Business
Paradoxically, the enduring competitive advantages in a global economy lie
increasingly in local things-knowledge, relationships, and motivation that
distant rivals cannot match.
CLUSTERS AND THE NEW
ECONOMICS Of COMPETITION
BY MICHAEL E. PORTER
Now THAT COMPANIES can source capital;goods, information, and technology from around the world, often with the click of a mouse, much of the conventional wisdom ahout how companies and nations compete needs to he overhauled. In theory, more open glohal markets and faster transportation and communication should diminish the role of location in competition. After all, anything that can he efficiently sourced from a distance through glohal markets and corporate networks is availahle to any company and therefore is essentially nullified as a source of competitive advantage.
Michael E. Porter is the C. Roland Chiistensen Professor of Business Administration at the Harvard Business School in Boston, Massachusetts. Further discussion of clusters can be found in two new essays-"Clusters and Competition" and "Competing Across Locations" - in his new collection titled On Competition (Harvard Business School Press, 1998}.
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
But if location matters less, why, then, is it true that the odds of finding a world-class mutual-fund company in Boston are much higher than in most any other place? Why could the same be said of textile-related companies in North Carolina and South Carolina, of high-performance auto compa- nies in southern Germany, or of fashion shoe com- panies in northern Italy?
Today's economic map of the world is dominated by wbat I call clusters: critical masses-in one place-of unusual competitive success in particular fields. Clusters are a striking feature of virtually every national, regional, state, and even metropoli- tan economy, especially in more economically ad- vanced nations. Silicon Valley and Hollywood may be the world's best-known clusters. Clusters are not unique, bowever; they are bigbly typical-and tberein lies a paradox: tbe enduring competitive advantages in a global economy lie increasingly in local things-knowledge, relationships, motiva- tion-tbat distant rivals eannot match.
Although location remains fundamental to com- petition, its role today differs vastly from a genera- tion ago. In an era wben competition was driven beavily by input costs, locations witb some impor- tant endowment-a natural barbor, for example, or a supply of cbeap labor-often enjoyed a compara- tive advantage tbat was both competitively deci- sive and persistent over time.
Competition in today's economy is far more dy- namic. Companies can mitigate many input-cost disadvantages tbrough global sourcing, rendering tbe old notion of comparative advantage less rele-
tion and competitive success in so many fields are geographically concentrated-wbetber it's enter- tainment in Hollywood, finance on Wall Street, or consumer eleetronics in Japan.
Clusters affect competitiveness witbin countries as well as across national borders. Tberefore, tbey lead to new agendas for all business executives- not just tbose wbo eompete globally. More broadly, clusters represent a new way of tbinking about lo- cation, cballenging mucb of the conventional wis- dom about bow companies sbould be configured, bow institutions sucb as universities can contribute to competitive success, and bow governments can promote economic development and prosperity
What Is a Cluster?
clusters are geograpbic concentrations of intercon- nected companies and institutions in a particular field. Clusters encompass an array of linked indus- tries and other entities important to competition. They include, for example, suppliers of speeialized inputs sucb as components, macbinery, and ser- vices, and providers of specialized infrastructure. Clusters also often extend downstream to ebannels and customers and laterally to manufacturers of complementary products and to companies in in- dustries related by skills, tecbnologies, or common inputs. Finally, many clusters include governmen- tal and other institutions - sucb as universities, standards-setting agencies, tbink tanks, vocational training providers, and trade associations - tbat pro- vide specialized training, education, information,
researcb, and tecbnical support.
- , The California wine cluster is a
U n t a n g l i n g t h e p a r a d o x o t l o c a t i o n good example it includes 680 com- C" Cj 1 ' • 1 mercial wineries as well as several
g l o b a l eCOnOmV o n e r s i n s i g h t s tbousana independent wine grape ^ y O growers. (See the exhibit "Anatomy
of tbe California Wine Cluster."] An . extensive complement of industries
supporting both wine making and grape growing exists, including sup- pliers of grape stoek, irrigation and
barvesting equipment, barrels, and labels; special- ized public relations and advertising firms; and nu- merous wine publications aimed at consumer and
onomy offers insigt into how companies continually create competitive advantage.
vant. Instead, competitive advantage rests on mak- ing more productive use of inputs, wbicb requires continual innovation.
Untangling the paradox of location in a global economy reveals a number of key insigbts about how companies continually create competitive ad- vantage. Wbat bappens inside companies is impor- tant, but clusters reveal tbat tbe immediate busi- ness environment outside companies plays a vital role as well. Tbis role of locations bas been long overlooked, despite striking evidence tbat innova-
trade audiences. A bost of local institutions is in- volved with wine, such as tbe world-renowned viti- culture and enology program at the University of California at Davis, the Wine Institute, and special committees of tbe California senate and assembly. Tbe cluster also enjoys weaker linkages to otber California clusters in agriculture, food and restau- rants, and wine-country tourism.
