The Social Architecture of Business

March 1 st 2002

September 11 and the preceding popping of the bubble economy of hi-flyin', hi-financed, hi-tech stocks without doubt changed the economic landscape in North America.

But these changes are more climactic than tectonic: financial global warming may have been replaced by a new financial ice age, but the drift of the underlying economic continental plates has neither halted nor sped up.

Despite medium-term border crossing slowdowns, the integration of the three NAFTA economies—Canada, the United States, and Mexico—continues unabated. As with continental plates colliding at their epochal pace, this integration forces up all sorts of social, cultural, and political mountain ranges. But the economic ocean divides that some might have imagined along the 49th parallel or the Rio Grande are irrevocable gone, for the very long run.

At the same time, however, the fragmentation of the American economy observed five years ago by economist David Friedman continues, and is—no surprise!—spreading to Canada and Mexico. In his article, "Are You Ready for the Networked Economy?," in the February 1996 issue of Inc magazine, Friedman commented on the fracturing of the American economy into three distinct economies, what he calls the networked economy, the kluge economy, and the provincial economy.

According to Friedman, the networked economy is made up of "densely packed concentrations of entrepreneurs and companies in urbanized areas that generate virtually all the nation's globally competitive, high-wage industries. These highly specialized companies flourish because they can rapidly team up to manufacture products for world markets."

By contrast, the kluge economy is made up of "the concentration of public-sector bureaucracies, universities, and closely aligned private companies in government-related industries like utilities or defence." "Kluge," by the way, turns out to be software programmers' slang, circa 1996, for "code that is an ill-assorted collection of poorly matching parts, forming a distressing whole."

In addition, the provincial economy consists of "back-office service providers; lower-wage, lower-skill producers; and urban corporate refugees," in the former hinterland—often the site of surprising job growth, if not of the high-paying variety.

Intriguingly, this structural fragmentation of the North American economy goes hand-in-hand with its simultaneous trade integration under NAFTA—actually, the fragmentation is possibly an effect of the integration, with a feedback loop mutually strengthening the two trends.

The continuing world-wide integration of economies under conditions of increased trade (within and beyond NAFTA) coincides with an increasing willingness of large companies to "shift complex design and manufacturing responsibilities to their vendors," as Friedman pointed out in an earlier article for Inc. ("The Enemy Within," October 1995). Very large nameplate companies—that is, companies with brand names like GM or Microsoft, that buy goods and services and then sell these under their own names—are willing, according to Friedman, "to pay premium prices to purchase high-quality finished products from trouble-free, self-supporting supply chains—irrespective of individual company's skills or of national exchange rates." The networked economy is made up of the companies in these fully integrated supply chains that link the nameplate company with its final assembly vendors, back through the various component manufacturers to the raw materials suppliers. Friedman tells a story of how this works:

Chrysler once tried to learn why a key engine part was failing at an unacceptable rate. Tracing back along the product's supply chain, it found that all the assemblers, designers, finishers, and machinists adhered to world-class standards. But a clay vendor for a casting company that sold raw metal to the downstream manufacturers had gone bankrupt; no other company sold clay with the proper consistency. Scores of efficient, quality companies were threatened by the failure of a seemingly insignificant link in their supply-chain.

In an even earlier article (Inc, March 1995), Friedman explained "Why Every Business Will Be like Show Business"—that is, operating in networks of smaller, more flexible, uniquely-skilled, and continually learning businesses in collaborative networks concentrated in dense clusters.

Friedman's popular analysis is backed up by the careful scholarly work of AnnaLee Saxenian in her book Regional Advantage: Culture and Competition in Silicon Valley and Route 128 (Harvard University Press, 1994).

Saxenian found that developed economies tend to be made up of regional industrial systems of two kinds: independent firm-based systems (Friedman's kluge and provincial economies) and network-based industrial systems (Friedman's networked economy).

