Today's date:
Fall-Winter 1984-1985
A New Kind of Competition
In the following article, Professor Scott warns that the national entrepreneurs of East Asia threaten our standard of living unless we change the traditional orientation of our economic life.

The traditional industrial states of the North Atlantic area face a new set of competitors and a new type of competition. The competitive challenge comes neither from each other, nor from nations with recently discovered natural wealth, such as oil. It comes instead from resource-poor countries, notably Japan and the "new Japans" of East Asia, which have consistently achieved more rapid increases in productivity, industrial output and exports than the older industrial countries despite a scarcity of natural wealth.

The critical element in this new competition is the effective participation of national governments in shaping respective business environments through what we will call a national strategy. Like a corporate strategy, a national strategy consists of goals, a concept of how to achieve those goals in a competitive environment, and a set of policies and institutions to implement the concept. It is the goals and the concept, or "vision" of how to compete which drive the system.

National strategies are distinctive. Some countries are growth-oriented, with strong incentives to promote savings and investment. They reduce short-term consumption in favor of greater future returns. Other countries give higher priority to short-term consumer benefits and choose to promote consumption rather than savings. Typically, such countries set minimum levels of income as a goal, and guarantee such levels as an entitlement of citizenship or membership in the community.

National strategies also differ in the degree to which they are resource versus opportunity oriented. Those that are resource-oriented tend to see markets and competition guided by the "invisible hand" as the most effective way to develop those resources. They believe government should play the role of referee and regulator. Those that are opportunity-oriented see a role for the "visible hand" of government as supplementing market forces in shaping incentives to promote savings and/or discourage consumption, promote mobility of resources, and alter risk/reward relationships.

The central premise of the distributional strategies is that free market outcomes yield the highest level of economic performance. Therefore, the essential role of government is that of a rule maker and referee whose responsibilities are to see to it that the market works on the one hand, and that the pie is more evenly distributed on the other. Competitiveness depends essentially on business enterprise; social justice is the province of government.

The key differences in strategies appear between those countries that are growth/productivity/opportunity-oriented and those that are distribution/security/resource-oriented. These broad orientations are what is important.

The U. S., for instance, has a consistent emphasis on economic security, short-term consumer interests, the adequacy of the invisible hand in exploitation of resources, and the primary role of government as rule maker and referee in how the pie should be divided. Only where the issue is national defense do we find a clearly visible hand of government promoting the development and exploitation of opportunities, or the baking of the pie. Based on a revised theory of comparative advantage, the nations with growth/productivity strategies are out-competing the distribution/security oriented societies.

Traditional Comparative Advantage
The theory of comparative advantage was first articulated by David Ricardo in 1817. He argued that England and Portugal would each gain by trading even if Portugal produced both wine and cloth more cheaply than England. If the British had less of a cost disadvantage in cloth, they should specialize in exporting cloth and import wine, The Portuguese should do the reverse. Both countries would be better off through specialization and trade in an open market than with a strategy of protection.

The theory was originally worked out for two commodities, wine and cloth, and a single measure of value - hours of labor. The basic idea is still one of the central pillars of Western economic theory and the basis for the trading system built since World War II. As stated in a current best-selling economics text, it is deceptively simple:

" ... countries export commodities whose production requires relatively intensive use of productive resources found locally in relative abundance."

Japanese high-technology on display at Tokyo trade fair.

Created Comparative Advantage
Traditional theory is challenged by the number of countries which have indeed succeeded in dramatically altering their traditional comparative advantage.

It is important to understand that the Japanese strategy is based on an economic theory of "created comparative advantage." With this strategy, they have achieved not only greater export specialization but a continuous upgrading of their comparative advantage unmatched by any of the older industrial countries. Following the Japanese model, other East Asian countries are achieving similar results.

