Tuesday, June 15, 2010

Comparative Advantage: A Behavioral Theorem

The comparative advantage of a nation is its ability to produce products or services more efficiently and cheaply than others. Nations such as China and India can power their way in global economic ranking only through sustainable comparative advantage. The comparative advantage of a nation, however, is broader than either the advantage of natural resources and factor supplies or the competitive advantage of industries in a nation.

Comparative advantage is a behavioral theorem rather than an economic model as is commonly understood. In fact, while economic parameters may quantify comparative advantage, they do not adequately adequate describe the sources or processes of comparative advantage of a nation. The comparative advantage is a function of certain basic behavior patterns exhibited by socio-economic constituents in a nation.

Each nation comprises individuals and entities. Though entities are the creations of individuals, over time entities and individuals develop their own behavior patterns. These determine the economic performance of a nation. Individuals and entities simultaneously function as producers and consumers, savers and investors, and ruled (governed) as rulers (governors). These behavior patterns in the aggregate define the national comparative advantage.

Individuals and entities in nations

At a broad level, individuals and entities of a nation need to function in harmony and synergy. The elaborate governance systems (for example, the corporate entities, the democratic polity, the administrative framework and the regulatory systems) are intended to align economic performance to society’s needs. However, individuals and entities are usually unable to make choices that are aligned to each others’ interests. Conflict rather than collaboration characterizes the functioning of individuals and entities thus affecting the comparative advantage of a nation.

There are a few cases in economic history that demonstrate how alignment of individual and entity behaviors leads to national comparative advantage. It occurred, decades ago, in America with swift economic construction, development of a large labor market and arguably one of the best university and research systems of the world. It occurred in Japan with emphasis on innovation and productivity, and almost seamless integration of social, national and corporate cultures for global economic domination. Select countries in Europe had at different points of time reflected periodic alignments and misalignments.

Nations which had individuals and entities passionate about efficiency and effectiveness clearly could generate national comparative advantage. However, over time, the very same nations began to lag as divergence between individuals and entities, and misalignment across behavior patterns within individuals and entities began to emerge. The loss of competitiveness of advanced nations, whether due to peaking of living conditions, unionism, lack of reinvestment or slowing down of knowledge formation, reflects this trend. The competitiveness of emerging countries, initially quantified through low labor costs and cheap facilities, need not as a corollary mean the natural emergence of sustainable comparative advantage.

China recognized the challenges of natural evolution of comparative advantage and began to shape the society’s behavior patterns through stringent rule. Mao’s Great Leap of the 1960s and Deng’s Great reforms of 1980s reflect unparalleled examples in behavioral management of nations. Factor supplies were regulated, utility costs administered, employee mindsets regimented and bank finances channeled to funnel competitive industrial growth. Massive investments in infrastructure fueled industrial consumption, opened up labor markets, encouraged labor migration, attracted foreign technologies and turned out cheap manufactured goods. Virtually all consumer electronic products are manufactured in millions and billions in China with perpetual lowering of scale-led manufacturing costs.

India, in contrast, relied on natural evolution to align individuals and entities for greater economic growth. Even though economic growth and export performance have been the avowed goals of post-independent India from 1947, India could not discover sources of sustainable comparative advantage for as many as five decades. The first signs of comparative advantage of India became evident in the globalization of India’s information technology and business process outsourcing industries between 1995 and 2005 during which decade China continued to take long strides as the manufacturing capital of the world. However, between 2005 and 2010 India also started to display new sources of comparative advantage on both manufacturing and services fronts.

Comparative advantage, beyond cost arbitrage

Quality related incidents (Heparin and toys, for example) and industrial regimentation aftereffects (Foxconn, for example) in China, mining backlashes in Asia, Australia and Africa, and operational safety hazards (from fireworks companies in India to oil drilling companies in advanced countries, for example) demonstrate that comparative advantage based on planetary exploitation, low labor costs, extended output targets, indiscriminate outsourcing and cheap manufacture may not constitute a sustainable phenomenon. Sooner or later cost levels and output levels would need to reflect realities of physical human life, and lead to equalization across economies and labor markets around the emerging countries eventually.