"Far from being isolated from what lies outside them," claims Saxenian, "firms are embedded in a social and institutional setting that shapes, and is shaped by, their strategies and structures." In a particular region, a pattern emerges in the relation between the internal organization of companies in that region and the connections between companies (and other social structures and institutions) in the region.

The economy of a region always has a social aspect, but this aspect functions differently, and shapes different structures, in different regions.

The industrial system of a region has three mutually interactive components, according to Saxenian:

  • A regional culture (shared understandings and practices in the region that define such things as labour market behaviour and common attitudes toward risk-taking) that shapes and is shaped by local institutions (such as universities, business associations, local governments, sports clubs, and pubs) that provide the social contours of the region, within which regular patterns of social interaction emerge;

  • A regional industrial structure that is made up of the degree of vertical integration—the "social division of labour"—of companies and the character and scope of links between suppliers, customers, and competitors in a particular industrial sector or closely related sectors in the region; and

  • Internal firm organization in particular companies: hierarchical versus horizontal coordination, centralization versus decentralization, and the allocation of accountability and specialization.

Using these components as the basis of her comparisons, Saxenian has identified two basic kinds of regional industrial systems in advanced economies.

An independent-firm based regional industrial system—like that of the Boston area's Route 128—is usually dominated by a small number of companies, operating independently and keeping much, perhaps most, of their business activities in-house. These firms keep their practices secret from one another as far as possible—and even from their suppliers, customers, and sometimes employees. These independent firms tend to be very hierarchical in their internal management culture, with most business information flowing vertically up and won the hierarchic ladder. The boundaries between and within firms, and between firms and other local institutions are quite distinct.

A network-based regional industrial system—like that of Silicon Valley or Hollywood—in contrast consists of more numerous and more specialized producers who tend to compete and collaborate within industry clusters (that is, networks of businesses working in closely connected industries, concentrated in a geographic region, and drawing on shared infrastructure and a pool of skilled workers).

According to Saxenian, such a region's

dense social networks and open labour markets encourage experimentation and entrepreneurship. Companies compete intensely while at the same time learning from one another about changing markets and technologies through informal communication and collaborative practices; and loosely linked team structures encourage horizontal communication among firm divisions and with outside suppliers and customers. The functional boundaries within firms are porous in a network system, as are the boundaries between firms themselves and between firms and local institutions such as trade associations and universities.

Independent-firm based regional industrial systems do well when markets are stable and technologies are changing slowly, and when their leading companies can develop economies of scale and gain control over markets. Network-based regional industrial systems flourish when both markets and technologies are changing more quickly: this, according to AnnaLee Saxenian, because the system's "decentralization encourages the pursuit of multiple technical opportunities through spontaneous regroupings of skill, technology, and capital. Its production networks promote a process of collective technological learning that reduces the distinctions between large and small firms and between industries or sectors."

Some of the most interesting work on the social architecture of economic life in Canada has been done by Michael Porter. Porter is the Bishop William Lawrence University Professor, based at Harvard Business School. He is also one of the most influential economic thinkers of our time, and author of numerous books, including The Competitive Advantage of Nations (1990).

In 1991, Porter and Roger Martin released a study of the Canadian economy, Canada at the Crossroads. (Martin is dean of the Rotman School of Management at the University of Toronto, and chair of the Ontario Task Force on Competitiveness, Productivity, and Economic Progress.) In this study, they suggested that there were two paths the Canadian economy could take from that point onwards: the low road would hew "closely to the Canadian tradition of competing on the basis of lower-cost labour or raw materials and pursuing company strategies of replicating competitors elsewhere." The high road would be to compete "on the basis of uniqueness and innovation."

In 2001, Porter and Martin issued a second study, Canadian Competitiveness: A Decade after the Crossroads. In this study, they argue that between 1991 and 2001, the Canadian economy had chosen the low road. Although the federal government and many provincial governments made crucial policy decisions that did provide a macro-economic environment favourable to companies taking the high road, few businesses took up the opportunity. As a result, although Canada enjoyed, according to Porter and Martin , "a spectacular macroeconomic turnaround" between 1991 and 1999, Canada's relative prosperity has fallen.

