CHAPTER 1.2 Competitiveness has become a central preoccupation of both advanced and developing countries in an increasingly open and integrated world economy. Despite its acknowl- Building the Microeconomic edged importance, the concept of competitiveness is often misunderstood. Here, we define competitiveness concretely, Foundations of Prosperity: show its relationship to a nation’s standard of living, and outline a conceptual framework for understanding its Findings from the Business causes. Competitiveness Index1 The Business Competitiveness Index (BCI), based on this conceptual framework, provides a data-rich approach to measuring and analyzing the fundamental competitive- MICHAEL E. PORTER, Harvard University ness of a large number of countries in a comparative con- text.This year’s BCI includes 101 countries, up from 80 last year. Our aim is to rank country competitiveness across countries, identify individual countries’ competitive strengths and weaknesses, reveal the trends in competitive- 1.2: Building the Microeconomic Foundations of Prosperity ness in the global economy, and extend our basic knowl- edge about the sources of competitiveness and the process of economic development. Most discussion of competitiveness and economic development is still focused on the macroeconomic, politi- cal, legal, and social circumstances that underpin a success- ful economy. It is well understood that sound fiscal and monetary policies, a trusted and efficient legal system, a stable set of democratic institutions, and progress on social conditions contribute greatly to a healthy economy. However, these broader conditions are necessary but not 29 sufficient.They provide the opportunity to create wealth but do not themselves create wealth.Wealth is actually created at the microeconomic level of the economy, root- ed in the sophistication of actual companies as well as in the quality of the microeconomic business environment in which a nation’s firms compete. Unless these microeco- nomic capabilities improve, macroeconomic, political, legal, and social reforms will not bear full fruit. Beginning in 1998, we began an effort to examine statistically the microeconomic foundations of competi- tiveness and prosperity across a wide array of countries. This is a daunting task, given the need to measure and compare the complex array of national circumstances that support a high and sustainable level of productivity.The effort aims to move beyond the examination of broad, aggregate variables typical of most economic growth analyses, and provide a framework for countries and com- panies to understand their detailed competitive strengths and weaknesses. It also aims to be as rigorous as possible, verifying the importance of variables statistically and using statistical techniques to weight the contribution of indi- vidual variables. Finally, we know that improvement in competitiveness is not a simple linear process but one where nations at different levels of development face dif- ferent challenges and priorities.This effort aims to high- light these differences. The Business Competitiveness Index seeks to explore In developing countries, microeconomic failures nul- the underpinnings of a nation’s prosperity measured by its lify macroeconomic and social programs again and again. level of GDP per capita.The focus of this index is on By accessing global capital markets, countries can engineer whether current prosperity is sustainable, and on the spe- spurts of growth through macroeconomic stabilization and cific areas that must be addressed if GDP per capita is to financial reforms that bring in floods of capital and create achieve higher levels in the future.A separate Growth the illusion of progress as construction cranes dot the sky- Competitiveness Index (GCI), discussed in the previous line.Without microeconomic reforms, however, growth chapter of this Report, examines the sources of GDP per will be snuffed out as exports and jobs fail to materialize, capita growth, which is more dependent on investment wages stagnate, and the return on investments proves dis- rates and other macroeconomic policies.The sustainable appointing.This disappointment, and the austerity that level of current GDP per capita and its rate of growth will results from such cycles, is at the heart of the backlash be related in the long term, but each area requires its own against globalization. distinctive policy agenda.We have renamed the BCI this Successful economic development requires progress year to highlight its focus on firms and productivity. on multiple fronts simultaneously. Reform efforts need to However, the conceptual framework and statistical be tightly connected to the country’s current stage of 1.2: Building the Microeconomic Foundations of Prosperity approach follow that of the previous reports, and the find- development.As an economy progresses, the constraints to ings are fully comparable with previous Microeconomic its continued advancement shift.At strategic points in the Competitiveness Index results. development process, the whole basis of national competi- The analysis here is pragmatic, making use of the best tiveness must be transformed. Many aspects of company available data and econometric methods even though both strategy must be shifted and new requirements in the are far from perfect.We also confront the challenge of national business environment must be met. Our analysis establishing the direction of causality, given limited time provides the conceptual framework and comparative data series data. However, even if definitive tests of causality are to define such national agendas and to measure progress. not yet possible, understanding the microeconomic corre- lates of prosperity remains crucial.There may be a natural tendency for some microeconomic conditions to improve Competitiveness and its causes 30 as GDP per capita increases, but the large observed differ- Measuring and ranking competitiveness requires a clear ences across countries, even countries at similar income conceptual framework, drawing on the accumulated levels, reveal that this improvement is far from automatic. knowledge about competitiveness and its sources.We sum- Despite the statistical challenges and the addition of marize the framework here, drawing on previous years’ 21 mostly low income countries, mainly from Africa, to chapters while extending it to incorporate recent learning. the sample of countries, the statistical findings overall are remarkably stable and robust compared with the Global What is competitiveness? Competitiveness Report 2002–2003 (GCR) and earlier Competitiveness remains a concept that is not well under- Reports.We expand this year’s analysis to include an analy- stood, despite widespread acceptance of its importance. sis of natural resource endowments and their role in com- The most intuitive definition of competitiveness is a coun- petitiveness, a crucial issue especially for developing coun- try’s share of world markets for its products.This makes tries.The results again provide strong support for the competitiveness a zero-sum game, because one country’s importance of microeconomic competitiveness for eco- gain comes at the expense of others.This view of compet- nomic development and prosperity. Our findings also veri- itiveness is used to justify intervention to skew market fy the striking and regular pattern of microeconomic outcomes in a nation’s favor (so-called industrial policy). It changes that accompany economic development. also underpins policies intended to provide subsidies, hold The Business Competitiveness Index proves to down local wages, and devalue the nation’s currency, all account for 83 percent of the variation across countries in aimed at expanding exports. In fact, it is still often said the level GDP per capita,2 remarkably high given the that lower wages or devaluation “make a nation more addition of so many low income countries.These findings competitive.” Business leaders are drawn to the market- highlight the pressing need to better incorporate micro- share view because these policies seem to address their economic competitiveness agenda into efforts to stimulate immediate competitive concerns. economic growth. In advanced countries, which have Unfortunately, the most intuitive view of competi- largely gotten their macro policies right, it is micro reform tiveness is deeply flawed, and acting on it works against that holds the key to reversing unemployment problems, national economic progress.The need for low wages to growing exports, and to translating economic growth reveals a lack of competitiveness and holds down prosperi- into a rising standard of living. ty. Subsidies drain national income and bias choices away from the most productive use of the nation’s resources. Devaluation results in a collective national pay cut by dis- Figure 1: Determinants of productivity and productivity counting the products and services sold in world markets growth while raising the cost of the goods and services purchased abroad. Exports based on low wages or a cheap currency, Macroeconomic, Political, Legal, and Social Context for Development then, do not support an attractive standard of living. To understand competitiveness, the starting point Sophistication Quality of the must be the underlying sources of prosperity.A nation’s of Company Microeconomic standard of living is determined by the productivity of its Operations and Business Strategy Environment economy, which is measured by the value of goods and services produced