The competitive advantage of nations: is Porter's Diamond ...

The competitive advantage of nations: is Porter’s
Diamond Framework a new theory that explains
the international competitiveness of countries?
A.J. Smit
A B S T R A C T
The focus of this article is to clarify the meaning of international
competitiveness at the country level within in the context of
Porter’s (1990a) thesis that countries, like companies, compete
in international markets for their fair share of the world markets.
At a country level, there are two schools of thought on country
competitiveness: the economic school, which rejects Porter’s notion
of country competitiveness, and the management school, which
supports the notion of competitiveness at a country level. This article
reviews and contrasts the theories pertaining to these two schools of
thought with specifi c reference to trade theories and the ‘theory’ of
the competitive advantage of nations originally advanced by Porter
(1990a, 1997a, 1998b, 1998c, 2000). Although Porter’s Diamond
Framework has been extensively discussed in the management
literature, its actual contribution to the body of knowledge in the
economic and management literature has never been clarifi ed. The
purpose of this article is to explain why Porter’s Diamond Framework
is not a new theory that explains the competitiveness of countries
but rather a framework that enhances our understanding of the
international competitiveness of fi rms.
Key words: Porter, Diamond Framework, international competition, competitiveness of
countries, international business, national competitive advantage, country
sources of competitive advantage
Prof. A.J. Smit is an Associate Professor of International Business, Graduate School of Business Leadership,
University of South Africa. E-mail: ajsmit@sbleds.ac.za
Southern African Business Review Volume 14 Number 1 2010
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Introduction
“Today [South Africa] is part of a truly global economy. To maintain our standard of
living, we must learn to compete in an ever tougher world market place. That’s why
higher productivity and product quality have become essential. We need to move
the economy into high-value sectors that will generate jobs for the future and the
only way we can be competitive is to forge a new partnership between government
and business” (Krugmann 1994a: 109). According to Krugman (1994a), this is the
kind of statement one sees in academic journals and the popular press. It is also
a statement that is popular among business people, journalists and management
academics. It is a statement about the international competitiveness of countries.
These kinds of statements are also propagated by the World Economic Forum
in its Global Competitiveness Report (2008), which ranks countries in terms of
their international competitiveness. Krugman (1994a: 7) claims that these kinds
of statements and reports are “meaningless when applied to national economies”.
According to Krugman (1991b, 1994a, 1994b, 1995a, 1995b, 1998), countries do not
compete internationally. They are not like firms, competing with rivals in the global
market place. Kohler (2006: 140) supports this belief that countries do not compete,
because trade is a positive sum game and thus “a country’s welfare is .. determined
by its absolute level of productivity and not by some international competitiveness
rankings … In a trading world, productivity is magnified, in terms of its welfare
potential by international exchange .. ’
However, international competitiveness of countries is an ever-growing concern
for governments, firms as well as academic scholars (Ketels 2006). It is also one of the
most misused and misunderstood terms in the popular press and academic literature
today. Daniels (1991: 56) calls it “the elusive concept of national competitiveness”.
According to him, there is no consensus on how to measure, explain and predict
international competitiveness of countries, and “perhaps none is warranted”.
This new interest in country competitiveness has opened up the debate on the
true meaning and understanding of international competitiveness of countries. The
reason for the debate is based on the implicit assumption underlying the management
theories that firm competitiveness can be extended to country competitiveness,
as popularised by Porter (1990a) with his Diamond Framework and the world
competitiveness reports.
According to Stone and Ranchhod (2006: 284), Porter’s “focus on competition
or ‘rivalry’ is a diversion from traditional economic thinking”. This general belief
by management academics that countries are somehow in competition with one
another probably explains why Porter’s (1990a) Diamond Framework appears
in most international business textbooks. Peng (2009: 125) refers to it as the most
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recent theory that explains the international competitiveness of countries: “It is the
first multilevel theory to realistically connect firms, industries and nations, whereas
previous theories only work on one or two dimensions”. Hill (2009: 193) proclaims
that “although much of the theory sounds true, it has never been subjected to rigorous
testing”. However, thus far the Diamond ‘Theory’ is conspicuously absent from the
international economics textbooks.
