioning?
CIOs understand the enabling technologies to allow distinctive positions to be created, so the CIO has an important role to play. But that doesn’t mean that systems should be built internally, and it doesn’t mean that the CIO should control all the systems activity in the company.
There will continue to be a need for integration and certain standards and protocols, but that’s getting easier because the software itself is pushing it. The idea of central IS as traffic cop and enforcer is less important, and the CIO’s role should increasingly turn to supporting competitive advantage.
? 1996 CIO Communications, Inc.
Teaching Note 7: The Competitive Environment and Competitive Advantage
1.There are two fundamental issues, according to Michael Porter. First, is the industry/market attractive? – i.e. capable of delivering a healthy profit stream. Second, how might advantage be obtained and sustained?
2.Porter argues that five forces determine the profitability of an industry.
? The threat of new entrants; barriers to entry
? The bargaining power of suppliers
? The bargaining power of customers
? The threat of substitute products/services
Rivalry within the industry.
At the heart of the industry are rivals and their competitive strategies linked to, say, pricing or advertising; but, Porter contends, it is important to look beyond one’s immediate competitors as there are other determinants of profitability. Specifically there might be competition from substitute products or services. These alternatives may be perceived as substitutes by buyers even though they are part of a different industry. An example would be plastic bottles, cans and glass bottles for packaging soft drinks.
There may also be a potential threat of new entrants, although some competitors will see this as an opportunity to strengthen their position in the market by ensuring, as far as they can, customer loyalty.
Finally, it is important to appreciate that companies purchase from suppliers and sell to buyers. If these forces are powerful they are in a position to bargain profits away through reduced margins, by forcing either cost increases or price decreases. This relates to vertical integration.
Any company must seek to understand the nature of its competitive environment if it is to be successful in achieving its objectives and in establishing appropriate strategies. If a company fully understands the nature of the five forces, and particularly appreciates which one is the most important, it will be in a stronger position to defend itself against any threats, and to influence the forces with its strategy. The situation, of course, is fluid, and the nature and relative power of the forces will change. Consequently, the need to monitor and stay aware is continuous.
Competitive advantage implies a distinct, and ideally sustainable, edge overcompetitors. It is more than the idea of a competitive strategy, which may or may not prove distinctive.
Porter has also shown how companies can seek broad advantage within an industry or focus on one or a number of distinct segments. He argues that advantage can accrue from:
i.cost leadership, whereby a company prices around the average for the market (with a middle-of-the-road products or service) and enjoys superior profits because its costs are lower than those of its rivals;
ii.differentiation, where value is added in areas of real significance for customers, who are then willing to pay a premium price for the distinctiveness. A range of differentiated products (or services), each designed to appeal to a different segment, is possible, as is focus on just on a segment.
There are, consequently, four generic strategies: cost leadership, differentiation, cost focus, differentiation focus. An organization (according to Porter) should concentrate on just one of these and not be stuck in the middle.
Speed (say, quicker new product development) and fast reaction to opportunities and threats can
provide advantage, essentially by reducing costs and differentiating.
Real competitive advantage implies companies are able to satisfy customer needs more effectively than their competitors. Because few individual sources of advantage are sustainable in the long-run, the most successful companies innovate and seek continually new forms of advantage in order to open up a competitive gap and then maintain their lead. Achieving this successfully is a cultural issue, as we have seen.
4.Achieving competitive advantage
Competitive advantage, then, does not come from simply being different. It is achieved if and when real value is added for customers. This often requires companies to stretch their resources to achieve higher returns. Improved productivity may be involved; ideally, employees will come up with innovations, new and better ways of doing things for customers.
5.Porter’s Value Chain
Porter has provided another framework for examining the sources of added value.
He argues there are five primary activities and four support activities – listed below. Each of these is a cost and, therefore, a potential source of cost leadership; each activity can also be the source of any differentiation. The linkages between the activities are particularly important.
Marketing and sales
Human resource management
The firm’s infrastructure
thompnote7.htm – topthompnote7.htm – top
Sustainable Competitive Advantage
A well-designed business strategy is designed to make money for the owners, by competing in markets and selling products at a profit. In some cases, however, business leaders may decide that their market is no longer attractive or a product line is no longer profitable. At that point, it is appropriate to ?harvest? the business1 and extract as much value from the enterprise as possible. Exit strategies can be very lucrative, if managed properly.
