Managerial Economics

1
Managerial Economics

• Lecture Thirteen
• Alternative perspectives on globalisation

2
Recap

• Theory of comparative advantage
• Appeals to economists because
• Fits within age-old paradigm of specialisation
• 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
• This week alternative (you guessed it!)
  Schumpeterian theory
• Porters Competitive Advantage of Nations

3
Competitive 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 industrys world leaders?
• How can we explain why Germany is the home base
  for so many of the worlds leading makers of
  printing presses, luxury cars, chemicals?
• Why is tiny Switzerland the home base for
  international leaders in pharmaceuticals,
  chocolate? (1)

4
Competitive 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!)
• Porters 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)

5
Competitive 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 labour?
• 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.

6
Competitive Advantage

• Management style?
• What is celebrated as good management practice
  in one industry would be disastrous in another.
  (4)
• Labour relations? (An Australian favourite)
• 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 characterisation of nations as
  competitive
• We must abandon the whole notion of a
  competitive nation
• And focus instead on specific industries and
  industry segments (9)

7
Competitive 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 Samuelsonlast 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)

8
Competitive Advantage

• Old theory wrongly emphasises country factors
• New theory emphasises 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 localised 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

9
Competitive 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 nations 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

10
Competitive Advantage

• Statistical technique used to select
  industries/firms in which each country was
  outstanding competitor in 1985
• gt 100 industries selected
• From obvious (Japan semiconductors)
• To obscure (British biscuits)
• Industry classifications show how specific
  capital is
• Machines essential for one industry useless in
  another
• Key point in critique of neoclassical concept of
  factor of production ease of movement from
  one industry to another
• The complete list by country

11
Competitive Advantage
12

• 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

13
Competitive Advantage

• Successful firms are frequently concentrated in
  particular cities or states within a nation. In
  the United States
• many of the nations 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)

14
Competitive Advantage

• 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)

15
Competitive 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 scopehow
  broad industry is how much of it firm covers

16
Competitive Advantage

• Combination of cost differentiation give
  different forms of competitive advantage

17
Competitive Advantage

• 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)
• Schumpeters assumption confirmed Often,
  innovators are outsiders to existing
  industry. (48) Also
• larger companies were often supplanted by
  smaller ones (49)

18
Competitive Advantage

• 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)

19
Competitive Advantage

• Porters National Diamond
• Advantages throughout the diamond are
  necessary for achieving and sustaining
  competitive success but
• Advantage in every determinant is not a
  prerequisite (73)

20
Competitive Advantage

• 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 Hollands 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

21
Competitive Advantage

• 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 products 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)

22
Competitive Advantage

• 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

23
Competitive Advantage

• A more disaggregated view

24
Competitive Advantage

• Competitive advantage in suppliers means spinoffs
  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 worlds
  jewelry-making machinery. (101)
• Related industries give strength to each other

25
Competitive Advantage

• Competitive advantage in related industries

26
Competitive Advantage

• 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)

27
Competitive Advantage

• 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)

28
Competitive Advantage

• National goals
• Short term focus of US firmsadvantage in
  accounting
• Long term focus of German/Japaneseadvantage in
  engineering
• Domestic rivalry
• Desire to beat own national competitors often
  drives innovation
• Italian supercars Japanese electronics US
  software, computers
• With little domestic rivalry, firms are more
  content to rely on the home market. (119)

29
Competitive Advantage

• Japan in particular has large number of
  internationally competitive firms in different
  industries

30
Competitive Advantage

• 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

31
Competitive Advantage

• The individual determinants that define the
  national environment are mutually dependent
  because the effect of one often depends on the
  state of the others (129)

• Example of clustering Denmark

32
Competitive Advantage
33
Competitive Advantage

• Geographic clustering also strikingly obvious
• Clustering of internationally competitive
  industries in Italy

34
Competitive Advantage

• Interactions in the Diamond for Italian Ski
  Boot industry

35
Competitive Advantage

• Not so much a model in economic sense
• More description of process
• But better guide to feasible policy than
  comparative advantage
• Industry policy promoted over free trade
  obsession
• Identify present clusters
• Expect innovation in areas where domestic demand
  is an important share of local demand but a
  smaller share of demand elsewhere
• Obvious examples for Australia
• solar energy
• water conservation
• (if only government policy helped!)

