Porter or Pareto?

Understanding the industry makeup of your economic portfolio and then deciding on which industries to target is key to creating sustainable job growth and prosperity. Targeting helps drive discipline in your community, region or state strategic planning and in the resultant investment choices. Appropriate targeting (aka segmentation) will enhance the payback from your sales and marketing investment. Good segments have four characteristics – 1) actionable, 2) sizable, 3) unique and 4) stable. Ultimately the industries you choose should exhibit all four characteristics.

There are a number of ways to define a strategic list of industries to focus your economic development efforts. But, I want to discuss two. One that is well recognized and highly popular – Michael Porter’s Cluster analysis, and one approach I have personally found both effective and cost efficient – Pareto’s Principle.

Ultimately you need to decide on an approach that makes sense for your community. In an increasingly competitive environment, focus becomes mandatory for success. It is simply getting too expensive to try and be everything for everyone. If your community does not have a short list of industries to target your development efforts, I encourage you to take a stab at creating such a list using either of these two approaches.

Michael Porter’s Cluster Analysis

Clusters are geographic industry concentrations of companies, suppliers, service providers, and educational institutions. Michael Porter popularized the use of cluster analysis with the introduction of his book – The Competitive Advantage of Nations. The competitive advantage a cluster offers are in the areas of:

1. strategy/structure/rivalry – direct competition encourages innovation and a drive for productivity improvement
2. customer/consumer demand – stimulates a focus on quality delivery
3. related supporting industries – having upstream and downstream players in close proximity stimulates an exchange of ideas and innovation
4. factor conditions – specialized capabilities created by the unique profile of the cluster creates difficult to duplicate capabilities and cost structures

The keys to effective cluster analysis are the concepts of geographic concentration and interdependence. Each company’s success must depend on one, some or all of the members of the defined business cluster.

To apply Porter’s Cluster analysis to evaluate your economy, the best bet is to hire a consulting firm with a proven track record of successful application of the model. The process requires experience to execute correctly and interpret the statistical results.

I think there are two big and noteworthy benefits of Porter’s Cluster Analysis. First, executing any model that has a Harvard University professor associated with it creates automatic credibility with your community leadership. To digress, this phenomenon is a wonderful example of great branding by Harvard. Second, the name you give the cluster provides a shorthand way for everybody to understand and refer to the industry segment you will be focusing your sales and marketing efforts against. People get on the same page quickly.

In my mind, the big downside of Porter’s Cluster Analysis is cost. In addition, it is also a bit of a “black box” for people who don’t like statistics.

Vilfredo Pareto’s Principle

You probably know the Pareto Principle by a more common description – the 80:20 Rule. The basic idea is that roughly 80% of an economy’s output will come from 20% of the industries operating within a specific geography. The Pareto Principle applies best when contribution is not equal among participants. For example, an analysis of 1989 GDP data indicates 20% of the global population accounts for 82.7% of the world’s income.

To apply Pareto’s Principle in analyzing an economy, you simply use 3-digit, 4-digit or 6-digit NAICS data and identify the 20% of private industries that in aggregate account for roughly 80% of contribution to the gross state product. The 4-digit would be more appropriate for cities and 3-digit for states. The result is a list of core industries driving your current prosperity.

The benefits of the Pareto approach to segmenting your industries are: 1) it is not expensive, and 2) everybody can understand the process.

The downside is that because it is so simple and cost effective, many of your community leaders will have a hard time believing the results are correct. After all, Vilfredo graduated from the Polytechnic University of Turin in Italy and not Harvard.

Discussion

There are important differences in complexity and cost between the two approaches of evaluating an economy. But, the similarity is both are simply “aids to judgment”. Neither approach provides an infallible result and both require a level of subjectivity in the final decision-making.

I have hands-on experience in applying the Pareto Principle and have been very pleased with the outcome. For perspective, both the Porter Cluster method and the Pareto Principle approach are retrospective analyses and do not do a great job identifying gazelle industries. To account for the short fall, I suggest the additional step of looking forward to identify emerging industries with potential to become future driving industries of the economic portfolio. Rely on the collective judgment of private sector leadership on which few to include. Based on my experience, I’d recommend adding no more than 1 or 2 emerging industries to your list. Nurturing the development of new industries takes both time and money. But, it is necessary to ensure the long-term health of your economic portfolio. However, chasing too many is both impractical and typically way too costly.

Case Study Example

Let’s consider Illinois as a quick illustrative case study for the Pareto Principle. The 2009 NAICS data would suggest the following private industries are the driving industries for Illinois.

To this list, Illinois would want to add 1 – 2 emerging industries with the potential to be as big a contributor (or bigger) than the Construction, Information and Transportation & Warehousing industries.

In the above illustrative case, Illinois would want to focus on ensuring the business climate is conducive for capital attraction, retention and expansion in the identified driving industries (plus the 1 – 2 emerging industries that were added). These driving industries typically represent a critical mass of assets and capabilities (proxy for cluster) that are interdependent within the industry and can be leveraged to create a unique selling proposition for that industry. Protect and build from the core, and the rest of the economy will follow. To be clear, this approach won’t reinvent a community or necessarily create disruptive change. But, there is a reasonable probability it will lead to job growth and sustainable prosperity.

If you decide to use the Pareto Principle approach, the classic criticism you will hear is that it is overly simplistic. But, in my experience what the method lacks in sophistication, it makes up for in transparency. People simply “get it”.

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