By merely imitating your competitors, you cannot prevail. You must offer your customers an advantage that differentiates your products from competitors’. Michael E. Porter wrote, ?The fundamental basis of above average performance in the long run is ?sustainable competitive advantage’ … Without a sustainable competitive advantage, above-average performance is usually a sign of harvesting.? (see footnote)
Business writers talk about three types of advantage. You might be the low-cost producer, attracting customers by underselling competitors. Alternatively, you might offer features or options which attract customers through value. Finally, you might operate in a market segment that gives you an advantage.
Typically, the low cost producer is also a high-volume producer, offering standard products, commanding a large share of the market. While providing the lowest price, you must maintain approximately the same quality as your competitors.
Customers might find value from features, customized designs, operating advantages, immediate availability, service or maintenance experience, high reliability, training, or good resale value. Non-economic considerations, such as brand loyalty, ?image?, or even nationalism may be significant elements of product differentiation. The customer must be willing to pay extra for the features that differentiate your product. Furthermore, you must be able to produce the higher-value product for less than the sales price.
Specializing in a small portion of a large market or operating across related markets can create structural advantages over competitors who are trying to serve other customers.
Commercial Airplane Strategy for Boeing
Consider the low-cost strategy. We heard recently that our products were mature – ?approaching theoretical perfection.? Additional differentiation was not justified. We waged a fierce campaign for market-share based on cost. The results were not satisfying. Many customers claimed that competing products approached theoretical perfection more closely than ours. Our business strategy remains weighted toward ?cost.? In DCAC language, a low-cost strategy encourages Tailored Business Stream 1 features, and discourages TBS 2 and TBS 3.
We might consider a strategy weighted toward product differentiation. How would we use our resources? In a product differentiation strategy, we would encourage TBS 2 and 3, relying on the options in DCAC to provide value to customers. Furthermore, we would need highly-effective financial systems, so that we could price options properly. Another key resource would be awareness of our customers’ needs and preferences,
and an accurate means of computing the value our options would have in our customer’s business operations. We claim all these elements as key initiatives or core competencies.
Looking at a market-segment strategy, I can imagine focussing on business jets, airplane modification, airport ground operations, air traffic control, or some other market segments, looking for competitive advantages through interactions among business units. Interactions between commercial, military, space, and communications operations are traditional examples of this.
I am not really familiar with Lean Manufacturing, or platform teams, but I believe they could serve a range of business strategies. Two weak links, from my point of view, are our highly sub-optimized Theory X management culture and our glaringly backward employee relations practices. Our Theory X culture is at its best in standard, well-established stable operations. It is particularly ill-suited to changing environments and evolving conditions. Both the product differentiation strategy and the market segment strategy would require excellent communication, committed employees who understand their role in the business, and a general ability to respond quickly to changing markets and customer requirements. We are at a distinct competitive disadvantage in those areas.
The first major decision, of course, is whether to compete or harvest. Our share of the commercial airplane sales could easily drop from leader to follower this year. US Steel concluded that its steel markets were fundamentally unattractive. Their shareholders made a great deal of money harvesting their steel business, then shifting to other market segments. Other examples come to mind readily.
If we intend to compete, then we should compete! For the first time in many months, I am starting to see a return of interest in product development and process improvement. I hope we continue to regain our focus on customers, products, and processes. As employees, we are ready to build on our strengths and work toward a common goal: building long-term value for shareholders, customers and employees.
Competitive Advantage, Michael E. Porter, 1985, p. 11.
In Canada as well as in other countries, many of the concerns about the appropriateness of the technological basis of economic production are being expressed in terms of problems of competitiveness, sustainability, and innovation. Science and technology policies and innovation management practices, in particular, are addressing the competitiveness and sustainability agendas from an innovation perspective.1 Specialists have spilt much ink debating the meanings and implications of the notions of competitiveness and sustainability. Each notion often works as a metalanguage with its own set of assumptions, problems, and agenda of prescribed actions. The competitiveness and sustainability agendas share a sometimes apocalyptic language to describe the consequences of failure to attain competitiveness or sustainability. Both are frequently held up as imperatives which challenge systems of innovation at the deepest levels.
