paradoxically, the enduring competitive advantages in a ... · volve d wit h wine, suc as tbe...

Paradoxically, the enduring competitiveadvantages in a global economy lie

increasingly in local things-knowledge,relationships, and motivation that

distant rivals cannot match.

CLUSTERSAND THE NEW

ECONOMICS OfCOMPETITION

BY MICHAEL E. PORTER

Now THAT COMPANIES can source capital;goods, information, and technology from

around the world, often with the click of amouse, much of the conventional wisdomahout how companies and nations competeneeds to he overhauled. In theory, more openglohal markets and faster transportation andcommunication should diminish the role oflocation in competition. After all, anythingthat can he efficiently sourced from a distancethrough glohal markets and corporate networksis availahle to any company and therefore isessentially nullified as a source of competitiveadvantage.Michael E. Porter is the C. Roland Chiistensen Professor ofBusiness Administration at the Harvard Business School inBoston, Massachusetts. Further discussion of clusters can befound in two new essays-"Clusters and Competition" and"Competing Across Locations" - in his new collection titledOn Competition (Harvard Business School Press, 1998}.

HARVARD BUSINESS REVIEW November-December 1998 77

CLUSTERS AND THE NEW ECONOMICS OF COMPETITION

But if location matters less, why, then, is it truethat the odds of finding a world-class mutual-fundcompany in Boston are much higher than in mostany other place? Why could the same be said oftextile-related companies in North Carolina andSouth 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 dominatedby wbat I call clusters: critical masses-in oneplace-of unusual competitive success in particularfields. Clusters are a striking feature of virtuallyevery national, regional, state, and even metropoli-tan economy, especially in more economically ad-vanced nations. Silicon Valley and Hollywood maybe the world's best-known clusters. Clusters arenot unique, bowever; they are bigbly typical-andtberein lies a paradox: tbe enduring competitiveadvantages in a global economy lie increasingly inlocal 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 drivenbeavily by input costs, locations witb some impor-tant endowment-a natural barbor, for example, ora 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-costdisadvantages tbrough global sourcing, renderingtbe old notion of comparative advantage less rele-

tion and competitive success in so many fields aregeographically concentrated-wbetber it's enter-tainment in Hollywood, finance on Wall Street, orconsumer eleetronics in Japan.

Clusters affect competitiveness witbin countriesas well as across national borders. Tberefore, tbeylead 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 contributeto competitive success, and bow governments canpromote economic development and prosperity

What Is a Cluster?clusters are geograpbic concentrations of intercon-nected companies and institutions in a particularfield. Clusters encompass an array of linked indus-tries and other entities important to competition.They include, for example, suppliers of speeializedinputs sucb as components, macbinery, and ser-vices, and providers of specialized infrastructure.Clusters also often extend downstream to ebannelsand customers and laterally to manufacturers ofcomplementary products and to companies in in-dustries related by skills, tecbnologies, or commoninputs. Finally, many clusters include governmen-tal and other institutions - sucb as universities,standards-setting agencies, tbink tanks, vocationaltraining providers, and trade associations - tbat pro-vide specialized training, education, information,

researcb, and tecbnical support.- , The California wine cluster is a

Untang l ing the paradox ot loca t ion good example it includes 680 com-C" Cj 1 ' • 1 mercial wineries as well as several

global eCOnOmV oners ins ights 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 andgrape 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 insigtinto how companies continuallycreate competitive advantage.vant. Instead, competitive advantage rests on mak-ing more productive use of inputs, wbicb requirescontinual innovation.

Untangling the paradox of location in a globaleconomy reveals a number of key insigbts abouthow 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 vitalrole as well. Tbis role of locations bas been longoverlooked, 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 ofCalifornia at Davis, the Wine Institute, and specialcommittees of tbe California senate and assembly.Tbe cluster also enjoys weaker linkages to otberCalifornia clusters in agriculture, food and restau-rants, and wine-country tourism.