To understand why so much emphasis is place on the Diamond Framework in the
management literature and so little in the economic literature, a distinction has to be
drawn between the meaning of ‘competitiveness’ at a country level and ‘international
competitiveness’ at a firm level. At a firm level, international competitiveness does
matter. This is well researched and cannot be disregarded (Dunning 1997; Teece
1998; Kogut 1998; Kogut & Zander 1993). International competition at the firm
level has changed over the last decade because of the changing patterns of world
trade, globalisation of the world economy, rapid dissemination of technology and
information, and the rise of the transnational organisation. It is this emphasis on
competition among firms in world markets that has renewed intellectual interest in
international competitiveness at a country level (Porter 1990a, 2003; Rugman 1990,
1991; Dunning 2000), which has more recently been revisited by Aiginger (2006),
Grilo and Koopman (2006), Kohler (2006), Ketels (2006), Siggel (2006) and Stone
and Ranchhod (2006).
The focus of this article is on the debate as to whether or not countries compete
internationally, as proclaimed by Porter (1990a). There are two schools of thought;
the economic school, which ignores Porter’s notion of country competitiveness, and
the management school, which supports the notion of competitiveness at a country
level. This article reviews and contrasts the theories underlying the two schools of
thought. Although Porter’s Diamond Framework has been extensively discussed
in the management literature, its actual contribution to the body of knowledge in
the economic and management literature has never been clarified. The purpose of
this article is to explain why Porter’s Diamond Framework is not a new theory that
explains the international competitiveness of countries.
The first section of this article gives a short synoptic overview of trade theory
in order to provide some background on how economists differ from management
specialists on the issue of international competitiveness at a country level. The
aim is not to provide a detailed exposition of the different trade theories but to
review the theories as background for the discussion of Porter’s (1990a) Diamond
Framework, which explains the competitive advantage of nations. The second
section examines Porter’s (1990a) Diamond Framework within the context of the
trade theories. The Diamond Framework draws heavily on different theories of
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economics, but uses a conversational style that is distinctly different from that used
by many economists. Porter uses verbal descriptions of the different trade theories
based on logical reasoning instead of the mathematical models that dominate the
economic profession (Ketels 2006). This is easier for policy-makers to understand
and thus creates the impression that the Diamond Framework can be utilised to
enhance the international competitiveness of countries. The main risk of this is that
competitiveness of countries may be understood as a negative sum game, whereas,
according to international trade theory, it is a positive sum game. The last section
draws some generalisations about the validity of Porter’s Diamond Framework as a
theory of the international competitiveness of countries and explains the significant
contribution of the framework towards our understanding of the international
competitiveness of firms.
Trade theories and the international competitiveness of
countries
The first attempt to explain why countries engage freely in international trade has
its origin in 1876 with Adam Smith’s theory of absolute advantage (Krugman &
Obstfeld 2003). According to this theory, a country can enhance its prosperity if it
specialises in producing goods and services in which it has an absolute cost advantage
over other countries and imports those goods and services in which it has an absolute
cost disadvantage. This theory explains why countries, through imports, can increase
their welfare by simultaneously selling goods and services in international markets.
Adam Smith thus viewed trade as a positive sum game. This was in direct contrast to
the viewpoint of the mercantilists of the 16th century that trade is a zero sum game.
They believed that if countries wanted to become rich and powerful, they must export
more and restrict imports to the minimum. Such a policy would result in an inflow
of gold and silver that would make the country wealthy. Because they viewed trade as
a zero sum game, they advocated strict government control and preached economic
nationalism (Salvatore 2002).
The theory of absolute advantage became a paradox, however, in the sense that a
country that had an absolute advantage in all products or services it produces would
not import because it could produce more efficiently. According to Krugman (1995b),
however, it is imports rather than exports that matter for a country. Exports are
important in order to pay for the imports a county needs. According to Adam Smith’s
hypothesis, some countries will be excluded from importing and thus from the gains
from trade. This paradox that absolute cost advantage leads to specialisation, but that
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such specialisation may not necessarily lead to gains from trade, gave rise to Ricardo’s
theory of comparative advantage.
Comparative advantage
According to the law of comparative advantage, a country must specialise in
those products that it can produce relatively more efficiently than other countries
(Krugman & Obstfeld 2003). This implies that despite absolute cost disadvantages
in the production of goods and services, a country can still export those goods and
services in which its absolute disadvantages are the smallest and import products
with the largest absolute disadvantage. It also implies that a country with absolute
cost advantages in all its products will specialise and export those products where the
absolute advantage is the largest, and will import products with the smallest absolute
advantages. Comparative advantage thus also leads to specialisation, but differs from
specialisation based on absolute advantage, in that a country will always import,
whether or not it is more or less efficient overall in the production of all goods and
services relative to other countries.