Sustainable comparative advantage, on the other hand, would stem from aligning the individuals and entities on shared responsibilities and goals, which are broader than monitory ones. The behavioral theorem is based on individuals and entities being producers and consumers, savers and investors, and ruled and rulers simultaneously. In an ideal national system production is balanced by consumption, imports are compensated by exports, savings are directed towards investments and wealth maximization is harmonized with social equalization. This process, however, gets impeded by the fact that all nations are not equally endowed.

Globalization commenced as an answer to this disparity but could not provide an equitable solution. Globalization has had three phases. In the first phase products, technologies and people were imported from advanced countries into less developed countries to meet local demand. In the second phase, technologies were imported to mass produce products for consumption in developed markets. The third phase which is now emerging involves a fusion of technologies and management approaches of advanced and emerging markets to optimize production and consumption globally. The world order should logically move to an equilibrium state as the third phase of globalization progresses.

Cost arbitrage would diminish in importance as improvements in living conditions and greater consumerism would lead to demands for higher salaries in emerging markets. Producers would need to not only channel a large part of their production to local markets but also build global brands around local designs. As earning potential in emerging markets improves savings would need to be invested in productive activities in local markets. Employees and managements as well as societies and governments need to be bound by shared ethics of productivity, efficiency and egalitarianism. This would require nations to raise capabilities in a wide spectrum of products and services rather than being focused on only a few industries or just leverage natural resources.

Intellectual edge versus physical rigor

The days of glossy products deriving attractive revenues and profits from low cost internals could be over sooner than later. Rather, high quality standards in design, manufacturing and service could differentiate products in future. The days of a pioneering brand and scores of follower clones could also be over sooner than later. Rather, novel ways of fulfilling the user requirement through innovative products and services could become necessary. There could be limits to stretching physical performance given the machine speeds and 24 hours all that being available in a day. There would, however, be no limits in stretching human intellect to generate novel products and services, and novel methods of design, manufacturing, delivery and service.

The industrial revolution started in laboratories with scientists and technologists creating new products. As demand burgeoned methods of factory-led mass manufacture shifted accent from design to manufacture. The limits of manufacturing efficiency as derived from cost arbitrage may well have been reached. There is still a residual possibility to innovate in manufacturing system design and equipment configuration as being discovered by global automobile firms with Indian engineering ingenuity. Even this phase will get over in the next five to ten years. Time is appropriate to get back to fundamental research in laboratories to develop novel products and services.

As India gets increasingly recognized as a global hub of manufacturing India has choices to make; whether to follow the established Chinese model of low-cost mass manufacture, albeit with more consistent quality, delivery and regulatory parameters, modify it with innovative manufacturing system designs or supplement it with novel research innovations. Sustainable comparative advantage emerges from all the three. Natural resources and synthetic outputs would need to be protected with novel research and manufacturing technologies. Waste needs to be eliminated and savings generated by adopting optimal business and conversion processes. Employees and citizens need to see value in generating comparative advantage. Comparative advantage becomes a behavioral and intellectual exercise.

Individuals and entities tend to have production, consumption, savings, investment, governance and governed behaviors that could be synergistic or antagonistic. The sustainability of comparative advantage of a nation arises from how well these behaviors are made harmonious.

Production and consumption behavior

Modern industrial theory is based on aggressive production and consumption behavior to boost growth. Resources being limited it is important that production and consumption are supported by meaningful behavioral patterns that support wise utilization of resources both from production and consumption points of view. China and India may have paltry automobile ownership rates of 14 and 8 respectively compared to 478 in USA but what should be the levels to which the vehicle density would need to grow? Should not road density per unit area grow first in India before vehicle density leapfrogs? And even when road density leapfrogs should not bus density jump ahead of car density? These are complex questions that need to be answered as much by public policy considerations as by individual and social behaviors.