The competitiveness and sustainability agendas do not frequently refer to each other, and in many respects they talk past or contradict each other. There are few overlaps or linkages between the sustainability and competitiveness’ policy networks and interest groups. However, the two agendas are each increasingly sensitive to problems of technological innovation, and each hints at the necessity or the inevitability of a new techno-economic paradigm upon which the next century’s peace and prosperity can be based. In one formulation that is strongly advocated by some technology policy advisory agencies, a strategic course of technological innovation provides the only way to reconcile the two conflicting goals of reducing levels of pollution and resource deterioration while achieving major, sustainable increases in economic activity. In other words, a particular course of action regarding technological innovation may provide an intersection between the competitiveness and sustainability agendas.
This paper is meant to stimulate discussion about a social science research agenda on innovation, sustainability, and competitiveness in the North American region. I will try to be explicit about the paper’s assumptions. First, I use the term competitiveness to refer to the ability to successfully offer products or services in an open trading system, in exchange for income, despite others who offer similar products or services, thus maintaining or expanding access to the life chances that income can purchase. Competitiveness is a frequently cited rationale and objective of innovation policy measures in Canada. I use the term sustainability to refer to development that does not pass on undue or irreversible environmental costs to succeeding generations.2 The term innovation usually refers to the first commercial application of a product or process by a user.1 This definition of innovation is close to what is commonly understood as technological progress and it focuses attention on increases in efficiency and productivity. About one-third of U.S. economic growth between 1929 and 1982 can be attributed to innovation of this sort (Denison, 1985).
A broader definition of innovation to address issues raised by the competitiveness and sustainability agendas is required because the larger the increment of technological change, the more likely organizational or social innovations are involved. Understanding innovation at the managerial, organizational, social, or cultural levels requires, at the very least, that a host of conceptual and measurement problems be addressed. Second, I claim that two of the most consistent (and increasingly explicit) policy agendas of our times, the competitiveness and sustainability agendas, are committed to stimulating, guiding, or directing science and technology to achieve their ends. Each agenda attempts to influence technological and industrial innovation in the narrow sense and each ponders the broader issues of institutional and social innovation, raising a host of questions about ends and means.
Third, innovation takes place in systems of public and private institutions and the rules and routines of their behavior. Innovation research uses notions such as system of innovation (Niosi et al. 1993; Nelson 1993) to describe the social institutions of innovation.
The set of distinctions among minor and major forms of technological change employed by evolutionary economists helps to address the level-of-analysis problem that one encounters when searching for the boundaries of a system. Freeman (1992) distinguishes among innovation at the level of the firm, the production system, the technology system, and the technoeconomic paradigm. These distinctions identify progressively larger increments of change in current practices of production, and progressively broader groups of organizations and behaviors taken as reference points. Incremental innovations are minor cumulative changes continuously occurring in firms which can add up over time to significant improvements in productivity and efficiency. Radical innovations are discontinuities in the production system. Nylon and the oxygen steelmaking process are historical examples. More recently, radical innovations are usually the result of deliberate research and development in enterprises and/or in university and government laboratories (Freeman 1992). Changes of technology system are the result of clusters of radical innovations that create far- reaching changes in technology, affecting several branches of the economy, as well as ultimately giving rise to entirely new sectors. Synthetic materials and the associated manufacturing techniques are examples. Technological revolutions, or change of technoeconomic paradigm, are new technology systems which have such pervasive effects on the economy as a whole that they change the style of production and management throughout the economy (Freeman 1992). Technological innovation entails organizational, social, or cultural innovation.
Fourth, I inquire whether it might be useful to develop and apply a systems of innovation approach in the North American region. The existence of a North American system of innovation may be surmised on the basis of the considerable degree of economic integration that has taken place among the United States, Mexico, and Canada. However, the contours and dynamics of this system have not been well described.
Fifth, my discussion focuses primarily on problems of industrial innovation, and the section on sustainability is correspondingly limited. Issues of natural resource management, energy, transportation, sustainable cities, or sustainable agriculture need to be examined from an innovation perspective, but it has not been possible to do it here.
While neither competitiveness nor sustainability (however defined) is imaginable in the absence of innovation, the key issue, in my view, is the degree to which a production system can be both competitive and sustainable in a given context. As North American economic integration proceeds, science and technology policies and private management strategies will respond to the emerging conditions of innovation in the region. Subregional patterns of economic activity will change, and successful social mastery of new configurations of production will be an important skill to acquire. The greening of technology policies and management practices presents a new set of challenges in the context of trade regional liberalization, heightened intra- and inter-regional competition, and increased mobility in factors of production.
