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

Michael PorterClusters 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

Vilfredo ParetoYou 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.

Industry % GSP Cumulative %
Real Estate & Leasing 14 14
Finance & Insurance 12 26
Manufacturing 12 38
Professional & Technical Services 10 48
Health Care 8 56
Wholesale Trade 7 63
Retail Trade 6 69
Construction 5 74
Information 4 78
Transportation & Warehousing 4 82

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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7 Comments so far

  1. Medicine Ball Exercises

    January 14, 2011

    Superb blog post, I have book marked this internet site so ideally I’ll see much more on this subject in the foreseeable future!

  2. Della Rucker

    January 14, 2011

    One of the critical shortcomings of the Porter cluster approach is that it presumes that geography matters — It assumes that businesses need their suppliers to be located with a short distance, and that proximity automatically creates benefit. That may still be the case with certain kinds of creative fields, or with small business suppliers, but even midsized corporations now source from all over the world. For many businesses, ready access to transportation systems and information systems are likely to be more influential on location choices than having a supplier five minutes away. That might change, of course, if transportation costs become truly astronomical, but my suspicion is that such conditions would remake the way we do business from top to bottom.

    A Pareto approach is certainly much easier and more transparent, but the key shortcoming here is that it’s a static picture of the status quo. If your local economy is robust, or if the goal is to build on the existing business base, then a Pareto approach tells you very quickly and easily where to focus your attention. But, as the Illinois example indicates, a Pareto will probably not give you much guidance on where the emerging growth opportunities are, and those might be the segments where you have the best chance of making your limited resources pay off.

    Economic development analysts sometimes use a simple tool called a shift-share analysis to identify how much of a community’s economy is driven by a particular sector and how that has changed over time. That time factor can be a particullarly effective supplement to the Pareto approach, although that method itself has it’s own shortcomings.

    I would propose that the ideal approach for identifying where to target economic development resources would be a multi-prong approach that integrates both quantitative and qualitative data. First. conduct two of three different types of economic sector analysis, like a Pareto and a shift-share or location quotient, depending on what your objectives are. Equally importatnt, though, is to spend some time talking to people who are likely to have a “gut sense” of where the local economy is going. Local business leaders often have a unique sense of what is being overlooked in their local market, or what untapped needs could be met profitably. Where there comments and the analysis intersect will be the sectors where targeted efforts to overcome whatever market barriers have been preventing these sectors from fully emerging, may represent the community’s best return on investment.

    At the end of the day, though, the most critical thing that any community can do is to find some method for identifying reasonable growth opportunities (it certainly doesn’t have to be academically sound!) and _do_ something to help make it happen. The communities that do something reasonable, do it in an incremental fashion, and monitor and alter their actions if they are not going the direction that was intended, are the ones that find ways to be successful.

  3. David Michael

    January 18, 2011

    This question is an ongoing challenge for industrial policy makers and investment analysts. The first question to ask, however, is whether it is sensible to target industries at all? The answer to that depends to some extent on who is actually asking the question. Is it an investor or fund or government. Governments around the world have discovered they are not very good at identifying target industries or winning firms. Instead, they may be better off having an investment climate target, using competing countries as benchmarks. Improvements to the investment climate, however, can sometimes take a long time. In that case some countries have introduced special economic zones/business parks to encourage foreign firm entry, more activity from local firms and formation of industrial clusters. Again, this scheme doesn’t require specific industries to be targeted. Increased activity at business parks may be achieved by building capacity and incentive for innovation. In addition, detailed examination of value chains and introduction of incentives to stimulate improved value chain performance can sometimes produce solutions to some of the most onerous constraints to business investment.

  4. Marcin Czaplicki

    January 18, 2011

    What we do is we just analyse what already exist, what is missing and what are the capabilities that exist to attract those industries. Because to attract an industry you need to prove that the market exists. Also what we do is we look at what are the most common products imported and we try to convince that it would be better to produce this locally. One important factor is the size of the market.

  5. Blogging to the Bank Scam

    February 14, 2011

    Hi buddy, your blog’s model is easy and clean and i like it. Your blog posts are superb. Please preserve them coming. Greets!!!

  6. canoe equipment

    February 17, 2011

    Solid blog. I got a lot of effective info. I’ve been keeping an eye on this technology for awhile. It’s interesting how it keeps shifting, yet some of the core factors remain the same. Have you seen much change since Google made their most recent acquisition in the domain?

  7. Michael Haywood

    June 4, 2013

    Communities have to be extremely careful in the use of methodologies that may be based on challengeable assumptions. Targeting industry clusters that match the identified four characteristics is becoming extremely difficult, if not inappropriate and misleading.

    On one hand, the whole notion of “industries” is morphing with the
    manifestation of convergence. “Sizeable” often equates to mature and highly competitive. Therefore, what qualifies as “unique” may not be sizeable, but emerging. Anything that is “stable” is not emerging and may in fact be on its death bed. Vestige of stability in any industry today is virtually impossible to find……….. All told, industry anaysis requires deep appreciation and knowledge as to the complexity of competitve dynamics as it continues to emerge. The industries that are driving a community’s economy today may be unlikely to be driving the economy in the future; and, even if they will be, they will be shadows of their former self.

    While Michael Porter’s “five force anaysis” may help in appreciating the essence and use of power within an industry, his model is being usurped by the “Value Capture Model”. In other words, a more complete understanding of competitveness comes from appreciating the fact that every agent within an industry’s framework is intent on producing value. All are changing how they engage in transactions with their customers and suppliers and are just as likely to switch to other suppliers and customers. The complexity of this reality means that the value chain is more appropriately a value network. The sublety of change within any part of the network can send shivers and shockways throughout the system.

    Communities represent an essenial component in this network. By assisting companies to develop, or have ease of access to, highy regarded capabilities and resources that influence and impact on the capture of present and future, actual or potential, value, and how effectively and efficiently they can be deployed, communities engage in meaningful, competitve intent, not merely persuasive inetent..

    Companies and industries will only be attracted to those communities that have (1) the foresight to invest in those assets and technologies that will prove valuable in realizing future intent; (2) have the insight to identify those assets and activities that will prove rare, distinctive and valuable; and (3) have the cross-sight essential in encouraging enterprise complementarity, thereby encouraging the creation of vitally important new clusters.

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