36
Integrating Managerial Economics

• Weve covered a fair bit of territory
• Theory empirics of
• Firm
• Market
• Economy
• Finance
• Trade
• In all areas
• Data doesnt support conventional economic
  beliefs
• Dominant theories have obvious flaws
• But alternative theories exist

37
The Firm

• Conventional Theory
• Production subject to diminishing marginal
  productivity
• Firms internal structure black box
• Firms objective profit maximisation
• Equates marginal cost to marginal revenue
• Empirical Evidence
• 89 (Blinder) to 95 (Eiteman) of firms have
  constant or falling marginal costs
• Prices via markup on average costs
• Marginal cost well below average
• Marginal considerations irrelevant
• Alternative Theory
• Conventional profit maximisation rule wrong for
  multi-firm industries
• Profit maximisation where marginal revenue
  exceeds marginal cost even with rising marginal
  cost

38
The Firm

• Alternative Theory (cont.)
• Sraffa well-designed factories mean factor
  proportions constant out to capacity
• Constant marginal cost
• Kornai firms in dynamic industries
• Growth uncertainty make excess capacity
  sensible
• Schumpeter creative destruction
• Entrepreneurs profit by revolutionising
  production
• Technical change drives costs down, diversity up
• Combination means
• Costs constant/falling
• Firms compete on product diversity/production
  innovation rather than just price

39
The Market

• Conventional Theory
• Taxonomy of industry types
• Competitive markets
• Many sellers, buyers
• Homogenous product
• Price equals marginal cost (with erroneous
  maths!)
• Monopoly
• Single seller
• Single product
• Price exceeds marginal cost
• Oligopoly
• Several sellers
• Compete with each other game theoretic style
• Welfare position between monopoly PC

40
The Market

• Empirical Evidence
• Most industries characterised by power law
  distribution of firm sizes
• Some very large many very small no average
  size
• Competitive outcomes (falling price, rising
  quality diversity) independent of number of
  firms in industry
• Alternative Theory
• Evolutionary process of dynamic selection.
• Varying products increases survival chances of
  firms
• Varying consumer interaction alters environment
• Multi-agent modeling can capture essential
  features of process
• Diversity of firm behavior rather than
  homogeneity
• Power-law distribution of firm sizes rather than
  non-existent neoclassical taxonomy of PC,
  monopoly, oligopoly

41
The Economy

• Conventional Theory
• Equilibrium processes
• Keynesian/Neoclassical dispute over tendency to
  full employment
• Both agree real wages have to fall in boom
  (diminishing marginal productivity)
• Exogenous money, causation from base money supply
  to credit money to economic activity
• Empirical Evidence
• Disequilibrium the rule all variables cyclical
• Real wages rise, prices (relatively) fall during
  boom (no DMP)
• Credit money drives economy, base money reacts
  afterwards
• Rising debt levels since WWII

42
The Economy

• Alternative Theory
• Schumpeters vision
• Underlying disequilibrium dynamics reflect
  entrepreneurial search for profit
• Credit essential to entrepreneurial process and
  endogenous to economy
• Debt entrepreneurial activity co-extensive
• Minskys vision
• Cyclical trend for debt over trade cycle
• Secular trend for debt/output levels to rise as
  memory of crisis recedes
• Potential for debt-deflation
• Big Government reduces likelihood of crisis by
  anti-cyclical spending

43
The Finance Sector

• Conventional Theory
• Equilibrium process
• Investors balance risk vs return
• Empirical Evidence
• Far from equilibrium dynamics
• Fractal rather than efficient markets
• Beta is dead (and always was!)
• Market inefficient but still hard to predict
• Alternative Theory
• Sophisticated models from physicists
• Power law / Hurst exponent / Tsalliss
  qnon-extensive statistical mechanics /
  minority game

44
The Finance Sector

• Alternative Theory (cont.)
• Inefficient Markets Hypothesis
• Non-institutional investors can construct low
  volatility high return portfolios
• Tendency of finance boom/bust cycle to drive
  economy
• Argument for reform of asset markets

45
Trade Global Economics

• Conventional Theory
• Comparative advantage
• Countries specialise where they have comparative
  advantage over rest of world, not absolute
  advantage
• Trade governed by relative factor abundance
• Free trade equalises wages profits worldwide
• Empirical Evidence
• Comparative Advantage a flop
• Absolute advantage more relevant than comparative
• Factor abundance largely irrelevant to trade
• Innovation rules
• Compounded by transnational corporations,
  outsourcing
• Take advantage of absolute cost differences

46
Trade Global Economics

• Alternative Theory
• Role for industry promotion in development
• Success comes via competitive advantage
• Not countries but firms, products, industry
  clusters
• Where to from here?
• Other courses at UWS
• Behavioural Finance (myself Craig Ellis)
• History of Economic Thought (James Farrell
  sometimes also me)
• Political Economy
• Undergraduate (Neil Hart others)
• Honours (myself others)
• Further reading

47
Building on Managerial Economics

• Further reading
• All full readings from this course but
  especially
• Schumpeter Theory of Economic Development
• Minsky John Maynard Keynes
• Ormerod Butterfly Economics
• Haugen The New Finance
• Peters The Fractal Markets Hypothesis
• Debunking Economics
• Book via Zed Books, Pluto Press
• Website www.debunking-economics.com
• Other critical resources
• PAECON movement www.paecon.net