Modern competition theory suggests that corporations intensify their efforts to segment the markets with diverse products of multiple functionalities to capture market share. Supported by saturation marketing this would prompt higher consumption, increased production and better economic growth. Such industrial theories lead to nagging worries on true competitiveness. Would not multiplication of products reduce innovation or at best perpetuate incremental innovation? Would not corporations be better placed by opening out new products with new features rather than by crowding out existing market segments with only incrementally relevant products? Would not consumers be better off by owning different types of products and services rather than many variants of the same product and service? These again are complex questions to be answered as much by regulators and strategists as by individual and social behaviors.

Modern economic theory has favored consumerism. It is believed that increased purchases and ownerships of houses, gadgets, equipment and stocks will lead to multiplier effects in the economy. Supply push and demand pull are considered synchronous. Consumerism is measured by the screens on which a movie is screened in the first days, the millions a gadget is sold on launch, the apartments that are booked on announcement and the times a capital market issue is oversubscribed. Consumerist economic thought generates its own questions. Would not overwhelming consumerism reduce product life cycle artificially and lock up capital in both production and consumption? Would not producers and consumers be better served by an orderly, rather than by a hyperactive, production and buying spree? Are considerations of quality well-served by saturated production and consumption? These are challenging issues that need to be answered as much by resource considerations as by individual and social behaviors.

Savings and investment behavior

Traditional Indian society moorings favored living within means. Savings were the pillar of social security for families and driving force of banking behavior. Typically, the Indian salaried class used to own a house at the end of the career out of the savings. The savings paradigm has undergone a fundamental transformation over the last three decades. Ambitious executives splurge their earnings on gadgets and are willing to make early purchase of loan-funded houses, only to live on wafer-thin savings. Credit cards are used by people to live beyond the means. Loans are treated as deferred savings. This distinctly American trend raises disturbing question for the Indian society. At a time when the American society has learnt at great cost the perils of living beyond means on credit the wisdom of Indian society following the disastrous trend is highly debatable. Have banks and financial institutions developed a vested interest in funding the society to profligacy? These questions need to be answered by economists and individuals as well as society in search of security and status.

Savings are meant to be channeled as prudent investments. Investments are to be made keeping in view lifestyle goals for retirement. Investments are to be made in assets to be held over a long time for capital appreciation. Modern trends have turned investment into expenditure and popularized buy-sell transactions as opportunistic short term alternatives to long term investments. With the proliferation of such investment trends America created asset bubbles in housing which shook the global economy to its core. Would not societies be safer by prudential allocation and management of investments? Should mathematical models be allowed to blur rational and logical investment behavior? Should complex instruments like derivatives and opportunistic methodologies such as short sales and day trades be banned? Again, these are critical questions for the stability of economies and societies to be answered by policy makers and market participants.

Ruler and ruled behavior

Rulers come in many forms; employers, companies, leaders, regulators, ministers, administrators, and so on. Correspondingly, ruled also come in more simple forms; employees, followers and citizens. The relationship between the ruled and rulers, or the governors and the governed, determines the equity, strength and stability of the society and polity. The drivers for rulers and the ruled are quite distinct. Rulers whether of corporations or nations are driven by control over resources and power. Ruled, on the other hand, are driven by needs for security and development. Different socio-economic systems and national governance systems sought to develop different methodologies to align the interests of the rulers and the ruled. The welfare states of Sweden and Switzerland represent one end of the spectrum while the controlled state of China represents another end. The purely capitalistic, but democratic, state of USA and the highly fragmented democratic polity of India represent other typical examples.

Totalitarian states provide quick fixes and democratic capitalistic states encourage but also punish excesses while fragmented democratic states are caught in chaotic turmoil of informed and uninformed debate. In the long run, informed democracies align the ruled and rulers better than highly controlled totalitarian states which force the ruled to subjugate free expression in exchange for economic rewards. The challenge for the ruled in democratic states is to gain absolute literacy and awareness and exercise the democratic power to keep the ruled focused on the imperatives of equitable economic growth. If any single factor is holding back India becoming a super economic power, it is neither industry nor infrastructure as commonly hypothesized but it is its inability to achieve complete literacy. The ruled in India which hitherto had a vested interest in keeping literacy at low levels has taken an epoch-making step with the Right to Education (RTE) bill. When the RTE and other education bills are implemented in letter and spirit India will beat all the emerging countries including China to a virtuous superpower status.