An ideal pattern of adjustment in today's international economy would show the U. S. adding relative market share in higher technology categories and dropping it in lower technology categories. Adjustment in this sense means "upgrading" the export portfolio toward higher technology categories. This is in keeping with the U. S. self-image as a technological leader and with the economic necessities of a high-wage country shifting its exports to products presumably requiring highly skilled labor,

Using data from the U.S. Commerce Department and the French government, it has been possible to analyze the patterns of true comparative advantage for a variety of countries during the period from 1967-1980, ranking strength in exports from high technology to low technology.

In terms of change over these years, the U.S. has lost relative world market share in 11 of the top 20 categories and made significant gains in only three: aircraft, office equipment and agricultural chemicals. Germany has lost relative share in high technology areas as well, with losses in 16 of the top 20 categories, with gains in only three. France and the U.K. have shown less severe losses in this period, but when compared to Japan, all four of the North Atlantic countries look more or less alike. Japan has added relative world market share in 13 of the top 20 categories, while losing four, all of which are chemical-based and related to the OPEC oil shock of 1973.

The significance of the "Japanese model" becomes clearer when we look at the pattern of those who have followed it - the "new Japans", or Fast-Developing Countries of East Asia - Korea, Taiwan, Hong Kong and Singapore. Like Japan, these countries show a high degree of specialization in their exports. Like Japan, they also show a high degree of adjustment over time. And, like Japan, they show a pattern of gaining share at the high end and losing it at the low end. In 15 or 20 years, they have accomplished what Japan did in 25 or 30.

This pattern is even more remarkable when coupled with the overall growth rate of exports. In 1982, for example, Hong Kong, Korea, and Taiwan EACH exported more manufactures than all the Latin American countries combined - Mexico and Brazil included.

The Dynamic Theory of Comparative Advantage
One of the key innovations of the new East Asian competitors is a revised theory of comparative advantage. It is a theory focused on exploiting world market opportunities as well as resources, and one which shows how a country can mobilize whatever limited resources it has to seize those opportunities.

If we return to Ricardo's original theory with the advantage of hindsight, it is obvious that the short-term and long-term growth and productivity prospects for wine and cloth were quite different. For Portugal the short-term advantage came from specialization in wine; the long-term advantage would have come from making a success in cloth, the "high-tech", high-growth, rapidly changing industry of the period. When the Portuguese followed the Western theory of comparative advantage, they were sacrificing long-term growth for short-term gains and implicitly accepting a lower standard of living than the British. While there is merit in the old theory of "static", or natural comparative advantage based on abundant resources, its implications for an economic strategy are likely to lead to second rate performance at best.

The Japanese model of dynamic comparative advantage says that Portugal did not have to remain a second-class world economic citizen relative to Great Britain. It says that Portugal could have chosen those industries in which it wished to participate and adapted its policies and institutions as required to participate successfully. While it could not be best at everything, Portugal had considerable leeway, beyond 'Its natural resources. In other words, it had a considerable measure of freedom to create the comparative advantage it wished, provided it had the political will and ingenuity to create or borrow the necessary mix of policies and institutions. The Japanese appear to have been the first to recognize that advantages could be created through the mobilization of technology, capital and skilled labor to attack a particular sector. Furthermore, government could create policies and institutions which accelerated the attack on new sectors on the one hand and the abandonment of declining or threatened sectors on the other. In so doing, the Japanese created a strategy of dynamic comparative advantage at the national level which in many ways parallels the strategy of a diversified firm as it shifts resources from less promising to more promising areas.

How the Japanese Select Industries
The criterion used by the Japanese in selecting which industries to emphasize or target is often loosely described as higher value added. This is true in the rough sense; after the fact, however, their criteria appear to be more subtle, less mechanical, and above all require sophisticated judgements about the future. Miyohei Shinohara, former head of the Japanese Economic Planning Agency and long-time member of the Industrial Structure Council, explains:

"The two basic criteria to which the industrial structure policies adopted by MITI conformed ... were 'income elasticity criterion' and a comparative 'technical progress criterion'.