78 HARVARD BUSINESS REVIEW November-December 1998
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
ANATOMY OF THE CALl FORN lA WINE CLUSTER
State government agencies
Grape stock
Fertilizer, pesticides, herbicides
Grape harvesting equipment
Irrigation technology
Growers and vineyards
Wineries and processing
facilities
Educational, research, and trade organizations
California agricultural cluster
Wine-making equipment
Barrels
Bottles
Caps and corics
Labels
1 1
Public relations and advertising
Specialized publications
Tourism cluster
Food and restaurant cluster
1
Consider also the Italian leather fashion cluster, which contains well-known shoe companies such as Ferragamo and Gucci as well as a host of special- ized suppliers of footwear components, machin- ery, molds, design services, and tanned leather. (See the exhihit "Mapping the Italian Leather Fashion Cluster.") It also consists of several chains of related industries, including those producing different types of leather goods (linked hy common inputs and technologies) and different types of footwear (linked hy overlapping channels and technologies). These industries employ common marketing me- dia and compete with similar images in similar cus- tomer segments. A related Italian cluster in textile fashion, including clothing, scarves, and acces- sories, produces complementary products that of- ten employ common channels. The extraordinary strength of the Italian leather fashion cluster can he attrihuted, at least in part, to the multiple link- ages and synergies that participating Italian busi- nesses enjoy.
A cluster's boundaries are defined by the linkages and complementarities across industries and insti- tutions that are most important to competition. Al- though clusters often fit within political bound- aries, they may cross state or even national borders. In the United States, for example, a pharmaceuti- cals cluster straddles New Jersey and Pennsylvania
HARVARD BUSINESS REVIEW November-December 1998
near Philadelphia. Similarly, a chemicals cluster in Germany crosses over into German-speaking Switzerland.
Clusters rarely conform to standard industrial classification systems, which fail to capture many important actors and relationships in competition. Thus significant clusters may be obscured or even go unrecognized. In Massachusetts, for example, more than 400 companies, representing at least 39,000 high-paying jobs, are involved in medical de- vices in some way. The cluster long remained all but invisible, however, buried within larger and overlapping industry categories such as electronic equipment and plastic products. Executives in the medical devices cluster have only recently come to- gether to work on issues that will benefit them all.
Clusters promote both competition and coopera- tion. Rivals compete intensely to win and retain customers. Without vigorous competition, a clus- ter will fail. Yet there is also cooperation, much of it vertical, involving companies in related industries and local institutions. Competition can coexist with cooperation because they occur on different dimensions and among different players.
Clusters represent a kind of new spatial organiza- tional form in between arm's-length markets on the one hand and hierarchies, or vertical integra- tion, on the other. A cluster, then, is an alternative
79
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
.MAPPING THE ITALIAN LEATHER EASHION CLUSTER
Tanning equipment
1 Tanneries
Leather-working machinery
Plastk-working equipment
Footwear CAD systems
Speciaiized machine tools
Woodworking equipment
way of organizing the value chain. Compared with market transactions among dispersed and random buyers and sellers, the proximity of companies and institutions in one location-and the repeated ex- changes among them-fosters hetter coordination and trust. Thus clusters mitigate the problems in- herent in arm's-length relationships without im- posing the inflexihilities of vertical integration or the management challenges of creating and main- taining formal linkages such as networks, alliances, and partnerships. A cluster of independent and in- formally linked companies and institutions repre- sents a rohust organizational form that offers ad- vantages in efficiency, effectiveness, and flexibility.
Why Clusters Are Critical to Competition Modern competition depends on productivity, not on access to inputs or the scale of individual enter- prises. Productivity rests on how companies com- pete, not on the particular fields they compete in. Companies can he highly productive in any indus- try-shoes, agriculture, or semiconductors - if they employ sophisticated methods, use advanced tech- nology, and offer unique products and services. All industries can employ advanced technology,- all in- dustries can be knowledge intensive.
The sophistication with which companies com- pete in a particular location, however, is strongly influenced by the quality of the local business en- vironment.' Companies cannot employ advanced logistical techniques, for example, without a high- quality transportation infrastructure. Nor can com- panies effectively compete on sophisticated service without well-educated employees. Businesses can- not operate efficiently under onerous regulatory red tape or under a court system that fails to re- solve disputes quickly and fairly. Some aspects of the business environment, such as the legal sys- tem, for example, or corporate tax rates, affect all industries. In advanced economics, however, the more decisive aspects of the husiness environment are often cluster specific; these constitute some of the most important microeconomic foundations for competition.
Clusters affect competition in three hroad ways: first, hy increasing the productivity of companies hased in the area; second, hy driving the direction and pace of innovation, which underpins future productivity growth; and third, hy stimulating the formation of new husinesses, which expands and strengthens the cluster itself. A cluster allows each member to benefit as if it had greater scale or as if it had joined with others formally-without requir- ing it to sacrifice its flexibility.
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
Clusters and Productivity. Being part of a cluster allows companies to operate more productively in soureing inputs; accessing information, technology, and needed institutions; coordinating with related companies; and measuring and motivating im- provement.
Better Access to Employees and Suppliers. Com- panies in vibrant clusters can tap into an existing pool of specialized and experienced employees, thereby lowering their search and transaction costs in recruiting. Because a cluster signals opportunity and reduces tbe risk of relocation for employees, it can also be easier to attract talented people from other locations, a decisive advantage in some in- dustries.
A well-developed cluster also provides an effi- cient means of obtaining other important inputs. Such a cluster offers a deep and specialized supplier base. Sourcing locally instead of from distant sup- pliers lowers transaction costs. It minimizes the need for inventory, eliminates importing costs and delays, and-because local reputation is import- ant-lowers the risk that suppliers will overprice or renege on commitments. Proximity improves com- munications and makes it easier for suppliers to provide ancillary or support services such as instal- lation and debugging. Other things being equal, then, local outsourcing is a better solution than dis- tant outsourcing, especially for advanced and spe- cialized inputs involving embedded technology, in- formation, and service content.