78 HARVARD BUSINESS REVIEW November-December 1998


ANATOMY OF THE CALl FORN lA WINE CLUSTER

State government agencies

Grape stock

Fertilizer, pesticides, herbicides

Grape harvesting equipment

Irrigation technology

Growers andvineyards

Wineries andprocessing

facilities

Educational, research, andtrade organizations

California agricultural cluster

Wine-making equipment

Barrels

Bottles

Caps and corics

Labels

11

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 suchas Ferragamo and Gucci as well as a host of special-ized suppliers of footwear components, machin-ery, molds, design services, and tanned leather. (Seethe exhihit "Mapping the Italian Leather FashionCluster.") It also consists of several chains of relatedindustries, including those producing differenttypes of leather goods (linked hy common inputsand 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 textilefashion, including clothing, scarves, and acces-sories, produces complementary products that of-ten employ common channels. The extraordinarystrength of the Italian leather fashion cluster canhe 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 linkagesand 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 inGermany crosses over into German-speakingSwitzerland.

Clusters rarely conform to standard industrialclassification systems, which fail to capture manyimportant actors and relationships in competition.Thus significant clusters may be obscured or evengo unrecognized. In Massachusetts, for example,more than 400 companies, representing at least39,000 high-paying jobs, are involved in medical de-vices in some way. The cluster long remained allbut invisible, however, buried within larger andoverlapping industry categories such as electronicequipment and plastic products. Executives in themedical 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 retaincustomers. Without vigorous competition, a clus-ter will fail. Yet there is also cooperation, much of itvertical, involving companies in related industriesand local institutions. Competition can coexistwith cooperation because they occur on differentdimensions and among different players.

Clusters represent a kind of new spatial organiza-tional form in between arm's-length markets onthe one hand and hierarchies, or vertical integra-tion, on the other. A cluster, then, is an alternative

79


.MAPPING THE ITALIAN LEATHER EASHION CLUSTER

Tanning equipment

1Tanneries

Leather-working machinery

Plastk-working equipment

Footwear CAD systems

Speciaiized machine tools

Woodworking equipment

way of organizing the value chain. Compared withmarket transactions among dispersed and randombuyers and sellers, the proximity of companies andinstitutions in one location-and the repeated ex-changes among them-fosters hetter coordinationand trust. Thus clusters mitigate the problems in-herent in arm's-length relationships without im-posing the inflexihilities of vertical integration orthe 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 toCompetitionModern competition depends on productivity, noton 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 theyemploy sophisticated methods, use advanced tech-nology, and offer unique products and services. Allindustries can employ advanced technology,- all in-dustries can be knowledge intensive.

The sophistication with which companies com-pete in a particular location, however, is stronglyinfluenced by the quality of the local business en-vironment.' Companies cannot employ advancedlogistical techniques, for example, without a high-quality transportation infrastructure. Nor can com-panies effectively compete on sophisticated servicewithout well-educated employees. Businesses can-not operate efficiently under onerous regulatoryred tape or under a court system that fails to re-solve disputes quickly and fairly. Some aspects ofthe business environment, such as the legal sys-tem, for example, or corporate tax rates, affect allindustries. In advanced economics, however, themore decisive aspects of the husiness environmentare often cluster specific; these constitute some ofthe most important microeconomic foundationsfor competition.

Clusters affect competition in three hroad ways:first, hy increasing the productivity of companieshased in the area; second, hy driving the directionand pace of innovation, which underpins futureproductivity growth; and third, hy stimulating theformation of new husinesses, which expands andstrengthens the cluster itself. A cluster allows eachmember to benefit as if it had greater scale or as ifit had joined with others formally-without requir-ing it to sacrifice its flexibility.



Clusters and Productivity. Being part of a clusterallows companies to operate more productively insoureing inputs; accessing information, technology,and needed institutions; coordinating with relatedcompanies; and measuring and motivating im-provement.

Better Access to Employees and Suppliers. Com-panies in vibrant clusters can tap into an existingpool of specialized and experienced employees,thereby lowering their search and transaction costsin recruiting. Because a cluster signals opportunityand reduces tbe risk of relocation for employees,it can also be easier to attract talented people fromother 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 supplierbase. Sourcing locally instead of from distant sup-pliers lowers transaction costs. It minimizes theneed for inventory, eliminates importing costs anddelays, and-because local reputation is import-ant-lowers the risk that suppliers will overprice orrenege on commitments. Proximity improves com-munications and makes it easier for suppliers toprovide 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 involvetheir own complex bargaining andgovernance problems and can inhibita company's flexibility. The close, in-formal relationships possible amongcompanies in a cluster are often a su-perior arrangement.