The question that frequently arises, and that is sometimes the source of confusion
with regard to the law of comparative advantage, is how is it possible for a country
that is less efficient in the production of all products to export any of these products
to another country that is more efficient in the production of all these products? The
answer lies in the self-equilibrating nature of the trade balance between countries
(Krugman 1993a). This means that in equilibrium, if the input cost is sufficiently
lower in one country than another country, the price of the product will be lower in
the low input cost country, even if that country is less efficient in the production of the
product (Salvatore 2002). Any deviations from equilibrium will automatically realign
the exchange rate between the two countries to ensure new trade equilibrium.
Ricardo’s theory of comparative advantage is based on the labour theory of value
(Salvatore 2002). This implies that labour is the only production factor and that
it is used in fixed proportions in the production of all products. The theory also
assumes that labour is homogeneous (Salvatore 2002). These unrealistic assumptions
led to the incorporation of opportunity cost into the explanation of the theory of
comparative advantage. If the Ricardian theory of comparative advantage is redefined
in terms of opportunity cost, then a country will have a comparative advantage in
the production of goods and services if such goods and services can be produced at
a lower opportunity cost. This implies that a country will have a comparative cost
advantage in the production of those goods and services that can be produced at a
lower opportunity cost than in other countries (Salvatore 2002).
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Although the theory of comparative cost advantage is based on a set of strict
assumptions, this does not invalidate the general acceptance of the theory in
explaining gains from trade (Krugman 1990; Culbertson 1986; Keesing 1966;
Vernon 1979). This is furthermore underscored by the fact that most of the principles
of the World Trade Organisation (WTO) are based on the belief in the validity of
the law of comparative advantage (Root 2001). Even the relaxation of most of the
assumptions does not affect the general validity of the theory in any significant way
(Harkness 1983; Sweikausks 1983; Balassa 1965), and enough empirical evidence
exists to support the theory of comparative advantage (Bernhofen & Brown 2004;
Schott 2004; Uchida & Cook 2005; Krugman & Obstfeld 2003).
The superiority of the theory of comparative advantage lies in the remarkable
amount of useful information that it summarises clearly and concisely. According
to Salvatore (2002: 91): “It shows the conditions of production, the autarky point
of production and consumption, the equilibrium relative commodity prices in the
absence of trade, the comparative advantage of each nation .. it also shows the degree
of specialisation in production with trade, the volume of trade, the terms of trade, the
gains from trade, and the share of these gains to each of the trading nations.” It is this
power of the theory that provides a convincing explanation why trade is a positive
sum game (Krugman 1992, 1993b, 1994a, 1994b, 1995a, 1998).
The theory of comparative advantage, as discussed thus far, does not explain
the location of these advantages. Whereas the Ricardian model of trade conveys the
essential idea of comparative advantage, it does not explain the direction of trade.
Economists thus needed an alternative model of comparative advantage to explain
the direction of trade.
An important theory to explain the reasons, or causes, of comparative advantage
differences between countries is the Heckscher-Ohlin (H-O) theory (Salvatore
2002). According to this theory, countries differ with respect to their factor intensities,
namely the labour and capital that are used in the production of goods and services.
While there are many different resource explanations of comparative advantage, the
H-O theory isolates factor abundance or endowments as the basic determinant of
comparative advantage. Although the H-O theory is based on a set of simplifying
assumptions, relaxing these assumptions modifies but does not invalidate the theory
(Salvatore 2002).
A number of empirical studies have been conducted to verify the H-O theory.
One of the first such studies was conducted by Leontief (1953), who found that,
irrespective of the general believe that the US was expected to be an exporter of
capital-intensive products and an importer of labour-intensive products, the results
confirmed just the opposite. The paradox was later confirmed by Baldwin (1971).
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Similar results were reported in studies based on data for Japan, Germany, India and
Canada (Baldwin 1979).
The Leontief paradox has led economists to look for alternative explanations for
the H-O theory. The most important of these was the introduction of differences in
human capital (Karvis 1956; Kenen 1965; Keesing 1966; Baldwin 1971; Bowen 1985)
as an explanation of the paradox. Others were the product cycle theory (Vernon
1966) and the technology gap theories (Gurber, Metha & Vernon 1967; Gold 1981)
that incorporate time as a dynamic extension to the basic H-O theory. Most of these
theories were mere modifications and extensions of the basic H-O theory and did
not reduce the validity of the theory in explaining the direction of trade between
countries.