Formal alliances with distant suppliers can miti- gate some of the disadvantages of distant outsourc- ing. But all formal alliances involve their own complex bargaining and governance problems and can inhibit a company's flexibility. The close, in- formal relationships possible among companies in a cluster are often a su- perior arrangement.
In many cases, clusters are also a better alternative to vertical integra- tion. Compared witb in-house units, outside specialists are often more cost effective and responsive, not only in component production but also in services such as training. Al- though extensive vertical integration may have once been the norm, a fast-changing environment can render vertical integration inefficient, ineffec- tive, and inflexible.
Even when some inputs are best sourced from a distance, clusters offer advantages. Suppliers trying to penetrate a. large, concentrated market will price more aggressively, knowing that as they do so they can realize efficiencies in marketing and in service.
HARVARD BUSINESS REVIEW November-December 1998
Working against a cluster's advantages in assem- bling resources is the possibility that competition will render them more expensive and scarce. But companies do have the alternative of outsourcing many inputs from other locations, which tends to limit potential cost penalties. More important, clusters increase not only the demand for special- ized inputs but also their supply.
Access to Specialized Information. Extensive market, technical, and competitive information accumulates within a cluster, and members have preferred access to it. In addition, personal relation- ships and community ties foster trust and facilitate the flow of information. These conditions make in- formation more transferable.
Complementarities. A bost of linkages among cluster members results in a whole greater than the sum of its parts. In a typical tourism cluster, for ex- ample, the quality of a visitor's experience depends not only on the appeal of the primary attraction but also on the quality and efficiency of complemen- tary businesses such as hotels, restaurants, shop- ping outlets, and transportation facilities. Because members of the cluster are mutually dependent, good performance by one can boost the success of the others.
Complementarities come in many forms. The most obvious is when products complement one another in meeting eustomers' needs, as the tourism example illustrates. Another form is the coordina- tion of activities across companies to optimize their collective productivity. In wood products, for instance, the efficiency of sawmills depends on a
A cluster allows each member to benefit as if it had greater scale or
as if it had joined with others without sacrificing its flexibility.
reliable supply of high-quality timber and the ability to put all tbe timber to use-in furniture (highest quality), pallets and boxes [lower quality), or wood chips (lowest quality). In the early 1990s, Por- tuguese sawmills suffered from poor timber quality because local landowners did not invest in timber management. Hence most timber was processed for use in pallets and boxes, a lower-value use that lim- ited the price paid to landowners. Substantial im- provement in productivity was possible, but only if several parts of the cluster changed simultaneously.
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
Logging operations, for example, had to modify cut- ting and sorting procedures, while sawmills had to develop the capacity to process wood in more so- phisticated ways. Coordination to develop standard wood classifications and measures was an impor-
tant enahling step. Geographically dispersed com- panies are less likely to recognize and capture such linkages.
Other complementarities arise in marketing. A cluster frequently enhances the reputation of a lo-
M A P P I N G SELECTED U.S. CLUSTERS
Here are just some of the clusters in the United States. A few-Hollywood's entertainment cluster and High Point, North Carolina's household-furniture eluster- are well known. Others are less familiar, such as golf equipment in Carlsbad, California, and optics in Phoenix, Arizona. A relatively small number of clus- ters usually account for a major share of the economy within a geographic area as well as for an overwhelm-
ing share of its economic activity that is "exported" to other locations. Exporting clusters - those that export products or make investments to compete outside the local area-are the primary source of an area's eco- nomic growth and prosperity over the long run. The demand for local industries is inherently limited by the size of the local market, but exporting clusters can grow far beyond that limit.
Seattle Aircraft equipment and design Boat and shipbuilding Metal fabrication
Oregon Electrical measuring equipment Woodworking equipment Logging and lumber supplies
L I I boise "̂ """ / ^ ^/sawmills
/ / V Farm machinery
9
Las Vegas Amusements and casinos Small airlines
V Phoenix Helicopters Semiconductors Electronic testing labs Optics
'
Carlsbad Golf equipment
Wisconsin/ Iowa/Illinois Agricultural equipment
Minneapolis Cardiovascular equipment and services
Western Michigan Office and institutional furniture
Michigan Clocks
Detroit Auto equipment and parts
Boston Mutual funds Biotechnology Software and networking Venture capital
Providence Jewelry Marine equipment
Omaha -Telemarketing Hotel reservations Credit card processing
Witchita Light aircraft Farm equipment
Western Massachusetts Polymers
Rochester Imaging equipment
Warsaw, Indiana Orthopedic devices
Cleveland/ Louisville Paints and coatir
Los Angeles area Defense and aerospace Entertainment
Dallas Real estate development
Silicon Valley Microelectronics Biotechnology Venture capital
Colorado Computer-integrated systems and programming Engineering services Mining and oil and gas exploration
Baton Rouge/ New Orleans Specialty foods
Southeastern Texas/ Louisiana Chemicals
Pittsburgh Advanced materials Energy
lartford • ' " Insurance
New York City Financial services
\ Advertising \ Publishing
^A Multimedia
Pennsylvania/ New Jersey Pharmaceuticals
North Carolina Household furniture Synthetic fibers Hosiery
Southern Florida Health technology Computers
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
cation in a particular field, making it more likely that buyers will turn to a vendor based there. Italy's strong reputation for fashion and design, for exam- ple, benefits companies involved in leather goods, footwear, apparel, and accessories. Beyond reputa- tion, cluster memhers often profit from a variety of joint marketing mechanisms, such as company re- ferrals, trade fairs, trade magazines, and marketing delegations.
