Is competitive advantage still an applicable concept so many years after its introduction? Our research demonstrates that competitive advantage remains relevant, and that it is the primary driver of firm and regional competitiveness. In rediscovering the need to embrace the opportunities offered by a strong localisation strategy, our article aims to offer a fresh, adapted and practical view of opportunities beyond externalities as a source of competitive advantage.
The localisation of industry is not a new concept. For years, companies located in a cluster have benefitted from the intangible benefits associated with clusters. In fact, more than a hundred years ago, Alfred Marshall observed: ‘Localised industry gains a great advantage from the fact that it offers a constant market for a skill … The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously’.1 At about the same time, the 1900 US Census recorded fifteen areas of industry concentration, as Paul Krugman pointed out: ‘Collars and cuffs, localized in Troy, New York; leather gloves, localized in the two neighboring New York towns of Gloversville (sic) and Johnstown; shoes, in several cities in the northeastern part of Massachusetts; silk goods, in Paterson, New Jersey; jewelry, in and around Providence, Rhode Island; and agricultural machinery, in Chicago’.2 In 1990, Michael Porter found that the creation of national competitive advantage in a particular industry does not occur by chance. He observed prominent economic clusters, such as the London Financial Centre and Silicon Valley, dominating particular industries on the world map. Porter defined a cluster as “a geographically proximate group of interconnected companies and associated institutions in a particular field, linked by commonalities and complementarities”. Interestingly, the industrial concentrations he discussed in 1990 remain relevant and highly contemporary today.[ms-protect-content id=”9932″]
Why is location the preamble of competitive advantage?
As Porter argues, competitive advantages arise from the value-creating propositions of a firm or a country. Such propositions may emerge from the firm’s (or country’s) management of its competitive strategy for competition or its value-creating activities. Competitive advantage can also be derived from rare, unique and heterogeneous resources, which can be translated into capabilities that offer value to both the firm and its customers. Resources other than those originating from the firm may be derived from the locality. For example, tacit and industry-specific knowledge are viewed as resources available to incumbents in clusters. A high-quality environment – in terms of its factor conditions, its demand conditions, the presence of related and supporting industries, and the firms’ structures and rivalries – helps incumbents and regions achieve a high and rising level of productivity in their particular fields.
Location plays an important role in helping global firms achieve an advantage in terms of their global strategies. Multinationals employ a global strategy to reap internal economies of scale, to efficiently assemble resources (e.g. raw materials, capital, labour and technology) and to assimilate market needs more internationally. However, not all industries require a global strategy or have the capacity to develop such a strategy. Actors in such industries develop specific country strategies with fewer linkages with their other operations. In such cases, the local industry structure is important, especially if the location contains the entire value chain from suppliers to buyers. While globalisation has permeated corporate practices across regions and countries, thereby creating “hemisphere-to-hemisphere operations”, the location concept carries a more economic-geographic connotation that links activities to a rich set of commercial and industrial elements.
The dominant mode of competition that emerged with the rise of globalisation approximately thirty years ago was for corporations to achieve internal economies of scale and scope. Economic geographers also argue that corporations sought to locate their activities close to each other in order to reduce transportation and other infrastructural costs, thereby achieving internal agglomeration economies for their production facilities. Internally based agglomeration economies concern the central allocation of resources within the firm and the use of its capabilities to generate economies. Today, firms must seek to take advantage of agglomeration economies, especially in the context of competition. Notably, many smaller companies can exploit the benefits of such agglomeration.
In contrast, externalities, or external agglomeration economies, are defined as cost savings that result from the concentration of production at a given location. The net benefit of being in a location together with other firms is argued to increase as the number of firms in that location rises. This leads to two questions. First, how many externalities exist that are associated with the process of clustering? Second, How does each externality relate to the process?