While it is generally accepted that these theories explain inter-industry trade
sufficiently, they fail to explain intra-industry trade (Grubel & Lloyd 1975). To
explain intra-industry trade, economists put forth a new set of trade theories that
relax the assumptions of perfect competition and constant economies of scale. These
new trade theories opened up the debate around government intervention as an
active policy to advance the international competitiveness of a country.
New trade theory
Up until the 1970s, international trade theory was dominated by the theory of
comparative advantage, which can be loosely defined as trade due to differences
between countries. Two of the basic underlying assumptions of comparative
advantage are perfect competition and constant returns to scale. In terms of these
assumptions, monopoly profits are competed away as firms strive to improve their
strategic positions in markets.
Since World War II, however, a large and growing part of trade has come from
massive two-way trade in similar industries (Grubel & Lloyd 1975; Linder 1961;
Vernon 1966; Krugman 1990) that could not be explained by comparative advantage
and was principally driven by advantages resulting from economies of scale. This
changing pattern of world trade has made the traditional assumption of constant
returns to scale unworkable to explain intra-industry trade. A new approach was
needed to explain the advantages of trade due to large-scale production, cumulative
experience and transitory advantages resulting from innovation. Furthermore,
to explain economies of scale (internal and external), a new market structure was
needed that was altogether different from perfect competition (Krugman 1986).
The breakthrough came during the late 1970s with the introduction of new
models of monopolistic competition by industrial organisational theorists (Spence
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1976; Dixit & Stiglitz 1977) that allowed trade theorists (Krugman 1980, 1981, 1983;
Lancaster 1980; Helpman 1981; Ethier 1982a, 1982b) to overcome the complexity of
modelling oligopolistic rivalry in a general equilibrium framework. The main appeal
for using monopolistic competition was to focus on economies of scale as the core in
explaining trade rather than on imperfect competition (Krugman 1990).
The difference between the traditional and the new trade theory (based on
monopolistic competition) is that at the level of inter-industry trade, comparative
advantage continues to be the dominant explanation of trade flows, whereas at the
level of intra-industry trade, economies of scale become the dominant explanation of
trade flows in differentiated products. The similarity is that in both the traditional
and the new thinking about trade, advantage comes through specialisation. However,
in the former, specialisation takes place because of country differences, while in the
latter, the inherent advantage of specialisation is based on increasing returns.
What the new trade theory does not explain is where the actual location of
production will be, as in the case of comparative advantage (H-O model). In the case
of comparative advantage, the underlying resource differences between countries
determine the location of production, whereas under increasing returns, the answer is
more likely to depend on historical accident (Krugman 1988). However, the location
implication of increasing returns, when it is present, will keep the industry in a
specific location that will be difficult to be competed away by industries of another
country (Krugman & Obstfeld 2003), which in effect gives a country a comparative
advantage in that industry without any government intervention.
The most important insight of the new trade theory based on monopolistic
competition (as far as this article is concerned) is that under free trade there will
be gains from trade (Krugman 1987, 1991a, 1992), which implies, as in the case of
comparative advantage, that trade is a positive sum game (Krugman 1992).
Monopolistic competition, however, is not a true reflection of the real world. Many
of today’s global industries are characterised by oligopolistic competition (Yoffie
1995), where economies of scale at the level of the firm are sufficient to limit the
number of competitors (Krugman 1992). The focus in the economic trade literature
therefore changed from analysing economies of scale as the core in explaining
trade to imperfect competition as the core (Krugman 1990). The result was a set
of trade models that assumed an oligopoly market structure (Krugman & Obstfeld
2003). The main emphasis of these models is that even in the complete absence of
comparative advantage, trade still occurs as two-way trade in identical products, and
that such trade can be mutually beneficial in industries where internal economies
of scale are important (Krugman & Obstfeld 2003). However, the problem with
models of this type is that they allow for the possibility that government protection
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can shift specialisation to a protecting country (Krugman 1990). This opened up the
argument that government policy (strategic trade policy) can change the terms of
oligopolistic rivalry in such a way as to shift excess returns from foreign to domestic
firms (Krugman 1987).
The modelling of trade within an oligopolistic market structure framework has
resulted in the possibility of industry targeting where government policy can play a
significant role. In such cases, government policies may shift profits from a foreign
firm to a domestic competitor, which may result in national gain at the expense of
a foreign country, provided that the foreign government does not retaliate (Corden
1990; Krugman 1990). Because these models support a mercantilist idea of the world,
they made the strategic trade policy argument attractive from a policy perspective.