Finally, complementarities can make buying from a cluster more attractive for customers. Visit- ing huyers can see many vendors in a single trip. They also may perceive their buying risk to be lower because one location provides alternative suppliers. That allows them to multisource or to switch ven- dors if the need arises. Hong Kong thrives as a source of fashion apparel in part for this reason.
Access to Institutions and Public Goods. Invest- ments made by government or other public institu- tions - such as public spending for specialized infra- structure or educational programs-can enhance a company's productivity. The ability to recruit em- ployees trained at local programs, for example, low- ers the cost of internal training. Other quasi-public goods, such as the cluster's information and tech- nology pools and its reputation, arise as natural hy-products of competition.
It is not just governments that create puhlic goods that enhance productivity in the private sector. In- vestments by companies-in training programs, infrastructure, quality centers, testing laboratories, and so on - also contribute to increased productivity. Such private investments are often made collectively because cluster participants recognize the potential for eoUective benefits.
Better Motivation and Measure- ment. Local rivalry is highly moti- vating. Peer pressure amplifies competitive pressure within a clus- ter, even among noncompeting or indirectly competing companies. Pride and the de- sire to look good in the local community spur exec- utives to attempt to outdo one another.
Clusters also often make it easier to measure and compare performances hecause local rivals share general circumstances-for example, labor costs and local market access-and they perform similar activities. Companies within clusters typically have intimate knowledge of their suppliers' costs. Managers are able to compare costs and employees' performance with other local companies. Addition- ally, financial institutions can accumulate knowl- edge about the cluster that can be used to monitor performance.
Clusters and Innovation. In addition to enhanc- ing productivity, clusters play a vital role in a com- pany's ongoing ability to innovate. Some of the same characteristics that enhance current produc- tivity have an even more dramatic effect on innova- tion and productivity growth.
Because sophisticated buyers are often part of a cluster, companies inside clusters usually have a better window on the market than isolated com- petitors do. Computer companies based in Silicon Valley and Austin, Texas, for example, plug into customer needs and trends with a speed difficult to match by companies located elsewhere. The on- going relationships with other entities within the cluster also help companies to learn early about evolving technology, component and machinery availability, service and marketing concepts, and so on. Such learning is facilitated hy the ease of mak- ing site visits and frequent face-to-face contact.
Clusters do more than make opportunities for innovation more visihle. They also provide the ca- pacity and the flexibility to act rapidly. A company within a cluster often can source what it needs to implement innovations more quickly. Local suppli- ers and partners can and do get closely involved in the innovation process, thus ensuring a better match with customers' requirements.
Companies within a cluster can experiment at lower cost and can delay large commitments until they are more assured that a given innovation will pan out. In contrast, a company relying on distant suppliers faces greater challenges in every activity
Peer pressure, pride, and the desire look good in the community spur
executives to outdo one another.
it coordinates with other organizations-in con- tracting, for example, or securing delivery or ob- taining associated technical and service support. Innovation can be even harder in vertically inte- grated companies, especially in those that face diffi- cult trade-offs if the innovation erodes the value of in-house assets or if current products or processes must he maintained while new ones are developed.
Reinforeing the other advantages for innovation is the sheer pressure-competitive pressure, peer pressure, constant comparison-that occurs in a cluster. Executives vie with one another to set their companies apart. For all these reasons, clusters can remain centers of innovation for decades.
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
Clusters and New Business Formation. It is not surprising, then, that many new companies grow up within an existing cluster rather than at isolated locations. New suppliers, for example, proliferate within a cluster hecause a concentrated customer base lowers their risks and makes it easier for them to spot market opportunities. Moreover, hecause developed clusters comprise related industries that normally draw on common or very similar inputs, suppliers enjoy expanded opportunities.
Clusters are conducive to new business forma- tion for a variety of reasons. Individuals working within a cluster can more easily perceive gaps in products or services around which they can build
At tlie intersection of clusters, insights and skills from various fields merge, sparking new businesses.
businesses. Beyond that, barriers to entry are lower than elsewhere. Needed assets, skills, inputs, and staff are often readily available at the cluster loca- tion, waiting to be assembled into a new enterprise. Local financial institutions and investors, already familiar with the cluster, may require a lower risk premium on capital In addition, the cluster often presents a significant local market, and an entrepre- neur may benefit from established relationships. All of these factors reduce the perceived risks of entry - and of exit, should the enterprise fail.
The formation of new businesses within a cluster is part of a positive feedback loop. An expanded cluster amplifies all the benefits I have described- it increases the collective pool of competitive re- sources, which benefits all the cluster's members. The net result is that companies in the cluster ad- vance relative to rivals at other locations.
Birth, Evolution, and Decline A cluster's roots can often be traced to historical circumstances. In Massachusetts, for example, sev- eral clusters had their heginnings in research done at MIT or Harvard. The Dutch transportation clus- ter owes much to Holland's central location within Europe, an extensive network of waterways, the efficiency of the port of Rotterdam, and the skills accumulated by the Dutch through Holland's long maritime history.
Clusters may also arise from unusual, sophisti- cated, or stringent local demand. Israel's cluster in
irrigation equipment and other advanced agricul- tural technologies refiects that nation's strong de- sire for self-sufficiency in food together with a scarcity of water and hot, arid growing conditions. The environmental cluster in Finland emerged as a result of pollution prohlems created hy local pro- cess industries such as metals, forestry, chemicals, and energy.