In many cases, clusters are also abetter alternative to vertical integra-tion. Compared witb in-house units,outside specialists are often more costeffective and responsive, not only in componentproduction but also in services such as training. Al-though extensive vertical integration may haveonce been the norm, a fast-changing environmentcan render vertical integration inefficient, ineffec-tive, and inflexible.

Even when some inputs are best sourced from adistance, clusters offer advantages. Suppliers tryingto penetrate a. large, concentrated market will pricemore aggressively, knowing that as they do so theycan realize efficiencies in marketing and in service.


Working against a cluster's advantages in assem-bling resources is the possibility that competitionwill render them more expensive and scarce. Butcompanies do have the alternative of outsourcingmany inputs from other locations, which tends tolimit potential cost penalties. More important,clusters increase not only the demand for special-ized inputs but also their supply.

Access to Specialized Information. Extensivemarket, technical, and competitive informationaccumulates within a cluster, and members havepreferred access to it. In addition, personal relation-ships and community ties foster trust and facilitatethe flow of information. These conditions make in-formation more transferable.

Complementarities. A bost of linkages amongcluster members results in a whole greater than thesum of its parts. In a typical tourism cluster, for ex-ample, the quality of a visitor's experience dependsnot only on the appeal of the primary attraction butalso on the quality and efficiency of complemen-tary businesses such as hotels, restaurants, shop-ping outlets, and transportation facilities. Becausemembers of the cluster are mutually dependent,good performance by one can boost the success ofthe others.

Complementarities come in many forms. Themost obvious is when products complement oneanother in meeting eustomers' needs, as the tourismexample illustrates. Another form is the coordina-tion of activities across companies to optimizetheir collective productivity. In wood products, forinstance, the efficiency of sawmills depends on a

A cluster allows each member tobenefit as if it had greater scale or

as if it had joined with otherswithout sacrificing its flexibility.

reliable supply of high-quality timber and the abilityto put all tbe timber to use-in furniture (highestquality), pallets and boxes [lower quality), or woodchips (lowest quality). In the early 1990s, Por-tuguese sawmills suffered from poor timber qualitybecause local landowners did not invest in timbermanagement. Hence most timber was processed foruse 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 ifseveral parts of the cluster changed simultaneously.

81


Logging operations, for example, had to modify cut-ting and sorting procedures, while sawmills had todevelop the capacity to process wood in more so-phisticated ways. Coordination to develop standardwood classifications and measures was an impor-

tant enahling step. Geographically dispersed com-panies are less likely to recognize and capture suchlinkages.

Other complementarities arise in marketing. Acluster frequently enhances the reputation of a lo-

MAPPING SELECTED U.S. CLUSTERS

Here are just some of the clusters in the United States.A few-Hollywood's entertainment cluster and HighPoint, North Carolina's household-furniture eluster-are well known. Others are less familiar, such as golfequipment in Carlsbad, California, and optics inPhoenix, Arizona. A relatively small number of clus-ters usually account for a major share of the economywithin a geographic area as well as for an overwhelm-

ing share of its economic activity that is "exported" toother locations. Exporting clusters - those that exportproducts or make investments to compete outsidethe local area-are the primary source of an area's eco-nomic growth and prosperity over the long run. Thedemand for local industries is inherently limited bythe size of the local market, but exporting clusters cangrow far beyond that limit.

SeattleAircraft equipment and designBoat and shipbuildingMetal fabrication

OregonElectrical measuring equipmentWoodworking equipmentLogging and lumber supplies

L I I boise "̂ """/ ^ ^/sawmills

/ / V Farm machinery

9

Las VegasAmusements andcasinosSmall airlines

V PhoenixHelicoptersSemiconductorsElectronictesting labsOptics

'

CarlsbadGolf equipment

Wisconsin/Iowa/IllinoisAgriculturalequipment

MinneapolisCardiovascularequipment andservices

Western MichiganOffice andinstitutionalfurniture

MichiganClocks

DetroitAutoequipmentand parts

BostonMutual fundsBiotechnologySoftware andnetworkingVenture capital

ProvidenceJewelryMarine equipment

Omaha-TelemarketingHotel reservationsCredit card processing

WitchitaLight aircraftFarm equipment

WesternMassachusettsPolymers

RochesterImagingequipment

Warsaw,IndianaOrthopedicdevices

Cleveland/LouisvillePaints and coatir

Los Angeles areaDefense and aerospaceEntertainment

DallasReal estatedevelopment

Silicon ValleyMicroelectronicsBiotechnologyVenture capital

ColoradoComputer-integratedsystems and programmingEngineering servicesMining and oil andgas exploration