Comparative advantage is more of a human endeavor rather than an economic or industrial endeavor. Individuals and entities in a national system pursue aggressive pursuit of production and consumption patterns on one hand and savings and investment patterns on the other that encourage profligacy. Ruled are unaware of their rights and responsibilities on one hand and their capabilities and potentialities on the other hand. The rulers tend to have a vested interest in achieving a totalitarian control or a democratic fragmentation of these human behavior patterns. All these behaviors need to be harmonized for sustainable comparative advantage. Universal education is the key enabler for a tolerant society and democratic nation as India to discover its full potential through creative intellect rather than regimented labor.

Posted by Dr CB Rao on June 15, 2010

Sunday, June 6, 2010

Exit Cross-functional: Enter Cross-industry

Organizational structure is both the boon and bane of corporate development. Without organizational structure, management would be chaotic and even impossible. With organization structure, management is constrained, and even thwarted by silos. Organization experts have tried to configure several models of organizational structure – functional, product, geographic, project, matrix, congruence, strategic business to name a few – to make organizational structures support efficient and effective realization of corporate goals. As companies diversify and globalize on multiple product-market dimensions, structural and process challenges of organization design become more intense.

Whatever be the nature of business and the type of the organization however, departmental configurations perpetuate themselves into structural silos. Functions, domains, businesses or any other part of value chain of any organization turn into structural silos. As leaders of functions, domains and businesses compete to grow in an organization, silos become even more obdurate and ossified. Organization experts have tried to configure solutions by advocating cross-functional management as a process approach to break silos. In today’s fast changing technology space and competitive world, however, it is no longer sufficient to have solutions that attempt to merely overcome self-inflicted organizational problems.

Limitations of intra-organization approach

Cross-functional approach within an organization is at best palliative and is neither curative nor preventive of typical organizational ills. It merely accepts the limitations of organizational structure and leadership styles at higher levels and seeks to discover solutions by encouraging middle and lower levels to work together cutting across functions and enhance organizational delivery. Very often, these cross-functional solutions are presented to, and are discussed and finalized by cross-functional groups of leaders. The entire process merely restores value chain management within a business which is fragmented by the type of organization structure adopted.

Cross-functional groups themselves may not function to the best of the abilities of individual members as often ‘give and take’ of positions is involved in team dynamics. Very often different line functions (such as manufacturing, materials, engineering, research and marketing) and staff functions (such as finance, human resources, corporate planning and information technology) tend to have differentially respected positions in an organization. Cross-functional processes fail to remove such intrinsic legacy positions. In addition, members are often faced with conflicts of time management related to their internal functions and external functions. They are also occasionally faced with the challenges of coping with leadership conflicts. More importantly, cross-functional groups are introverted into organizational vortices rather than extroverted to discover what lies outside the organizations.

Limitations of intra-industry approach

Many times managers and leaders attempt to enhance functional and cross-functional effectiveness by focusing their own attention and the attention of team members on the more effective competitors. Benchmarking of structure, processes, talent and results against those of competitors in an industry is utilized to focus attention on potential improvements. Most such studies are done based on public domain information or syndicated information. Neither approach provides information on the true status and fundamental sources of competitive advantage of a successful competitor in an authentic manner.

The intra-industry approach is also deficient as typically players in an industry replicate the strategies of other players to reach an equilibrium state. For example, a player who specializes in mass products would endeavor to establish a division for differentiated products. A niche player, on the other hand, would seek to enter the mass markets by acquiring capabilities for cost leadership. Eventually, players within an industry tend to have little that can learn from each other. The focus then turns to execution which would require increasingly higher efforts to derive rather unfortunately decreasing levels of additional benefits.