Navigating through externalities
Localisation externality. The localisation of similar competing firms creates external economies of scale. A large number of competing firms in a certain location attracts workers and suppliers, and can increase a firm’s returns, according to Krugman.3 The resulting pooling of the labour market benefits both workers and companies, as a large labour pool helps individual firms cope with the uncertainties related to the business cycle. For example, in London a large number of contract workers are highly mobile and feel that they work for the London Financial Centre rather than for a specific firm. A strong localised industry can also support a greater number of specialised suppliers of inputs and services, as economies of scale and scope can be gained by the suppliers, thereby lowering costs for local firms while improving the variety of available supplies. The total employment among competing firms at a location may serve as a measure of this scale effect. In our article appeared in the Journal of Competitiveness and Strategy4 we show that localisation can benefit incumbents in terms of growth, significantly in the UK financial sector. Furthermore, research has shown that such agglomeration effects benefit firms with fewer resources in terms of technology, human capital, suppliers or distributors, while they also enable firms to grow faster. Although a high number of firms in an agglomeration may lead to congestion, the presence of competitive supporting and related industries in a cluster has been shown to be beneficial.
An urbanisation externality arises from a diversity of industries in a city or region, and is associated with the benefits that arise irrespective of a firm’s area of activity. The presence of thriving industries in a location draws a more diverse labour pool and brings about better infrastructure, as well as all of the benefits associated with the formation of cities. For example, a competitive machinery-maintenance industry that provides specialist support to the food-processing industry in a certain location may attract another industry – such as paper processing –, which seeks to benefit from the urbanisation externality. This represents an external economy of scope brought about by the diversity of industries in an urban concentration, which develops because firms may benefit from being close to other industries that support completely different industries. A city’s total employment is indicative of such scope effects. Research has suggested that dissimilar firms gain most in terms of performance due to heightened demand in such regions.
In industries where activities are closely related, such as financial services, the lineage and linkages among several sectors will benefit from the close physical proximity of the firms. This creates an external economy of complexity. One example is the London Financial Centre, where the banks are reliant on their proximity to elements in the market sector, such as the London Stock Exchange. Other sectors, such as financial leasing and insurance, work closely with the banking sector and also rely on proximity to the market. Furthermore, banks and financial leasing firms often transfer (or sell) their acquired loans to each other as financial assets. We have found that such effects from urbanisation and complexity in London allow incumbents to obtain financial gains, and hence perform better.
A pecuniary externality is said to exist if a firm’s profits depend not only on its own activities but also on the activities of other firms in upstream and lateral industries. A positive pecuniary externality may arise in agglomerations when the economic benefits of clustering outweigh the costs, such as increased congestion and transportation costs. For example, insurance and reinsurance processes involve a chain of insurance firms and private equity holders in the London Financial Centre as a way of spreading risk. They may, therefore, result in net pecuniary benefits for all involved in profitable ventures. There are known interdependencies among financial services activities within the London cluster, with profuse lateral relationships in the banking industry and the insurance industry, while fund management and investment banking maintain vertical relations with the commercial banks.
Another source of pecuniary externalities in the London Financial Centre lies in the transfer and cross-fertilisation of skilled labour among related financial sectors, such as banks and asset-management firms. For example, one firm’s investment in staff training may eventually benefit another firm in the Centre. In this regard, clustering provides mechanisms for knowledge exchange and knowledge spillover, which in turn enhance firm knowledge. This occurs because knowledge resides at the employee level, and the transfer of knowledge takes place between skilled workers in their day-to-day interactions or as they move from one firm to another.
Complex, embedded, tacit and firm-specific knowledge are internal resources that may be tantamount to the competencies of a firm. In other words, this knowledge may be a determinant of firm-level performance.
Groups of firms exchange knowledge in a cooperative, if sometimes unknowing, fashion. Two forms of knowledge exist. Component knowledge, such as product and market knowledge, are easily transferred among individuals in similar industries and with similar scientific backgrounds when they interact. As such, the greater the number of firms in a cluster, the higher the number of opportunities to share similar experiences and problems. Proximity enables such firms to easily participate in mutual transfers of component knowledge. Spillover involves information about competitors’ moves and industry changes resulting in a wide range of effects, such as alterations in financing, marketing, managerial or organisational practices among incumbents. In Silicon Valley’s growth phase, for example, many small firms collaborated and promoted collective learning. Informal communication and collaborative practices were plentiful among players both upstream and downstream in the value chain, as were linkages among those involved in related technologies (even among competitors).
Architectural knowledge relates to an organisation’s system, structure and routines for coordinating and integrating component knowledge so that it can be used productively. Over time, incumbents in a cluster develop a cluster-specific stock of architectural knowledge that is location specific. Such knowledge is exclusive to incumbents and unavailable to non-members. For example, firms in Silicon Valley possessed intimate knowledge of their suppliers’ costs, and incumbents were able to compare costs and employee performance with other local firms.