2. A North American System of Innovation
The notion of system of innovation can be operationalized in terms of financial flows, legal and policy links, and flows of information, science, technology, and people (Niosi et al. 1993). Among the legal and policy measures that are contributing to an integrated North American innovation system are the NAFTA rules governing investment, intellectual property, and technical standards. Among the financial and technology flows is the huge volume of bilateral trade between the United States and its two neighbors, especially intrafirm trade. Among the flows of science are the innumerable linkages between Canada and the U.S. on the one hand and the U.S. and Mexico on the other. The familiar hub-and- spokes pattern of North American economic interchange, in which the United States’ neighbors entertain extensive interactions with it but very little with each other, is paralleled in patterns of scientific communication.1
A regional system integrator is an actor that aligns and integrates the economic and technological systems of regional members in interaction with them, including bilateral and multilateral trade, direct investment, official development assistance, non market technological collaboration (for example, military), political relationships, provision of services, establishment of trade rules, export of production technology, and export of the software of technological development such as management beliefs, social science paradigms, administrative and technical curricula, information, publications, symbolic reward systems, etc. (Yama*censored*a 1991). These linkages help spread a pattern of growth into related economies. In Asia, the Japanese role of regional integrator may represent an enlargement of the parent-subcontract industrial relation to include newly industrializing countries (Yama*censored*a 1991, 4). In Europe the role of systems integrator is played by a supranational institution, the European Community, its multitude of programs and policies, and the networks of firms and institutions within the regional economic space. The United States, its large firms, and the regional trade rules are the principal innovation system integrators in North America.
In contrast to trends in Asia and Europe, science, technology, and innovation have not been prominent considerations in the discussions about the North American region’s future. Before the present decade, neither Canada, nor the United States, nor Mexico tended to see itself as a member of a North American community or system. Most attention focused instead on the extensive bilateral relationships between Canada and the United States on the one hand, and between Mexico and the U.S. on the other. It was implausible to suggest that North America might evolve into a region possessing a specific, shared identity and continental-scale institutions. Regional economic integration is reshaping the North American economic landscape. The North American Free Trade Agreement (NAFTA) establishes a framework for a trade regime encompassing one of the largest (about 360 million people) and richest (about $6 trillion) regional markets in the world. NAFTA sets trade rules for a regional economy that has already undergone substantial integration. Canada and the United States have the world’s largest bilateral trade relationship, and the United States is Mexico’s largest trading partner.
NAFTA includes provisions for the reduction and eventual elimination of most tariffs affecting commerce among Canada, the United States, and Mexico in commodities, manufactured goods, and services. However, NAFTA goes beyond tariff elimination to establish rules governing trade and investment. The three countries agree not to discriminate against each others’ goods and services, and to eliminate most tariffs over a decade. Customs procedures and temporary entry for business travellers are simplified. Mexican import licensing procedures are immediately eliminated. The chapter on rules of origin sets out formulae by which Mexican, American, or Canadian products incorporating third-party materials or components can qualify for preferential access to each other’s markets. Under the net cost formula, most products qualify for preferential treatment with 50% North American content. In the case of light vehicles, the figure is 62.5%. This provision is designed to discourage new transplants from using Mexico to supply the U.S. automotive market. The rules for determining North American content can be complex in practice, and their primary implication for manufacturing is in sourcing practices.
NAFTA extends national treatment to member countries’ suppliers of goods and services to public markets. NAFTA signatories agree not to impose offsets or performance requirements in public procurement. Improved tendering and dispute resolution procedures are specified. The rules governing public procurement are broader than those in the GATT procurement code, and NAFTA, in its extension of procurement rules to subnational governments (states, provinces, and municipalities), goes well beyond the Canada-U.S. Free Trade Agreement. The net result is to liberalize a North American public market of about $70 billion.
NAFTA sets rules regarding control over foreign investments. It establishes the principle of national treatment for all three parties regarding investments, establishment of new businesses, acquisition and sale of businesses, and the conduct and operation of businesses. No minimum levels of equity may be imposed on purchases or ownership. No performance requirements (for import substitution, local sourcing, export targets, foreign exchange generation, production sharing, product mandates, hiring of nationals in management positions, or technology transfer) may be imposed on investments from any of the three countries or on any investments from any third country (Article 1106). However, governments may offer advantages to firms in exchange for commitments regarding R&D, training, expansion, or location of production facilities. Canada retains the investment screening regime established under CUFTA (the right to review direct acquisition of Canadian controlled firms valued at more than C$ 150 million). No restrictions may be placed on the patriation of profits and transfer payments. Mexico retains a range of investment prohibition privileges in the energy and communication sectors.