Baton Rouge/New OrleansSpecialty foods

Southeastern Texas/LouisianaChemicals

PittsburghAdvancedmaterialsEnergy

lartford• ' " Insurance

New York CityFinancial services

\ Advertising\ Publishing

^A Multimedia

Pennsylvania/New JerseyPharmaceuticals

North CarolinaHousehold furnitureSynthetic fibersHosiery

Southern FloridaHealth technologyComputers



cation in a particular field, making it more likelythat buyers will turn to a vendor based there. Italy'sstrong 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 ofjoint marketing mechanisms, such as company re-ferrals, trade fairs, trade magazines, and marketingdelegations.

Finally, complementarities can make buyingfrom 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 lowerbecause one location provides alternative suppliers.That allows them to multisource or to switch ven-dors if the need arises. Hong Kong thrives as asource 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 acompany's productivity. The ability to recruit em-ployees trained at local programs, for example, low-ers the cost of internal training. Other quasi-publicgoods, such as the cluster's information and tech-nology pools and its reputation, arise as naturalhy-products of competition.

It is not just governments that create puhlic goodsthat 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 oftenmade collectively because clusterparticipants recognize the potentialfor eoUective benefits.

Better Motivation and Measure-ment. Local rivalry is highly moti-vating. Peer pressure amplifiescompetitive pressure within a clus-ter, even among noncompeting orindirectly 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 andcompare performances hecause local rivals sharegeneral circumstances-for example, labor costsand local market access-and they perform similaractivities. Companies within clusters typicallyhave 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 monitorperformance.

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 thesame characteristics that enhance current produc-tivity have an even more dramatic effect on innova-tion and productivity growth.

Because sophisticated buyers are often part ofa cluster, companies inside clusters usually have abetter window on the market than isolated com-petitors do. Computer companies based in SiliconValley and Austin, Texas, for example, plug intocustomer needs and trends with a speed difficultto match by companies located elsewhere. The on-going relationships with other entities within thecluster also help companies to learn early aboutevolving technology, component and machineryavailability, service and marketing concepts, and soon. Such learning is facilitated hy the ease of mak-ing site visits and frequent face-to-face contact.

Clusters do more than make opportunities forinnovation more visihle. They also provide the ca-pacity and the flexibility to act rapidly. A companywithin a cluster often can source what it needs toimplement innovations more quickly. Local suppli-ers and partners can and do get closely involvedin the innovation process, thus ensuring a bettermatch with customers' requirements.

Companies within a cluster can experiment atlower cost and can delay large commitments untilthey are more assured that a given innovation willpan out. In contrast, a company relying on distantsuppliers faces greater challenges in every activity

Peer pressure, pride, and the desirelook 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 ofin-house assets or if current products or processesmust he maintained while new ones are developed.

Reinforeing the other advantages for innovationis the sheer pressure-competitive pressure, peerpressure, constant comparison-that occurs in acluster. Executives vie with one another to set theircompanies apart. For all these reasons, clusters canremain centers of innovation for decades.

HARVARD BUSINESS REVIEW November-December 1998 83


Clusters and New Business Formation. It is notsurprising, then, that many new companies growup within an existing cluster rather than at isolatedlocations. New suppliers, for example, proliferatewithin a cluster hecause a concentrated customerbase lowers their risks and makes it easier for themto spot market opportunities. Moreover, hecausedeveloped clusters comprise related industries thatnormally 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 workingwithin a cluster can more easily perceive gaps inproducts or services around which they can build

At tlie intersection of clusters,insights and skills from various fieldsmerge, sparking new businesses.businesses. Beyond that, barriers to entry are lowerthan elsewhere. Needed assets, skills, inputs, andstaff are often readily available at the cluster loca-tion, waiting to be assembled into a new enterprise.Local financial institutions and investors, alreadyfamiliar with the cluster, may require a lower riskpremium on capital In addition, the cluster oftenpresents a significant local market, and an entrepre-neur may benefit from established relationships.All of these factors reduce the perceived risks ofentry - and of exit, should the enterprise fail.