The 'income elasticity criterion' provides a suggestion that an industry whose elasticity of export demand with respect to world real income as a whole is comparatively high should be developed as an export industry.

The 'comparative technical progress criterion' pays more attention to the possibility of placing a particular industry in a more advantageous position in the future through a comparatively greater degree of technical progress, even if the cost of the products is relatively high at this stage."

The emergence of industries characterized by rapid growth, technical change, and declining costs allows for the development of an industrial strategy. A firm can accelerate its run down the experience curve through increasing its market share and hence its volume relative to competitors. Aggressive if not predatory pricing becomes a way to trade lower short-run earnings for a stronger, presumably more profitable long-run position. It can also accelerate its run down the curve by acquisition of the latest technology either through internal R&D or through licensing from a competitor.

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A nation can build upon these ideas by protecting the home market during the initial period of relatively high costs, by helping to provide low-cost. long-term finance to promote capital investment, and by a variety of measure to maintain or promote the mobility of resources - both capital and labor.

Along with its method of selecting industries to promote, these strategies are known as the "Japanese model".

The U.S. Strategy
(A) The US strategy has been overwhelmingly distribution-oriented and, like those of the other major North Atlantic countries, increasingly noncompetitive. It has created an ever-increasing array of rights and entitlements for which there are no corresponding duties. Entitlements reduce incentives to work and save. They add rigidity to the system.

Over time this distributional strategy has relieved an ever-larger segment of the population of much of the responsibility for its own welfare. This increased degree of dependence has become an added burden on the productive part of the economy. In contrast, the "employment security" provided by the growth/productivity oriented countries is less costly, less inhibiting for labor mobility, and has a more realistic balance of rights and duties.

(B) There are no technical solutions or quick fixes for the competitive problems of distribution-oriented nations such as the U. S. The fundamental problem lies in the goals and the basic premises upon which strategies are built, not the policies with which they are implemented. Distributional priorities lead to ever-increasing levels of transfer payments. These are unrelated to effort and dramatically reduce incentives to work, save and invest.

Much of the current enthusiasm for industrial policy is based on the notion that it can be added on to a distributional strategy without a basic shift in priorities, as a painless quick fix. However, none of the distributional states has shown significant progress in upgrading its industrial portfolio the way the developmental states have.

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(C) Declining competitiveness is a particularly serious problem for the U. S. in view of its political, military and economic commitments. The performance of the U. S. economy since the late 1960s has not been strong enough to support the costs of international leadership and simultaneous expansion of social programs at home. This problem was masked for over a decade by the steady erosion of military spending. Recent political decisions have committed the U. S. to a major rearmament effort. Yet, there has been no corresponding moderation in the growth of the principal social programs - middle-class entitlements such as pensions and medical care.

The conflict between ambitious commitments and limited means may lead to a dramatic event which will resolve the issue. The more likely prospect, however, would appear to be a long, slow, irregular decline. Faced with a similar situation after World War 1, Great Britain opted for expanded social programs while allowing its military power and its competitiveness to decline. The consequences of Great Britain were less serious for the Western Alliance because the United States assumed the British role and many of its former international responsibilities. It is not clear that a similar option exists if the United States were to abdicate its military-political role in the next decade or two.

(D) The first and absolutely indispensable issue for the U. S. is to recognize a real challenge exists. For a nation used to being "number one", nothing is more difficult to admit than such a reality. Even to entertain the question is to admit time-tested axioms and traditions have to change at a less leisurely pace than our traditional position of leadership has accustomed us.

Adapted from the paper "National Strategies: Key to International Competition" by Bruce R. Scott delivered at the Harvard Business School 75th Colloquium on US Competitiveness in the World Economy and published in Bruce R. Scott and George C. Lodge, eds., US Competitiveness in the World Economy, Boston: Harvard Business School Press, 1985. Copyright 1984 by the President and Fellows of Harvard College. Reprinted by permission.