Unlike CUFTA, NAFTA contains a chapter setting out rules for intellectual property. Chapter 17 applies standards regarding sound recordings, literary and artistic works, software, data, designs, copyright, trademarks, and patents. It makes provisions for enforcing intellectual property rights, and it restrains the parties’ latitude to permit compulsory licensing of patents. NAFTA also contains provisions governing energy, natural resources, agriculture, financial services, technical standards, telecommunications, cultural industries, and transportation services. Like the Agreement’s provisions discussed above, the general thrust is to deregulate and liberalize trade in these industries within North America, and to specify special cases in which governments retain rights to discriminate. Two side agreements cover labor and environmental issues. However, the disciplines envisaged by these two agreements in case of noncompliance are weak (Shrybman, 1993; Martin 1992). Continental market liberalization necessarily modifies the options available to policymakers to structure national or subnational economic development, and reduces the range of policy instruments available. Because NAFTA establishes new rules of the game for regional trade, it has been called an economic constitution for North America. What are the implications of NAFTA for innovation policy and management?
In the first place, NAFTA clearly restrains governments from imposing performance requirements on foreign investors, North American or other, and considerably reduces governments’ latitude to screen foreign direct investment (FDI).1 Also, under NAFTA governments cannot impose performance requirements but may negotiate some kinds of innovation-related performances with firms in exchange for incentives.
In the second place, like CUFTA, NAFTA contains no rules governing subsidies, one of the most difficult issues on the trade policy agenda. Many kinds of government assistance have been labelled subsidies in U.S.-Canada trade disputes, including grants, tax credits, low-interest loans, and unemployment insurance. The subsidy issue was not resolvable during CUFTA negotiations. In the case of NAFTA, the subsidy issue was referred to the GATT, where the recently signed Dunkel text contains rules governing publicly- supported R&D and other kinds of subsidies. Since NAFTA does not cover subsidies, the rules of the game are unclear regarding direct or indirect public involvement in initiatives that help create advantage in the private sector. Given the uncertainty about subsidies, policymakers in Canada and Mexico will probably pay close attention to innovation policy practices in the United States in the belief that American practices will set a de facto standard in the region. The Clinton administration has adopted a more vigorous approach to promotion of industrial innovation than the two preceding administrations.
In the third place, NAFTA is clearly intended to cover the activities of subnational governments, insofar as the respective Federal governments are empowered to commit subnational governments through international agreements. This will have the same effects on state and provincial innovation policies as on national policies in North America. Many states and provinces have developed quite extensive programs and institutions in support of innovation. Similarly, many American cities offer substantial industrial incentives. Tax and subsidy competition among localities is widespread in North America.
European and North American regional trade arrangements shield regional economies from offshore competition. However, the two regional arrangements are based on quite divergent philosophies. Europe has adopted a Keynesian approach to regional economic integration, creating a wide range of institutional arrangements to address economic and social issues. European economic integration involves an attempt to build an administrative framework that takes into account the economic efficiency and collective security needs of the community, by means of the creation of a genuinely mixed economy at the regional level, when it seemed no longer viable on a national level (Deblock and Rioux 1993: 32). In contrast, NAFTA, like the Canada-U.S. Free Trade Agreement it superseded, largely concentrates on removing barriers to the movement of goods and capital. NAFTA is a negative approach to regional economic integration. It is concerned largely with removing tariff and nontariff barriers to movements of goods, services, and capital. It has no mechanisms to promote positive adjustment to economic integration. Problems of adjustment are largely left to the national governments to resolve.
A regional trade agreement provides preferences among member countries, and fosters intraregional trade at the expense of interregional trade. Continental trade liberalization is precipitating wide discussion in North America about jobs, the environment, and national sovereignty. What are the implications of economic continentalization for science and technology strategies in the region, considering the increasingly integrated continental production system into which the two smaller countries have opted, and considering also the constraints placed by NAFTA on use of a wide range of traditional instruments of industrial and economic policy?