The formation of new businesses within a clusteris part of a positive feedback loop. An expandedcluster 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 DeclineA cluster's roots can often be traced to historicalcircumstances. In Massachusetts, for example, sev-eral clusters had their heginnings in research doneat MIT or Harvard. The Dutch transportation clus-ter owes much to Holland's central location withinEurope, an extensive network of waterways, theefficiency of the port of Rotterdam, and the skillsaccumulated by the Dutch through Holland's longmaritime 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 ascarcity of water and hot, arid growing conditions.The environmental cluster in Finland emerged asa 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 yetanother seed for new clusters. The golf equipmentcluster near San Diego, for example, has its roots insouthern 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 experiencein those technologies.

New clusters may also arisefrom one or two innovative com-panies that stimulate the growthof many others. Medtronic playedthis role in helping to create theMinneapolis medical-device clus-

ter. Similarly, MCI and America Online have beenhubs 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. Thetelemarketing cluster in Omaha, Nehraska, for ex-ample, owes much to the decision by the UnitedStates Air Force to locate the Strategic Air Com-mand (SAC) there. Charged with a key role in thecountry's nuclear deterrence strategy, SAC wasthe site of the first installation of fiber-optic tele-communications cables in the United States. Thelocal Bell operating company (now U.S. West) de-veloped unusual capabilities through its dealingswith 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 understandablelocal accent, provided the underpinnings of thearea's telemarketing cluster.

Once a cluster begins to form, a self-reinforcingcycle promotes its growth, especially when localinstitutions are supportive and local competition isvigorous. As the cluster expands, so does its infiu-ence with government and with public and privateinstitutions.

A growing cluster signals opportunity, and itssuccess stories help attract the best talent. Entre-



preneurs take notice, and individuals with ideas orrelevant 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'sstrength and visibility grow. Eventually, the clusterbroadens to encompass related industries. Numer-ous case studies suggest that clusters require adecade or more to develop depth and real competi-tive advantage.̂

Cluster development is often particularly vibrantat 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 appliancesand household furniture, each hased on differenttechnologies and inputs. At the intersection of thetwo, though, is a cluster of built-in kitchens and ap-pliances, an area in which Germany commands ahigher share of world exports than in either appli-ances or furniture.

Clusters continually evolve as new companiesand industries emerge or decline and as local insti-tutions develop and change. They can maintain vi-brancy as competitive locations for centuries; mostsuccessful clusters prosper for decades at least.However, they can and do lose their competitiveedge due to both external and internal forces. Tech-nological discontinuities are perhaps the most sig-nificant of the external threats because they canneutralize many advantages simultane-ously. A cluster's assets-market infor-mation, employees' skills, scientific andtechnical 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 beganmaking golf clubs with advanced mate-rials, East Coast producers had difficulty compet-ing. A number of them were acquired or went out ofbusiness.

A shift in huyers' needs, creating a divergence he-tween local needs and needs elsewhere, constitutesanother external threat. U.S. companies in a varietyof clusters, for example, suffered when energy effi-ciency grew in importance in most parts of theworld while the United States maintained low en-ergy prices. Lacking both pressure to improve andinsight into customer needs, U.S. companies wereslow to innovate, and they lost ground to Europeanand Japanese competitors.

HARVARD BUSINESS REVIEW November-Ducember 1998

Clusters are at least as vulnerable to internalrigidities as they are to external threats. Overcon-solidation, mutual understandings, cartels, andother restraints to competition undermine localrivalry. Regulatory infiexihility or the introductionof restrictive union rules slows productivity im-provement. The quality of institutions such asschools and universities can stagnate.

Groupthink among cluster participants - Detroit'sattachment to gas-guzzling autos in the 1970s isone example-can be another powerful form ofrigidity. If companies in a cluster are too inwardlooking, the whole cluster suffers from a collectiveinertia, making it harder for individual companiesto embrace new ideas, much less perceive the needfor radical innovation.

Such rigidities tend to arise when governmentsuspends or intervenes in competition or whencompanies persist in old behaviors and relation-ships that no longer contribute to competitive ad-vantage. Increases in the cost of doing businessbegin to outrun the ability to upgrade. Rigidities ofthis 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 riseahead of productivity. German companies in the1990s, for example, have been doing just that. Tech-

The term high tech has createdthe misconception that only a

handM of businesses competein 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 itfails to build capabilities in major new technologiesor needed supporting firms and institutions.