As a result, Porter and Martin argue that "Canada is again at a critical junction of its development and must ensure that it does not squander its macroeconomic achievements. The new, more fundamental challenge is to improve Canada's microeconomic business environment and upgrade the strategies and operations of its companies." A key part of improving the microeconomic business environment is what Porter and Martin call "cluster development"—a crucial way of cultivating the social architecture of business.

An industry cluster is a network of businesses working in closely connected industries, concentrated in a geographic region, and drawing on shared infrastructure and a pool of skilled workers. Industry clusters are, according to Michael Porter in his Competitive Advantage of Nations, the engines of flourishing economies. Without doubt, industry clusters themselves flourish in what AnnaLee Saxenian calls "network-based regional industrial systems," and falter in what she calls "independent-firm based regional industrial systems."

According to Porter and Martin,

There is room for government to show greater entrepreneurial acumen and zeal in providing support to clusters, whether in providing specialized training and research institutions, specialized infrastructure, or incentives for related and supporting industries to co-locate. Governments should seek out cluster participants and proactively understand their needs at a time when early action can have a transformative impact. There is little evidence worldwide that governments can succeed in choosing investment industries proactively. However, governments can and do promote the health and development of clusters by understanding their specialized factor requirements, determining which have such high levels of externalities involved that individual firms will not invest to create them, and proactively invest on behalf of the industry. Such investments can include specialized educational programs, specialized infrastructure, or special regulatory regimes.

Cluster development is not, however, only—or even primarily—the task of government. According to Porter and Martin,

Canadian firms must take greater responsibility for enhancing the local microeconomic context in their sector and strengthening their cluster. This requires a tricky combination of behaviours. On one hand, fierce competition with local rivals will strengthen the cluster by creating pressure for upgrading and providing customers with more opportunity to be sophisticated and demanding. On the other hand, some forms of cooperation to promote specialized factor creation (for example, through support of educational institutions) and improvements in infrastructure will result in higher productivity for the industry as a whole.

Regardless of the climactic changes of hot and cold economic times, and the blowin' and poppin' of stock bubbles, the underlying historical dynamic of world-wide economic integration continues to shift the economic continents underneath us, pressing up mountain ranges and causing rifts to gape between the low wage/low job creation kluge economy of independent-firm based regional industrial systems, the low wage/high job creation provincial economy in the hinterland, and the high wage/high job creation networked economy of network-based regional industrial systems.

Leaders in economic life cannot ignore these dynamics. Nor can they ignore the necessarily social nature of economic life. As AnnaLee Saxenian observes,

Although Silicon Valley's success has been based on collaborative practices, the region has long been dominated by the language of individual achievement. For the first time, that language is being replaced by a vocabulary that recognizes the value of community as well as competition. ... the region owes as much to its rich social, technical, and commercial relationships as to competitive rivalries and the initiative of individual entrepreneurs.

Journalists like David Friedman and scholars like AnnaLee Saxenian, Roger Martin and Michael Porter provide leaders in business, labour, and government with crucial insights that they ignore at their peril—but more importantly, at the peril of those to whom they provide leadership.

Economic life doesn't just happen. It is shaped by people and, in particular, by people in leadership. But it cannot be shaped at random or at will. Certain choices have certain consequences—including the choice to do nothing.

While it is extremely difficult to change a regional industrial system, and while no single individual leader in business, labour, or government can bring about such a change, it is both possible, and, for the sake of working people in an economy—and their children—necessary. Especially in a kluge economy.

Topics: Markets

Gideon Strauss was the editor of Comment from 2000 to 2010. He is currently Associate Professor of Worldview Studies at the Institute for Christian Studies, a graduate school of philosophy in Toronto, and a senior fellow with the Center for Public Justice in Washington DC. Gideon also facilitates vocational discipleship in churches in his native South Africa.