Opportunities of cross-industry approach

Notwithstanding the organizational limitations that could exist within players in an industry, exciting things are happening across industries. These fundamental changes occur mainly as a result of science and technology across industries on one hand, and growing consumerism and egalitarianism in the societies on the other. Some of the changes are truly mind-boggling and challenge what conventional organizations understood as the limits of creativity or performance. For example, automobile industry was the only leading protagonist of consumer choice with its concept of model year for the passenger cars. Upgrades of car designs each year and introduction of new series every four or five years was the ultimate epitome of customer orientation. However, today the electronics industry surprises us by having new models launched each month. Model month, rather than model year, is the new benchmark of competitive development.

The change is not reflected merely in the speed of new product development. The change is also reflected how conventional product features are replaced by new product functionalities. If personal computers rewrote the chapter of mainframe computers yesterday, tablets and cloud computing could consign the personal computers to history tomorrow. Each such new industry development, however, flourishes on certain embedded breakthrough processes of harnessing science, technology and management, which need to be observed and assimilated by other industries consistent with their own research, manufacturing and marketing characteristics. This would require leadership teams in industries discard their dogmas and rewrite the rules of business based on breakthrough concepts that occur in other industries.

Dogmas that need to be discarded

Conventional industrial and business development is severely limited by dogmas that have taken root in the in the theory and practice of management over the years. These dogmas provide stability to organizations and comfort to leaders and managers. When followed unquestioningly these dogmas perpetuate status quo in industries and render individual players uncompetitive and even obsolete. The first trickles of novel technology and new business processes are, however, enough to destabilize such firms. Innovators as well as established firms fall victims to such changes if they hold on to their dogmas. Palm is a classic example of an innovator which almost collapsed on the dogmatic plank of the invincibility of its original innovation. Microsoft, despite being an established colossus, has been wise to discard some of its dogmas and embrace newer trends to stay competitive.

The dogmas that are limiting the innovative capacity of firms are many. A few of these follow. The first is that the longer a product stays in the market the greater is the investment recovery. The second is that it is counter-productive to make one’s own product obsolete or cannibalize one’s own product. The third is that scale of each product is more important than the scale of the overall business. The fourth is that profitability is inversely proportional to product variety. The fifth is that market segmentation is quantitative and not qualitative. The sixth is that emerging markets are only production centers and not consumption markets. The seventh is that the costs of changing the customer mindset for new technologies are prohibitive. The eighth is that digital revolution is only for younger generation. The eighth is that certain technologies, for example touch technology and convergence, are limited only to consumer electronics. The ninth is that management is a superior enabler compared to science and technology. The tenth is that structures and processes shape and harness discordant mindsets. By discarding dogmas and stretching ingenuity to rewrite the traditional economic rules of management, leaders, managers and professionals can revitalize firms and industries.

From diseconomies to economies

Dogmas survive on the basis that any opposing practice leads to diseconomies. Newer pragmatic practices, however, generate their own economies, overturning dogmas. The cellular phone industry, for example, leads all industries in product innovation and launches. Even as one product is launched the next product launch is announced by firms in this industry. The diseconomies of the startling reduction in product life cycle are countered by the economies of saturation launch sale and multiple saturation launches. The consumer electronics industry thrives by making its products obsolete and even cannibalizing its own products. The lessons are that it is profitable to pull out all stops to research and innovation. The consumer goods industry proves that multiple products (SKUs) expand the market and eventually make sub-scale products viable. Skills in retooling, outsourcing and supply chain management can help firms manage the challenges of commercialization of multiple products in quick succession and make profitability directly proportional to product variety.

Market segmentation is the only productive way to serve customers more intensely with the right products, and in the process help firms grow profitably. Market segmentation is as much cardinal as it is ordinal. Products can be designed to fulfill customer needs in terms of application granulation as much as being positioned in terms of user image. Over the last few years, even emerging markets failed to recognize their own potential. Firms which focused on a judicious mix of developed and emerging markets have become more valuable companies than those companies which focused only on any one set of markets. Today’s consumer is information-savvy. The customer is willing to discover new product features on his or her own, providing a great support to product proliferation, with all the benefits underlined above. Boxing (packaging) of each product with appropriate product usage aids is an important contributor to the process of smooth product discovery by the customers.