This strengthened the notion that countries, like firms, compete for their fair share
of world markets and that governments have a major role to play in this competitive
game (Magaziner & Reich 1983; Magaziner & Patinkin 1990; Tyson 1992; Thurow
1992; Luttwak 1993; Dunning 1995; Porter 1998a; Prestowitz 1998; Garelli 2003;
Frenkel Koske & Swonke 2003; Budd & Hirmis 2004; Thompson 2004; Giap 2004;
Fendel & Frenkel 2005; Ezeala-Harrison 2005). The question, however, is the extent
to which these models are a true reflection of the real world of international trade,
how they fit the data, and whether they replace the conventional orthodox theory of
comparative advantage.
If international markets are to a large degree imperfectly competitive, then this
implies that trade between similar countries is driven by economies of scale rather
than comparative advantage (Krugman 1980, 1981; Lancaster 1980; Helpman 1981;
Ethier 1982a, 1982b). In that case, trade based on oligopolistic behaviour can be
viewed as a good approximation of how the real world works. However, the policy
implications of these kind of models (Brander & Krugman 1983; Brander & Spencer
1985; Eaton & Grossman 1986) depend on the assumptions of the model, because
according to Krugman (1987), these models are all based on special assumptions,
whereby small variations in the assumptions can result in different conclusions. All
of this introduced considerable distrust and uncertainty into the strategic trade policy
argument and questioned the validity of these models (Krugman 1987; Corden 1990).
A further criticism of the strategic trade policy argument is the partial equilibrium
nature of the new trade models, and any attempt through government policies
to favour some domestic firms over foreign firms may put the foreign firms at a
competitive disadvantage (Krugman 1988, 1990). Thus for strategic trade policy to
be successful, the assumption should be that governments are smarter than markets;
not only about the targeted industries, but also about how targeting will affect all the
other industries in the country (Krugman 1987, 1996). Strategic trade policy thus
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assumes that governments can spot winners before business or entrepreneurs can,
and that foreign governments will not react to counter this, which seems to be an
unrealistic assumption.
Although strategic trade policy supports interventionist policies that are desirable
for domestic firms, at a country level this may lead to a counter-reaction by other
countries and thus ignite a spiral of protectionist policies. Thus intervention may not
be in the best interest of a country (Krugman 1992) and thus may imply a movement
away from free trade to protectionism.
The empirical evidence in support of strategic trade policy is also not conclusive.
Studies by Cox and Harris (1985) and Dixit (1988) have found no explicit welfare
gains in favour of strategic trade policy or that any deviation from free trade will
result in significant gains from strategic trade policy actions. In general, the
conclusions from empirical research have shown that it will be extremely difficult
for any government to identify strategic industries, and even if it is remotely possible
to identify such industries, the payoffs would be very modest from an overall welfare
perspective (Krugman & Smith 1994; Krugman 1996; Bernhofen & Brown 2004;
Schott 2004; Uchida & Cook 2005).
As discussed, the limited theoretical and empirical justification in support of
strategic trade theory is not sufficiently conclusive to reject the principle of comparative
advantage in favour of strategic trade intervention. According to Siggel (2006: 140),
“any trade that results in welfare gains needs to be based on comparative advantage,
irrespective of the nature of its sources. The sources may be Ricardian productivity
differences (or different technologies), or they may be differences in factor endowments
that are reflected by factor cost differentials. But they may also include differences in
the scale of production, for firms that share the same cost function”. Thus the kind
of sophisticated intervention suggested by strategic trade policy may eventually result
in political rivalry between countries in which the negative consequences of such
political rivalry outweigh the potential gains from free trade (Bhagwati, Krugman,
Baldwin, Collins et al. 1993; Krugman & Obstfeld 2003).
Although the new trade theories of monopolistic and oligopolistic competition
challenge the orthodoxy of free trade, they do not provide any explanation of where the
actual location of production will take place. In contrast, comparative advantage not
only explains the direction and gains of trade between countries, but also determines
a country’s relative location advantages. Porter (1990a, 1998b), however, questioned
the ability of traditional trade theory to explain location advantages and therefore
proposed a ‘new theory’ to explain location advantages and thus the competitive
advantage of nations. As Stone and Ranchhod (2006: 284) explain, “Porter (1990a)
clearly disagrees with what he calls ‘standard economic theory’ … [he] even dares
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