The rationale for trade liberalization is well known. Manufacturing firms require economies of scale to compete in global markets, and production efficiencies are determined by relative size of market. Under tariff protection, inefficient, subcritical plants produce short runs of excessively diverse product lines. Access to a large market and increased competition should lead to rationalization and accelerated R&D investments (Daly and MacCharles 1986). Trade liberalization should induce manufacturers in Canada to rationalize within the North American market, decreasing unit costs and reducing the productivity gap with the United States (ECC, 1988). One expects increased competition to improve the technical and allocative efficiency of firms (Globerman 1990). Thus economic gains from trade liberalization are principally realizable in the presence of productivity growth via attainment of economies of scale, increased internal R&D investments, and a higher rate of technological diffusion within firms and their supplier networks. As for the reorganization of production in North America, the simplest assumption is that of segmented production, with resource extraction, mass assembly operations, and higher R&D and management functions all sited in different locations. However, a much wider range of organizational responses is available to firms, such as just-in-time production (and its implications for proximity to suppliers), strategic alliances, multilocational production strategies, flexible specialization and the like (Eden 1991; 1994). Concern is being voiced that the North American trade regime provides strong incentives for manufacturers to respond to market competition with a low-wage strategy, which will lower incomes and productivity over the long run, rather than [take] the more difficult path of producing quality products more efficiently.1 This would create downward pressures on social and environmental standards in North America.
While the objective pursued by conventional trade policy is to increase the allocative or Ricardian efficiency of the economy, the rationale of development-oriented innovation policy is to increase the growth or Schumpeterian efficiency of the economy (Dosi, Zysman, and Tyson 1990, 25). A major task facing policymakers, practitioners, and innovation scholars in North America is to identify plausible routes to technological learning in open economies and assemble a collection of policy instruments that are relatively effective (i.e. likely to induce technological spillovers into the economy), efficient (i.e. do not entail disproportionately high costs), and acceptable under the prevailing trade regime.
3. Industrial Innovation and Canadian Competitiveness
Canada is a trading nation. Approximately 30% Canada’s GDP is generated through international trade, and the combination of imports and exports amounts to half of Canada’s GDP. Of the G-7 countries, only in Germany does international trade contribute a higher proportion of GDP. Although much of the discussion about innovation in Canada has been pitched in terms of adjustment to globalization, Canada’s international trade is mainly continental. About three-quarters of Canadian trade is with the United States, and more than half of this is intra-firm trade. Furthermore, Canadian international trade is highly concentrated. About 70% takes place via about 50 firms, half of which are of Canadian origin.
The search for competitiveness has created an eager market for indicators, yardsticks, and report cards in Canada. These provide sometimes paradoxical views on the state of Canadian competitiveness. According to the United Nations Human Development Index in 1992, Canadians enjoy the highest quality of life in the world. According to the OECD, Canada recently had the fastest increase in employment among the G-7 countries and the second highest growth rate. But the World Competitiveness Report’s 1993 survey ranked Canada eleventh among twenty-two industrialized countries, down from fourth place just four years earlier. The World Competitiveness Report gave relatively high marks to Canada’s financial system (3d place) and infrastructure (5th place), but low marks to Canadian science and technology strategies (16th place), quality of production technologies (15th place), trade diversification (20th place), quality of management (14th place), and investment in new equipment (21st place). Of all countries surveyed, only Britain’s manufacturing base had deteriorated more dramatically than Canada’s. Canada has lost an estimated half million manufacturing jobs since 1989, with manufacturing’s share of overall employment falling to about 15%. The unemployment rate is about 11%, and by mid-1990s the net public debt/GDP ratio will have climbed to about 75% – up from about 30% at the beginning of the 1980s. Canada is carrying one of the highest per capita public debts among advanced countries.