Prior existence of supplier industries, related in- dustries, or even entire related clusters provides yet another seed for new clusters. The golf equipment cluster near San Diego, for example, has its roots in southern California's aerospace cluster. That clus- ter created a pool of suppliers for castings and ad-
I vanced materials as well as engi- neers with the requisite experience in those technologies.
New clusters may also arise from one or two innovative com- panies that stimulate the growth of many others. Medtronic played this role in helping to create the Minneapolis medical-device clus-
ter. Similarly, MCI and America Online have been hubs for growing new businesses in the telecom- munications cluster in the Washington, D.C., met- ropolitan area.
Sometimes a chance event creates some advanta- geous factor that, in turn, fosters cluster develop- ment-although chance rarely provides the sole ex- planation for a cluster's success in a location. The telemarketing cluster in Omaha, Nehraska, for ex- ample, owes much to the decision by the United States Air Force to locate the Strategic Air Com- mand (SAC) there. Charged with a key role in the country's nuclear deterrence strategy, SAC was the site of the first installation of fiber-optic tele- communications cables in the United States. The local Bell operating company (now U.S. West) de- veloped unusual capabilities through its dealings with such a demanding customer. The extraordi- nary telecommunications capability and infra- structure that consequently developed in Omaha, coupled with less unique attributes such as its cen- tral-time-zone location and easily understandable local accent, provided the underpinnings of the area's telemarketing cluster.
Once a cluster begins to form, a self-reinforcing cycle promotes its growth, especially when local institutions are supportive and local competition is vigorous. As the cluster expands, so does its infiu- ence with government and with public and private institutions.
A growing cluster signals opportunity, and its success stories help attract the best talent. Entre-
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
preneurs take notice, and individuals with ideas or relevant skills migrate in from other locations. Spe- cialized suppliers emerge; information accumu- lates; local institutions develop specialized train- ing, research, and infrastructure; and the cluster's strength and visibility grow. Eventually, the cluster broadens to encompass related industries. Numer- ous case studies suggest that clusters require a decade or more to develop depth and real competi- tive advantage.̂
Cluster development is often particularly vibrant at the intersection of clusters, where insights, skills, and technologies from various fields merge, sparking innovation and new husinesses. An exam- ple from Germany illustrates this point. The coun- try has distinct clusters in both home appliances and household furniture, each hased on different technologies and inputs. At the intersection of the two, though, is a cluster of built-in kitchens and ap- pliances, an area in which Germany commands a higher share of world exports than in either appli- ances or furniture.
Clusters continually evolve as new companies and industries emerge or decline and as local insti- tutions develop and change. They can maintain vi- brancy as competitive locations for centuries; most successful clusters prosper for decades at least. However, they can and do lose their competitive edge due to both external and internal forces. Tech- nological discontinuities are perhaps the most sig- nificant of the external threats because they can neutralize many advantages simultane- ously. A cluster's assets-market infor- mation, employees' skills, scientific and technical expertise, and supplier bases- may all become irrelevant. New Eng- land's loss of market share in golf equip- ment is a good example. The New Eng- land cluster was based on steel shafts, steel irons, and wooden-headed woods. When companies in California began making golf clubs with advanced mate- rials, East Coast producers had difficulty compet- ing. A number of them were acquired or went out of business.
A shift in huyers' needs, creating a divergence he- tween local needs and needs elsewhere, constitutes another external threat. U.S. companies in a variety of clusters, for example, suffered when energy effi- ciency grew in importance in most parts of the world while the United States maintained low en- ergy prices. Lacking both pressure to improve and insight into customer needs, U.S. companies were slow to innovate, and they lost ground to European and Japanese competitors.
HARVARD BUSINESS REVIEW November-Ducember 1998
Clusters are at least as vulnerable to internal rigidities as they are to external threats. Overcon- solidation, mutual understandings, cartels, and other restraints to competition undermine local rivalry. Regulatory infiexihility or the introduction of restrictive union rules slows productivity im- provement. The quality of institutions such as schools and universities can stagnate.
Groupthink among cluster participants - Detroit's attachment to gas-guzzling autos in the 1970s is one example-can be another powerful form of rigidity. If companies in a cluster are too inward looking, the whole cluster suffers from a collective inertia, making it harder for individual companies to embrace new ideas, much less perceive the need for radical innovation.
Such rigidities tend to arise when government suspends or intervenes in competition or when companies persist in old behaviors and relation- ships that no longer contribute to competitive ad- vantage. Increases in the cost of doing business begin to outrun the ability to upgrade. Rigidities of this nature currently work against a variety of clus- ters in Switzerland and Germany.
As long as rivalry remains sufficiently vigorous, companies can partially compensate for some de- cline in the cluster's competitiveness by outsourc- ing to distant suppliers or moving part or all of pro- duction elsewhere to offset local wages that rise ahead of productivity. German companies in the 1990s, for example, have been doing just that. Tech-
The term high tech has created the misconception that only a
handM of businesses compete in sophisticated ways.
nology can be licensed or sourced from otber loca- tions, and product development can be moved. Over time, however, a location will decline if it fails to build capabilities in major new technologies or needed supporting firms and institutions.
Implications for Companies In the new economics of competition, what mat- ters most is not inputs and scale, hut productivity- and that is true in all industries. The term high tech, normally used to refer to fields such as infor- mation technology and biotechnology, has distorted
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CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
CLUSTERS, GEOGRAPHY, AND ECONOMIC DEVELOPMENT
Poor countries lack well-developed clusters; they compete in the world market with cheap labor and natural resources. To move beyond this stage, the de- velopment of well-functioning clusters is essential. Clusters become an especially controlling factor for countries moving from a middle-income to an ad- vaneed economy. Even in high-wage economies, how- ever, the need for cluster upgrading is constant. The wealthier the economy, the more it will require inno- vation to support rising wages and to replace jobs eliminated by improvements in efficiency and the mi- gration of standard production to low-cost areas.