A digital bridge is developing at breakneck speed extending the present into a wildly different future. The digital bridge is visible to some and invisible to several others. Is the forthcoming ‘slate’ revolution only for the book readers or youngsters? Is the touch technology limited only to cellular phones? Are the robots that talk and walk robots just entertainers or real humanoids? These developments are, in fact, the start of a new wave of human engineering whereby technology would make products and people discover each other’s senses and sensitivities. Science and technology are original and dedicated to making life more productive and helpful; so much so, even human life could soon be synthetically cloned. In contrast, management has done so little in originality and creativity that it would appear counterproductive for science and technology to play second fiddle to management. Science and technology have discovered fundamental laws of life through physics, chemistry, mathematics and biology. Management needs to similarly integrate the social sciences such as economics, psychology, sociology and stochastic sciences to redefine itself.

Benefits of cross-industry assimilation

There are many lessons that can be learnt by firms through an open and structured process of cross-industry observation.

Cellular phone industry teaches one the paradigm of extremely fast-track product development. The industry believes in research as a continuous process rather than a batch process. R&D is organized as a factory operation virtually. The industry sees obsolescence as an opportunity and seeks to create as many opportunities as possible by making as many of its current products obsolete as possible. The industry also demonstrates how multiple functionalities can be optimized under a convergence model. Market segmentation in its ordinal and cardinal senses can be well-understood from the dynamics of cellular phone industry.

Automobile industry teaches one how product performance can be perked up by integrating electronics into design and manufacture. It also demonstrates how an essentially resource guzzling industry (oil reserves and road space) copes with environmental compulsions by enhancing fuel economy, using alternative fuels, and rediscovering compactness. Automobile industry also develops management as an optimal interface of man and machine where synchronization, whether on shop floor or in supply chain, holds the key.

Retail industry teaches one how a certain, fixed-cycle production system can be coordinated with an uncertain, variable-cycle market system. Firms which market non-consumer products can upgrade supply chain practices by observing how retail needs are met by the consumer goods and retail industries in tandem. Requirements of freshness and shelf-life require special capabilities in cold chain and distribution management. The industry also teaches how customer contact and communication intensity can lead to enhanced footfalls.

Infrastructure industry teaches one the challenges of dreaming big, executing under hazardous circumstances, living under regulatory uncertainty, raising massive finances and remaining motivated despite extended viability. Project management in the typically multi-dimensional infrastructure ventures demonstrates how facile should it be to project-manage normal research and manufacturing projects. Financial institutions and investors who see patience as a virtue in the long gestation infrastructure projects would help out other long-gestation industries such as pharmaceuticals and research in general.

Pharmaceutical industry demonstrates how product safety and efficacy as well as manufacturing quality and regulatory compliance determine the level of competitive advantage of a firm. The industry provides a template by which people are rigorously trained for institutionalization of quality and compliance. The industry demonstrates how multiple disciplines of science and technology to make life better for human beings, whereby an unknown molecular entity can be made to cure or prevent disease through innovation and rigor.

Fast moving consumer goods (FMCG) industry teaches how by taking care of day to day needs of individuals and families businesses can be created and grown. The industry teaches how mega businesses can be built on mini technologies. It also reflects on how perceptions and realities can be merged and de-merged to support business development. It brings forth the importance of packaging as a key differentiator. It also demonstrates the power of observation of consumer behavior as a trigger for strategy development. It is a perfect industrial crucible for merger of tradition with globalization and nativity with modernity.

The list could go on; the sooner firms realize that greater competitiveness could emerge from assimilation of best cross-industry practices the greater would be the benefits to economic, industrial and social development.

Posted by Dr CB Rao on June 6, 2010