Canadian competitiveness has been dissected and debated in an avalanche of reports and studies.1 Many believe that Canada’s overall technological effort is too modest, and R&D expenditures too heavily dependent on the public sector, to help realize Canada’s aspirations to maintain an advanced economy. To get to the bottom of the competitiveness question, in 1990 the Federal government and the Business Council on National Issues commissioned Harvard Business School strategist Michael Porter to apply his renowned diamond analysis to Canada. In The Competitive Advantage of Nations (1990) Porter says that a nation’s goal is to improve the standard of living by increasing the growth of industry through increasing industrial productivity and through shifting resources to higher productivity segments. This will normally happen as industry works to reduce unit costs and differentiate products, but industry will not choose to do so unless faced with competition (rivalry) and opportunities for innovation in their markets. Nations are competitive if their firms can engineer not just cost improvements but also differentiation. International rivalry normally pushes firms down product streams toward highly differentiated products. This requires constant innovation on the part of the firm. Internationally competitive firms create a virtuous cycle in which reinvestment drives further growth through innovation and learning. Mass production strategies are abandoned to less-developed countries. The most appropriate national innovation strategy is one that encourages firms to compete at the high end of the market through innovation, product differentiation, and service delivery, in contrast to sole reliance on traditional cost-cutting, productivity-enhancing measures.2 Porter’s thesis is that national competitive advantage is embedded in a competitive diamond of four essential attributes. These are: Factor conditions (labor, land, natural resources, infrastructure, labor skills, and services to industry); Demand conditions (the quality and strength of home-market demand for local industrial output. Porter attaches considerable importance to the presence of knowledgeable, demanding local customers); Related and supporting industries, especially the presence or absence of internationally competitive suppliers; and Firm strategy, structure and rivalry, which constitute the conditions in which companies are created, organized, and managed.
Porter says that firms have a home base where the key strategic decisions are taken and where the core product and process technologies are maintained. He says that if firms do not use their national home base in this way, they do not contribute to competitiveness of the national economy. Porter’s Canadian report, ominously entitled Canada at the Crossroads, argues that Canada is not doing so well in the new competitive environment (Porter, 1991). Five trends indicate underlying weaknesses: low productivity growth, high unit labor costs, persistently high unemployment, lagging investment in skills and technology upgrading, and an unencouraging macroeconomic climate for productive investments.
Porter observes that Canada is deficient in vigorous export industries. Most Canadian exports are in natural resources industries (materials and metals, forest products, and petroleum and chemicals), with some other successful exporters in transportation (mainly automobiles and avionics) and food and beverage industries (Porter, 1991). In other words, Canada is specialized in exports of unprocessed or semi-processed commodities. Many of the sales of the relatively higher value-added exporters, such as chemicals or autoparts, go to a very small number of parent firms in the United States. Porter concludes that in Canada, natural resource factor advantages are more important than innovation-related created advantages, and that an abundance of natural resource-related factors does not necessarily lead to new factor creation, it leads to specialized resource firms. One might expect an indigenous capital goods industry to service the resource industries, but this has not happened in Canada.
Furthermore, Canadian domestic demand plays a minor role in the development of internationally competitive Canadian firms; the American market and American suppliers predominate. Domestic rivalry is usually not significant in internationally competitive Canadian industries, nor do these industries develop local clusters of upstream and downstream linkages. Canadian regional development policies prevent geographical concentration of firms, and foreign direct investment in Canada has reduced the importance of supporting industries through intrafirm transactions or vertical integration. Moreover, Porter notes that few non-North American firms have developed a home base type relationship with Canada. Porter irked defenders of continental economic integration when he suggested that high levels of foreign direct investment in Canada are an impediment to international competitiveness. Canada has one of the highest levels of foreign ownership of industrial assets of any advanced country, raising the question of the extent to which foreign ownership inhibits the development of a national innovation system and, indeed, whether a national innovation system is necessarily preferred to integration into an international system (McFetridge 1993: 320).
Porter’s analysis provoked a debate about the appropriateness for small countries of the national diamond competitiveness framework. Canada’s home country diamond does not have the answers to explain Canada’s international competitiveness, say D’Cruz and Rugman (1992), who are concerned with the strategic behavior of MNCs operating from small, open economies. To be applicable to Canada, the Porter model needs to be corrected for the nature of foreign direct investment in Canada, the value added in Canada’s resource industries, and the relevance of Canada’s home country diamond in an integrated North American economic system (ibid.). In a stream of publications, Rugman and D’Cruz have put forward a series of critiques of the Porter model in particular and of the more generally held belief in Canada that policies to promote indigenous manufacturing or high technology firms firms are critically important.