Promoting cluster formation in developing econo- mies means starting at the most basic level. Policy- makers must first address the foundations: improving education and skill levels, huilding capacity in tech- nology, opening access to capital markets, and im- proving institutions. Over time, additional invest- ment in more cluster-specific assets is necessary.
Government policies in developing economies of- ten unwittingly work against cluster formation. Re- strictions on industrial location and subsidies to in- vest in distressed areas, for example, can disperse companies artificially. Protecting local companies from competition leads to excessive vertical integra- tion and blunted pressure for innovation, retarding cluster development.
In the early stages of economic development, coun- tries should expand internal trade among cities and states and trade with neighboring countries as impor- tant stepping stones to building the skills to compete globally. Such trade greatly enhances cluster develop- ment. Instead, attention is typically riveted on the large, advanced markets, an orientation that has often been reinforced by protectionist policies restricting trade with nearby markets. However, the kinds of goods developing countries can trade with advanced economies are limited to commodities and to activi- ties sensitive to labor costs.
While it is essential that clusters form, where they form also matters. In developing economies, a large
proportion of economic activity tends to concentrate around capital cities such as Bangkok and Bogota. That is usually because outlying areas lack infrastruc- ture, institutions, and suppliers. It may also reflect an intrusive role by the central government in control- ling competition, leading companies to locate near the seat of power and the agencies whose approval they re- quire to do business.
This pattern of economic geography inflicts high costs on productivity. Congestion, bottlenecks, and inflexibility lead to high administrative costs and ma- jor inefficiencies, not to mention a diminished quality of life. Companies cannot easily move out from the center, however, because neither infrastructure nor rudimentary clusters exist in the smaller cities and towns. (The building of a tourism cluster in develop- ing economies can be a positive force in improving the outlying infrastructure and in dispersing economic activity.)
Even in advanced economies, however, economic activity may be geographically concentrated, (apan offers a particularly striking case, with nearly 50% of total manufacturing shipments located around Tokyo and Osaka, This is due less to inadequacies in infra- structure in outlying areas than to a powerful and in- trusive central government, with its centralizing bias in policies and institutions. The Japanese case vividly illustrates the major inefficiencies and productivity costs resulting from such a pattern of economic geog- raphy, even for advanced nations. It is a major policy issue facing Japan.
An economic geography characterized by specializa- tion and dispersion - that is, a number of metropolitan areas, each specializing in an array of clusters - appears to be a far more productive industrial organization than one based on one or two huge, diversified cities. In nations such as Germany, Italy, Switzerland, and the United States, this kind of internal specialization and trade - and internal competition among locations - fuels productivity growth and hones the ahility of companies to compete effectively in the global arena.
thinking about competition, creating the miscon- ception that only a handful of husinesses compete in sophisticated ways.
In fact, there is no such thing as a low-tech indus- try. There are only low-tech companies - that is, companies that fail to use world-class technology and practices to enhance productivity and inno-
vation. A vibrant cluster can help any company in any industry compete in the most sophisticated ways, using the most advanced, relevant skills and technologies.
Thus executives must extend their thinking be- yond what goes on inside their own organizations and within their own industries. Strategy must also
86 HARVARD BUSINESS REVIEW November-December 1998
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
MAPPING PORTUGAL'S CLUSTERS
In a middle-income economy like Portugal, exporting clus- ters tend to be more natural-resource or labor intensive.
Cotton textiles Leather
Furniture
Casual shoes Dairy
Clothing Dress shoes
Cork stoppers
Ceramic tiles
Pulp and paper
Plastic molds
Pine wood furniture
Fruit
Leather Tourism
Automotive Cork-transformed products
Tourism
Cork agglomerates
Sheep and goats
Port wine
Automotive components
Clothing Red wine
Wool textiles
Clothing
Clothing
Ornamental stone
Red wine
Tourism
Horticulture
address what goes on outside. Extensive vertical integration may once have been appropriate, but companies today must forge close linkages with buyers, suppliers, and other institutions.
Specifically, understanding clusters adds the fol- lowing four issues to the strategic agenda.
1. Choosing Locations. Globalization and the ease of transportation and communication have led many companies to move some or all of their opera- tions to locations with low wages, taxes, and utility costs. What we know about clusters suggests, first, that some of those cost advantages may well turn out to be illusory. Locations with those advantages often lack efficient infrastructure, sophisticated suppliers, and other cluster benefits that can more than offset any savings from lower input costs. Sav-
ings in wages, utilities, and taxes may be highly visible and easy to measure up front, but productivity penalties remain hidden and unanticipated.
More important to ongoing competitive- ness is the role of location in innovation. Yes, companies have to spread activities globally to source inputs and gain access to markets. Failure to do so will lead to a com- petitive disadvantage. And for stable, labor- intensive activities such as assembly and software translation, low factor costs are often decisive in driving locational choices.
For a company's "home base" for each product line, however, clusters are critical. Home base activities-strategy develop- ment, core product and process R&D, a crit- ical mass of the most sophisticated produc- tion or service provision - create and renew the company's product, processes, and ser- vices. Therefore locational decisions must be based on both total systems costs and in- novation potential, not on input costs alone. Cluster thinking suggests that every product line needs a home base, and the most vibrant cluster will offer the best location. Within the United States, for example, Hewlett- Packard has chosen cluster locations for the home bases of its major product lines: Cali- fornia, where almost all of the world's lead- ing personal computer and workstation businesses are loeated, is home to personal computers and workstations,- Massachu- setts, which has an extraordinary concentra- tion of world-renowned research hospitals and leading medical instrument companies, is home to medical instruments.