Implications for CompaniesIn 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 hightech, normally used to refer to fields such as infor-mation technology and biotechnology, has distorted

85


CLUSTERS, GEOGRAPHY, ANDECONOMIC DEVELOPMENT

Poor countries lack well-developed clusters; theycompete in the world market with cheap labor andnatural resources. To move beyond this stage, the de-velopment of well-functioning clusters is essential.Clusters become an especially controlling factor forcountries moving from a middle-income to an ad-vaneed economy. Even in high-wage economies, how-ever, the need for cluster upgrading is constant. Thewealthier the economy, the more it will require inno-vation to support rising wages and to replace jobseliminated 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: improvingeducation 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 dispersecompanies artificially. Protecting local companiesfrom competition leads to excessive vertical integra-tion and blunted pressure for innovation, retardingcluster development.

In the early stages of economic development, coun-tries should expand internal trade among cities andstates and trade with neighboring countries as impor-tant stepping stones to building the skills to competeglobally. Such trade greatly enhances cluster develop-ment. Instead, attention is typically riveted on thelarge, advanced markets, an orientation that has oftenbeen reinforced by protectionist policies restrictingtrade with nearby markets. However, the kinds ofgoods developing countries can trade with advancedeconomies are limited to commodities and to activi-ties sensitive to labor costs.

While it is essential that clusters form, where theyform also matters. In developing economies, a large

proportion of economic activity tends to concentratearound capital cities such as Bangkok and Bogota.That is usually because outlying areas lack infrastruc-ture, institutions, and suppliers. It may also reflect anintrusive role by the central government in control-ling competition, leading companies to locate near theseat of power and the agencies whose approval they re-quire to do business.

This pattern of economic geography inflicts highcosts on productivity. Congestion, bottlenecks, andinflexibility lead to high administrative costs and ma-jor inefficiencies, not to mention a diminished qualityof life. Companies cannot easily move out from thecenter, however, because neither infrastructure norrudimentary clusters exist in the smaller cities andtowns. (The building of a tourism cluster in develop-ing economies can be a positive force in improving theoutlying infrastructure and in dispersing economicactivity.)

Even in advanced economies, however, economicactivity may be geographically concentrated, (apanoffers a particularly striking case, with nearly 50% oftotal manufacturing shipments located around Tokyoand 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 biasin policies and institutions. The Japanese case vividlyillustrates the major inefficiencies and productivitycosts resulting from such a pattern of economic geog-raphy, even for advanced nations. It is a major policyissue facing Japan.

An economic geography characterized by specializa-tion and dispersion - that is, a number of metropolitanareas, each specializing in an array of clusters - appearsto be a far more productive industrial organizationthan one based on one or two huge, diversified cities.In nations such as Germany, Italy, Switzerland, andthe United States, this kind of internal specializationand trade - and internal competition among locations -fuels productivity growth and hones the ahility ofcompanies to compete effectively in the global arena.

thinking about competition, creating the miscon-ception that only a handful of husinesses competein 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 technologyand practices to enhance productivity and inno-

vation. A vibrant cluster can help any company inany industry compete in the most sophisticatedways, using the most advanced, relevant skills andtechnologies.

Thus executives must extend their thinking be-yond what goes on inside their own organizationsand within their own industries. Strategy must also



MAPPING PORTUGAL'SCLUSTERS

In a middle-income economy like Portugal, exporting clus-ters tend to be more natural-resource or labor intensive.

Cotton textiles LeatherFurniture

Casual shoesDairy

ClothingDress shoes

Cork stoppers

Ceramic tiles

Pulp and paperPlastic molds

Pine woodfurniture

Fruit

LeatherTourism

AutomotiveCork-transformedproducts

Tourism

Cork agglomerates

Sheep andgoats

Port wineAutomotivecomponents

ClothingRed wine

Wool textiles

Clothing

Clothing

Ornamental stone

Red wine

Tourism

Horticulture

address what goes on outside. Extensive verticalintegration may once have been appropriate, butcompanies today must forge close linkages withbuyers, suppliers, and other institutions.

Specifically, understanding clusters adds the fol-lowing four issues to the strategic agenda.

1. Choosing Locations. Globalization and theease of transportation and communication have ledmany companies to move some or all of their opera-tions to locations with low wages, taxes, and utilitycosts. What we know about clusters suggests, first,that some of those cost advantages may well turnout to be illusory. Locations with those advantagesoften lack efficient infrastructure, sophisticatedsuppliers, and other cluster benefits that can morethan offset any savings from lower input costs. Sav-

ings in wages, utilities, and taxes may behighly visible and easy to measure up front,but productivity penalties remain hiddenand unanticipated.