D’Cruz’s and Rugman’s analysis of Canadian competitive advantage is based on the recognition that most Canadian firms are concentrated in sectors or production phases in which cost reduction is the primary competitive strategy. Canada’s ten leading export industries are automobiles, pulp and paper, vehicle components, commercial vehicles, non-edible agricultural products, non-ferrous metals, crude oil, cereal products, natural gas, and motors, turbines, and pumps. With the exception of the automotive sector, Canadian export performance is not determined by an ability on the part of its manufacturing sector to compete in international markets. It depends instead upon the output of the natural resource sectors (D’Cruz and Rugman 1992: 21). Also, Rugman and D’Cruz take issue with Porter’s selection of strategic industrial clusters. In Fast Forward: Improving Canada’s International Competitiveness (1991), they identify ten subregional clusters accounting for the bulk of Canadian GDP and note that seven of the ten clusters are in the resource sector or in wage-sensitive production phases of manufacturing.1 They view competitiveness in these industries as largely determined by productivity growth, which in turn is driven by factor costs, especially wage and capital costs. In other words, indigenous advanced-technology development is not regarded as important in these sectors’ competitiveness.
The problem of staples-driven economic development is the central theme of Canadian economic history. Trade in primary products is a very slowly growing segment of world trade. This is partly because barriers to entry are relatively low, encouraging exports from the Third World and soon from the former Soviet Union. Of equal concern is the phenomenon of dematerialization of production, in which information-rich, highly engineered components such as optical fibers, ceramics, or high- strength composites replace simple commodity-based components.2 Because of competition and dematerialization of production, the long-term trend for commodity prices is down. In 1992 the Economist reported that real commodity prices were at their lowest level since the magazine began calculating an all-item index in 1845 (Pestieau 1993: 2). Canada has specialized its international trade in a small range of slow-growth commodities concentrated in the North American market. Canadian resource firms typically develop firm-specific process innovations which provide advantage. They maintain technical currency through procurement of foreign machinery, licenses, patents, and foreign producers, and when they do undertake R&D it is frequently abroad. Thanks to their cultural or geographic proximity to American and British technology markets, Canadian multinationals are probably among the fast ‘technology followers’ (Niosi 1983, 189). However, compared to their competitors in other countries, Canadian firms distinguish themselves by choosing to compete more on the basis of cost than on the basis of innovation. For example, a recent study of innovation strategies in the Canadian non-ferrous metals sector found that R&D spending had declined in the 1980s, remaining at less than one percent of sales, while R&D spending in comparable Japanese and European firms had doubled to more than two percent of sales (SCC 1992b). This behavior reflects deliberate strategy, not just costs of production. According to Japanese and Finnish managers of mining companies quoted in the study, conventional business operations generating half or more of total revenues received only a small fraction of the R&D budget, while research on higher value-added activities – new materials and new products – received up to ninety percent of the R&D budget.3
A second key shortcoming of the Porter model when applied to small, open economies, according to Rugman and D’Cruz (1993), is that one cannot measure the international competitiveness of smaller countries in terms of export shares because much of the business of smaller countries is conducted abroad (through foreign direct investment) within the larger triad markets of the United States, E.C. and Japan – where the action is. Porter does not count overseas sales by the subsidiaries of Canadian-owned multinationals in export share data, giving the impression of poor Canadian export performance. Dunning (1993) points out that there are three kinds of cross-border commercial interactions: arm’s length trade, inter-firm cooperative agreements, and foreign direct investment. He argues that Porter has substantially underestimated the importance of globalized production, especially the cross-border value added activities of transnational firms, much of which takes place as intrafirm trade.
Canada is an important exporter of capital. Canadians invest abroad almost as much per capita as Americans. Between 1987 and 1991 about $5.4 billion was invested in the country annually, while about $6.6 billion was invested outside the country annually. In 1990 the foreign direct investment stock in Canada stood at $125.3 billion and the Canadian direct investment stock abroad stood at $86.7 billion (U.N. 1993). In 1990 Canada had some 1300 indigenous MNCs. Even the resource industries are footloose. Between 1980 and 1990, incoming foreign direct investment stock in the primary sector in Canada increased only slightly from $4.6 billion to $5 billion, while Canadian outward direct investments in the primary sector increased from $2.7 billion to $5.7 billion. The largest increases in outward FDI in the past decade are not in the primary sector however, but in low value-added segments of the secondary sector and in parts of the tertiary sector. In the former, the Canadian outward FDI stock increased from $17.3 to $46 billion between 1980 and 1990, with huge increases in FDI stock in food and beverages ($2.3 to $5.8 billion), pape