As global competition nullifies traditional comparative advantages and exposes com-
panies to the best rivals from around the world, a growing number of multinationals are shifting their home bases to more vibrant clusters-often using acquisitions as a means of establishing them- selves as insiders in a new loeation. Nestle, for ex- ample, after acquiring Rowntree Mackintosh, relo- cated its confectionary business to York, England, where Rowntree was originally based, because a vi- brant food cluster thrives there. England, with its sweet-toothed consumers, sophisticated retailers, advanced advertising agencies, and highly competi- tive media companies, constitutes a more dynamic environment for competing in mass-market candy than Switzerland did. Similarly, Nestle has moved its headquarters for bottled water to France, the most competitive location in that industry. North-
HARVARD BUSINESS REVIEW November-Dec ember 1998 87
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
ern Telecom has relocated its home hase for central office switching from Canada to the United States - drawn by the vibrancy of the U.S. telecommunica- tions-equipment cluster.
Cluster thinking also suggests that it is better to move groups of linked aetivities to the same place than to spread them across numerous locations. Colocating R&D, component fabrication, assem- bly, marketing, customer support, and even related businesses can facilitate internal efficiencies in sourcing and in sharing technology and informa- tion. Grouping activities into campuses also allows companies to extend deeper roots into local clus- ters, improving their ability to capture potential benefits.
2. Engaging Locally. The social glue that binds clusters together also facilitates access to impor- tant resources and information. Tapping into the competitively valuahle assets within a eluster re- quires personal relationships, face-to-face contact, a sense of common interest, and "insider" status. The mere colocation of companies, suppliers, and institutions creates the potential for economic value; it does not necessarily ensure its realization.
To maximize the benefits of cluster involvement, companies must participate actively and establish a signifieant local presence. They must have a sub- stantial local investment even if the parent com- pany is headquartered elsewhere. And they must foster ongoing relationships with government bod- ies and local institutions such as utilities, schools, and research groups.
Companies have much to gain by engaging be- yond their narrow confines as single entities. Yet managers tend to be wary, at least initially. They fear that a growing cluster will attract competition.
Tapping into the competitively valuable assets witliin a cluster requires personal relationships and "insider" status.
drive up costs, or cause them to lose valued em- ployees to rivals or spin-offs. As their understand- ing of the cluster concept grows, however, man- agers realize that many participants in the cluster do not compete directly and that the offsetting benefits, such as a greater supply of better trained people, for example, can outweigh any increase in competition.
3. Upgrading the Cluster. Because the health of the local business environment is important to the health of the company, upgrading the cluster should be part of management's agenda. Companies upgrade their clusters in a variety of ways.
Consider Genzyme. Massachusetts is home to a vibrant biotechnology cluster, which draws on the region's strong universities, medical centers, and venture capital firms. Once Genzyme reached the stage in its development when it needed a manufac- turing facility, CEO Henri Termeer initially consid- ered the Pharmaceuticals cluster in the New Jersey and Philadelphia area because it had what Massa- chusetts lacked: established expertise in drug man- ufacturing. Upon further reflection, however, Ter- meer decided to influence the process of creating a manufacturing capability in Genzyme's home base, reasoning that if his plans were successful, the company could become more competitive.
Thus Genzyme deliberately ehose to work with contractors committed to the Boston area, bypass- ing the many speeialized engineering firms located near Philadelphia. In addition, it undertook a num- ber of initiatives, with tbe help of city and state government, to improve the labor force, such as of- fering scholarships and internships to local youth. More broadly, Genzyme has worked to build criti- cal mass for its cluster. Termeer believes that Gen- zyme's success is linked to the cluster's-and that all members will benefit from a strong base of sup- porting functions and institutions.
4. Working Collectively. The way clusters oper- ate suggests a new agenda of collective action in the private sector. Investing in public goods is normally seen as a function of government, yet cluster think- ing clearly demonstrates how companies benefit
from local assets and institutions. In the past, collective action in the
private sector has focused on seeking government subsidies and special fa- vors that often distort competition. But executives' long-term interests would be better served by working to promote a higher plane of competi- tion. They can begin by rethinking the role of trade associations, which often do little more than lobby gov-
ernment, compile some statistics, and host social functions. The associations are missing an impor- tant opportunity.
Trade associations can provide a forum for the ex- change of ideas and a focal point for collective ac- tion in overcoming ohstacles to productivity and growth. Associations can take the lead in such ac- tivities as establishing university-based testing fa-
88 HARVARD BUSINESS REVIEW November-December 1998
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
cilitics and training or research programs; collect- ing cluster-related information; offering forums on common managerial problems; investigating solu- tions to environmental issues; organizing trade fairs and delegations; and managing purchasing consort ia.
For clusters consisting of many small and mid- size companies - such as tourism, apparel, and agri- culture - the need is particularly great for collective bodies to assume scale-sensitive functions. In the Netherlands, for instance, grower cooperatives built the specialized auction and handling facih- ties that constitute one of the Dutch flower cluster's greatest competitive advantages. The Dutch Flower Coun- cil and the Association of Dutch Flower Growers Research Groups, in which most growers participate, have taken on other functions as well, such as applied research and marketing.