More important to ongoing competitive-ness is the role of location in innovation.Yes, companies have to spread activitiesglobally to source inputs and gain access tomarkets. Failure to do so will lead to a com-petitive disadvantage. And for stable, labor-intensive activities such as assembly andsoftware translation, low factor costs areoften decisive in driving locational choices.

For a company's "home base" for eachproduct 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 renewthe company's product, processes, and ser-vices. Therefore locational decisions mustbe based on both total systems costs and in-novation potential, not on input costs alone.Cluster thinking suggests that every productline needs a home base, and the most vibrantcluster will offer the best location. Withinthe United States, for example, Hewlett-Packard has chosen cluster locations for thehome bases of its major product lines: Cali-fornia, where almost all of the world's lead-ing personal computer and workstationbusinesses are loeated, is home to personalcomputers and workstations,- Massachu-setts, which has an extraordinary concentra-tion of world-renowned research hospitalsand leading medical instrument companies,is home to medical instruments.

As global competition nullifies traditionalcomparative advantages and exposes com-

panies to the best rivals from around the world,a growing number of multinationals are shiftingtheir home bases to more vibrant clusters-oftenusing 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 itssweet-toothed consumers, sophisticated retailers,advanced advertising agencies, and highly competi-tive media companies, constitutes a more dynamicenvironment for competing in mass-market candythan Switzerland did. Similarly, Nestle has movedits headquarters for bottled water to France, themost competitive location in that industry. North-

HARVARD BUSINESS REVIEW November-Dec ember 1998 87


ern Telecom has relocated its home hase for centraloffice 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 tomove groups of linked aetivities to the same placethan to spread them across numerous locations.Colocating R&D, component fabrication, assem-bly, marketing, customer support, and even relatedbusinesses can facilitate internal efficiencies insourcing and in sharing technology and informa-tion. Grouping activities into campuses also allowscompanies to extend deeper roots into local clus-ters, improving their ability to capture potentialbenefits.

2. Engaging Locally. The social glue that bindsclusters together also facilitates access to impor-tant resources and information. Tapping into thecompetitively 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, andinstitutions creates the potential for economicvalue; it does not necessarily ensure its realization.

To maximize the benefits of cluster involvement,companies must participate actively and establisha signifieant local presence. They must have a sub-stantial local investment even if the parent com-pany is headquartered elsewhere. And they mustfoster 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. Yetmanagers tend to be wary, at least initially. Theyfear that a growing cluster will attract competition.

Tapping into the competitivelyvaluable assets witliin a clusterrequires personal relationshipsand "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 clusterdo not compete directly and that the offsettingbenefits, such as a greater supply of better trainedpeople, for example, can outweigh any increase incompetition.

3. Upgrading the Cluster. Because the health ofthe local business environment is important to thehealth of the company, upgrading the clustershould be part of management's agenda. Companiesupgrade their clusters in a variety of ways.

Consider Genzyme. Massachusetts is home to avibrant biotechnology cluster, which draws on theregion's strong universities, medical centers, andventure capital firms. Once Genzyme reached thestage in its development when it needed a manufac-turing facility, CEO Henri Termeer initially consid-ered the Pharmaceuticals cluster in the New Jerseyand 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 amanufacturing capability in Genzyme's home base,reasoning that if his plans were successful, thecompany could become more competitive.

Thus Genzyme deliberately ehose to work withcontractors committed to the Boston area, bypass-ing the many speeialized engineering firms locatednear Philadelphia. In addition, it undertook a num-ber of initiatives, with tbe help of city and stategovernment, 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 thatall 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 theprivate sector. Investing in public goods is normallyseen 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 seekinggovernment subsidies and special fa-vors that often distort competition.But executives' long-term interestswould be better served by working topromote a higher plane of competi-tion. They can begin by rethinkingthe role of trade associations, whichoften do little more than lobby gov-

ernment, compile some statistics, and host socialfunctions. 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 andgrowth. Associations can take the lead in such ac-tivities as establishing university-based testing fa-



cilitics and training or research programs; collect-ing cluster-related information; offering forums oncommon managerial problems; investigating solu-tions to environmental issues; organizing tradefairs and delegations; and managing purchasingconsort ia.