Competitive advantage Neuf
Porter states that ‘many cluster advantages rest on external economies or spill-overs across firms and industries of various sorts’.5 He also suggests that agglomeration economies have increasingly become important at the cluster level rather than at the industry level. This implies the importance of externalities and spillovers as new sources of competitive advantage.
Although researchers have generally emphasised that it is the quality of the environment that helps incumbents and regions achieve productivity improvements in a particular field, Porter only focuses on physical and tangible attributes. Porter develops the concept of the cluster as a generator of unique competitive skills that can be maintained by incumbents across global markets for an extended period of time. However, we argue that firms’ and organisations’ know-how lies in these intangible externalities, and that it is through these externalities that this know-how can be enhanced.
Externalities cannot be captured in financial reports and they cannot be classified as intangible assets. Therefore, they remain elusive to non-member firms that cannot differentiate them. As Marshall aptly states, an externality is something in the air that those who smell it cannot describe. It can be perpetuated as a market instinct, as an insider benefit, as guanxi, or as a personal network or relationship. We suggest that the degree to which a firm can exploit externalities at a particular location can determine the firm’s competitiveness.
Organisations have traditionally focused on generating internal economies. Recently, the focus has been on generating internal economies through acquisitions and mergers. However, the idea that “bigger is better” may not remain the de facto mode of competition. For example, AT&T, one of the largest corporations in US history suffered from a major antitrust suit, which resulted in its gradual breakup from 1982 to 1996. Although anti-monopoly regulations and government protection are typically a way of life, trends in deregulation in the 1990s prompted firms to search for new sources of competitive advantage.
As Vinod Khosla states in The Silicon Valley Edge, ‘to emulate … we first need to understand’.6 Our purpose is to inform managers of possible sources of new competitive advantages. The importance of externalities for competitive advantage cannot be overemphasised; as such externalities mean that firms need not be big to compete effectively. This levels the playing field. Rather than focusing on internal sources of economies, firms should watch for external sources that may supplement their internal capabilities and perhaps even enable them to benefit from competition
About the Authors
Adrian T H Kuah is Senior Lecturer at James Cook University in Singapore. He began his career in Fortune 500 companies and the civil service before entering academia. He is a Subject Matter Expert and Fellow of the Chartered Management Institute and Scholar of the Advanced Institute of Management in the UK. Called a leading expert on the value chain and recognized for theorizing the principle of globality and proximity, he advises governments and companies on strategy and competitiveness. He holds a PhD from the Manchester Business School, UK. ([email protected])
Mark Esposito is Associate Professor of Management at Grenoble Graduate School of Business in France & Instructor at the Harvard Extension School in the USA. He serves as Senior Associate for the University of Cambridge Program for Sustainability Leadership in the UK. He has advised governments, the UN, and the NATO over the past 10 years on development and sustainability issues. He holds a PhD from the International School of Management in Paris/New York, in a joint program with St. John’s University. ([email protected])
Terence Tse is an Associate Professor in Finance at the London campus of ESCP Europe Business School. He is also a director at i7 Institute for Innovation and Competitiveness, a Paris and London-based academic think tank. He began his career in investment banking, and later as an independent consultant to a University of Cambridge-based biotech start-up and various major corporations. He worked as a consultant at Ernst & Young in London. He holds a PhD from the Judge Business School, University of Cambridge, UK. ([email protected])
1. Marshall, A. (1890), Principles of Economics, Macmillan: London.; Marshall, A. (1920), Principles of Economics, 8th Ed. Macmillan: London, pp 271.
2. Krugman, P. (1991a), Geography and Trade, MIT Press: Cambridge, MA, pp61.
3. Krugman, P. (1991a), Geography and Trade, MIT Press: Cambridge, MA, pp61.
4. Kuah, A; Tse,T.; Esposito, M., (2013). Financial Agglomerations in the UK: Geographical Cluster Size and Firm Performance, Journal of Competitiveness and Strategy, Volume 3: 18-37.
5. Porter, M. E. (1990), Competitive Advantage of Nations, Free Press: New York.
6. Khosla, V. (2000), General Partner, Kleiner Perkins Caulfield and Byers, in Chang Moon Lee (ed) The Silicon Valley Edge, California: Stanford University Press (2000).