Most existing trade associations are too narrow; they represent industries, not clusters. In addition, hecausc their role is defined as lobbying the federal government, their scope is national rather than local. National associations, however, are rarely sufficient to ad- dress the local issues that are most important to cluster productivity.
By revealing how husiness and government to- gether create the conditions that promote growth, clusters offer a constructive way to change the na- ture of the dialogue between the public and private sectors. With a better understanding of what fosters true competitiveness, executives can start asking government for the right things. The example of MassMEDIC, an association formed in 1996 by the Massachusetts medical-devices cluster, illustrates this point. It recently worked successfully with the U.S. Food and Drug Administration to streamline the approval process for medical devices. Such a step clearly henefits cluster members and enhances competition at the same time.
What's Wrong with Industrial Policy Productivity, not exports or natural resources, de- termmcs the prosperity of any state or nation. Rec- ognizing this, governments should strive to create an environment that supports rising productivity. Sound macroeconomic policy is necessary but not sufficient. The microeconomic foundations for competition will ultimately determine productivity and competitiveness.
Governments-both national and local-have new roles to play. They must ensure the supply of
HARVARD BUSINESS REVIEW November-December 1998
high-quality inputs such as educated citizens and physical infrastructure. They must set the rules of competition-hy protecting intellectual property and enforcing antitrust laws, for example-so that productivity and innovation will govern success in the economy. Finally, governments should pro- mote cluster formation and upgrading and the buildup of public or quasi-public goods that have a significant impact on many linked husinesses.
This sort of role for government is a far cry from industrial policy. In industrial policy, governments target "desirable" industries and intervene-through
Clusters offer a constructive way to change the nature of the
dialogue between the public and private sectors.
subsidies or restrictions on investments by foreign companies, for example-to favor local companies. In contrast, the aim of cluster policy is to reinforce the development of all clusters. This means that a traditional cluster such as agriculture should not he ahandoned; it should be upgraded. Governments should not choose among clusters, because each one offers opportunities to improve productivity and support rising wages. Every cluster not only contributes directly to national productivity but also affects the productivity of other clusters. Not all clusters will succeed, of course, but market forces-not government decisions-should deter- mine the outcomes.
Government, working with the private sector, should reinforce and build on existing and emerg- ing clusters rather than attempt to create entirely new ones. Successful new industries and clusters often grow out of established ones. Businesses in- volving advanced technology succeed not in a vacu- um but where there is already a base of related ac- tivities in the field. In fact, most clusters form independently of government action-and some- times in spite of it. They form where a foundation of locational advantages exists. To justify cluster development efforts, some seeds of a cluster should have already passed a market test.
Cluster development initiatives should embrace the pursuit of competitive advantage and special- ization rather than simply imitate successful clus- ters in other locations. This requires building on local sources of uniqueness. Finding areas of spe-
CLUSTERS AND THE NEW ECONOMICS OF COMPETITION
cialization normally proves more effective than head-on competition with well-established rival locations.
New Public-Private Responsibilities Economic geography in an era of glohal competi- tion, then, poses a paradox. In a glohal economy- which hoasts rapid transportation, high-speed com- munication, and accessible markets-one would expect location to diminish in importance. But the opposite is true. The enduring competitive advan- tages in a global economy are often heavily local, arising from concentrations of highly specialized skills and knowledge, institutions, rivals, related businesses, and sophisticated eustomers. Geo- graphic, cultural, and institutional proximity leads to speeial access, closer relationships, better infor- mation, powerful incentives, and other advantages in productivity and innovation that are difficult to tap from a distance. Tbe more the world economy becomes complex, knowledge based, and dynamic, the more tbis is true.
Leaders of businesses, government, and institu- tions all bave a stake - and a role to play - in tbe new economics of competition. Clusters reveal the mu- tual dependence and collective responsibility of all
these entities for creating the conditions for pro- ductive competition. This task will require fresh thinking on the part of leaders and the willingness to abandon tbe traditional categories tbat drive our thinking about wbo does what in tbe economy. Tbe lines between public and private investment blur. Companies, no less tban governments and univer- sities, have a stake in education. Universities have a stake in the competitiveness of local businesses. By revealing tbe process by whieb wealtb is actually created in an economy, clusters open new public- private avenues for constructive action.
1.1 first made this argument in The Competitive AdvantdRc of Nations (New York: Free Press, 1990). 1 modeled tht effect of the local business en- vironment on competition in terms of four interrelated influences, grapb- icdlly depicted in a diamond: factor conditions (the cost and quality of in- puts); demand conditions (the sophistication of local customers|; the context for firm strategy and rivalry (the nature and intensity of local competition); and related and suppoitiiig industries |thc local extent and sophistication of suppliers and related industries). Diamonil theory stresses how these elements combine to produce a dynamic, stimulating, and intensely competitive business environment.
A duster is the manifestation of rhe diamond at work. Proximity - the colocation of companies, customers, and suppliers-amplifies all of the pressures to innovate and upgrade.
2. Selected case studies are described in "Clusters and Competition" in my book On Competition [Boston: Harvard Business Schtxil Press, 199KI, which also includes citations of the published output of a numhi-r of clus- ter initiatives. Readers can also find a full treatment of the iiitcUoitual roots of cluster thinking, along with an extensive bibliography.
Reprint 98609 To order reprints, see the last page of this issue.
"It's not as if we're insensitive, Haywaid. Every time we fire someone we plant a tree.
90 HARVARD BUSINESS REVIEW November-December 199K
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