For clusters consisting of many small and mid-size companies - such as tourism, apparel, and agri-culture - the need is particularly great for collectivebodies to assume scale-sensitive functions. In theNetherlands, for instance, grower cooperativesbuilt the specialized auction and handling facih-ties that constitute one of the Dutchflower cluster's greatest competitiveadvantages. The Dutch Flower Coun-cil and the Association of DutchFlower Growers Research Groups, inwhich most growers participate, havetaken on other functions as well, suchas applied research and marketing.

Most existing trade associations aretoo narrow; they represent industries,not clusters. In addition, hecausc theirrole is defined as lobbying the federal government,their scope is national rather than local. Nationalassociations, however, are rarely sufficient to ad-dress the local issues that are most important tocluster 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 privatesectors. With a better understanding of what fosterstrue competitiveness, executives can start askinggovernment for the right things. The example ofMassMEDIC, an association formed in 1996 by theMassachusetts medical-devices cluster, illustratesthis point. It recently worked successfully with theU.S. Food and Drug Administration to streamlinethe approval process for medical devices. Such astep clearly henefits cluster members and enhancescompetition at the same time.

What's Wrong with Industrial PolicyProductivity, not exports or natural resources, de-termmcs the prosperity of any state or nation. Rec-ognizing this, governments should strive to createan environment that supports rising productivity.Sound macroeconomic policy is necessary but notsufficient. The microeconomic foundations forcompetition will ultimately determine productivityand competitiveness.

Governments-both national and local-havenew roles to play. They must ensure the supply of


high-quality inputs such as educated citizens andphysical infrastructure. They must set the rules ofcompetition-hy protecting intellectual propertyand enforcing antitrust laws, for example-so thatproductivity and innovation will govern successin the economy. Finally, governments should pro-mote cluster formation and upgrading and thebuildup of public or quasi-public goods that have asignificant impact on many linked husinesses.

This sort of role for government is a far cry fromindustrial policy. In industrial policy, governmentstarget "desirable" industries and intervene-through

Clusters offer a constructive wayto change the nature of the

dialogue between the public andprivate sectors.

subsidies or restrictions on investments by foreigncompanies, for example-to favor local companies.In contrast, the aim of cluster policy is to reinforcethe development of all clusters. This means that atraditional cluster such as agriculture should nothe ahandoned; it should be upgraded. Governmentsshould not choose among clusters, because eachone offers opportunities to improve productivityand support rising wages. Every cluster not onlycontributes directly to national productivity butalso affects the productivity of other clusters. Notall clusters will succeed, of course, but marketforces-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 entirelynew ones. Successful new industries and clustersoften 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 formindependently of government action-and some-times in spite of it. They form where a foundationof locational advantages exists. To justify clusterdevelopment efforts, some seeds of a cluster shouldhave already passed a market test.

Cluster development initiatives should embracethe pursuit of competitive advantage and special-ization rather than simply imitate successful clus-ters in other locations. This requires building onlocal sources of uniqueness. Finding areas of spe-


cialization normally proves more effective thanhead-on competition with well-established rivallocations.

New Public-Private ResponsibilitiesEconomic 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 wouldexpect location to diminish in importance. But theopposite is true. The enduring competitive advan-tages in a global economy are often heavily local,arising from concentrations of highly specializedskills and knowledge, institutions, rivals, relatedbusinesses, and sophisticated eustomers. Geo-graphic, cultural, and institutional proximity leadsto speeial access, closer relationships, better infor-mation, powerful incentives, and other advantagesin productivity and innovation that are difficult totap from a distance. Tbe more the world economybecomes 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 neweconomics 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 freshthinking on the part of leaders and the willingnessto abandon tbe traditional categories tbat drive ourthinking about wbo does what in tbe economy. Tbelines between public and private investment blur.Companies, no less tban governments and univer-sities, have a stake in education. Universities havea stake in the competitiveness of local businesses.By revealing tbe process by whieb wealtb is actuallycreated 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|; thecontext for firm strategy and rivalry (the nature and intensity of localcompetition); and related and suppoitiiig industries |thc local extent andsophistication of suppliers and related industries). Diamonil theorystresses 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 - thecolocation of companies, customers, and suppliers-amplifies all of thepressures to innovate and upgrade.2. Selected case studies are described in "Clusters and Competition" inmy 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 iiitcUoitualroots 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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