Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter.
Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.
Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.
OCR for page 17
The Dynamics of Long-Term Growth:
Gaining and Losing Advantage in the
Chemical Industry1
RALPH LANDAU
Stanford University
ASHISH ARORA
Carnegie Mellon University
What factors support the long-term growth of industrial societies? This chap-
ter examines the innovative and competitive performance of the chemicals indus-
try over the past 150 years. It draws on a recent book analyzing factors that
contribute to the flourishing or failure of companies in the industry in the United
States, the United Kingdom, Germany, and Japan the four countries with the
most extensive available data and case histories (Arora et al., 1998~. It links this
history with the external factors, the "climate" in which these companies oper-
ated during different periods and probes the interrelationship. By focusing on the
"long run," we hope to bring out some of the underlying factors, such as change
in the institutional landscape, that influence industrial and economic performance
but that are not easily captured in analyses covering shorter time periods. This
analysis of the long-run factors supporting industrial growth and competitiveness
complements the discussion of short-term trends in performance in the other chap-
ters of this volume.
The chapter relies on an analytical framework developed elsewhere, a frame-
work that highlights the multiple sources of comparative advantage (Landau et
al., 1996) (Figure 1~. As Krugman (1996) notes, countries do not compete, firms
do. Nonetheless, countries can establish a more or less favorable climate for their
firms to compete, helping them to gain comparative advantage for their industry
and producing benefits for their home country.
iThe authors are grateful for the invaluable assistance of Johann Peter Murmann and for continuing
advice from Nathan Rosenberg and Paul Romer.
17
OCR for page 18
8
U.S. INDUSTRYIN2000
FIGURE 1 Levels of sources of comparative advantage.
We conclude that a well-functioning and growing economy depends on
.
a complex mix of institutions and policies that extend beyond the legal
system and fiscal and monetary authorities to include entities such as national
systems of higher education, industry-specific and economy-wide regulation, and
trade policy;
· market-based policies that support the interaction of social institutions
and policies to generate higher economic growth within a relatively stable macro-
economic environment but avoid unwarranted intervention; and
· the size of the market, the historical development, and the political and
social environment of the country in question.
Our long-term view highlights the central importance of technological inno-
vation for the growth of the chemical industry and for industrial societies as a
whole. But like other chapters in this collection, we stress that a narrow defini-
tion of "technological innovation" is inadequate for this analysis. Instead, tech-
nological innovation must be defined to include the broader constellation of risk-
taking activities that commercialize the technology and underlying science. These
activities are influenced by social institutions and policies.
OCR for page 19
THE DYNAMICS OF LONG-TERM GROWTH
SOME PERSPECTIVES ON GROWTH
19
The conventional neoclassical views of the causes of growth neglect other
aspects of economic structure, policy, and society that affect the growth or de-
cline in comparative advantage. Most neoclassical models of economic growth
assumed a world of perfect competition, in which the only institutions needed
to achieve good economic performance are a legal system, a specification of
property rights, and an antitrust authority that can prevent the emergence of mo-
nopoly power. Experience has taught economists to add to this list government
institutions that seek to ensure a stable monetary policy and avoid macroeco-
nomic disruption.
"Growth accounting" studies inspired by neoclassical models have consis-
tently found a significant unexplained residual, labeled "technology" or, more
accurately, multifactor productivity. The factors contributing to this residual en-
compass a substantially broader and more diverse list than those included in nar-
row definitions of technological change indeed, they encompass many of the
factors included in Figure 1. Moses Abramovitz (1956) coined the words "social
capability" to describe the complex of institutions and policies embedded in these
levels. The factors influencing economic growth in this conceptual framework
are more numerous and complex than the parsimonious list associated with the
neoclassical model and its applications in growth accounting.2
Newer work on endogenous growth theory has introduced concepts to mod-
els of economic growth that fit reality more closely (Romer, 1994, for example).
This theory recognizes that the underlying assumptions of neoclassical econo-
mists, such as perfect competition, emphasized the central role of new technolo-
gies and simultaneously denied the possibility that economic analysis could have
anything to say about the processes that affect their creation, improvement, or
adoption. These neoclassical models allowed little scope or significance for in-
vention or innovation, learning by doing, technology transfer from abroad, or
systematic research and development, all of which can produce new and improved
products, processes, and services and greatly enhance the growth process. A1-
though endogenous growth theory has recognized many of these important fac-
tors, neither it nor its neoclassical predecessor takes into account historical ef-
fects, such as path dependence (Arora et al., 1998~.
A richer model of long-term economic growth requires examination of how
commercialization of technology actually takes place at the firm level and an
understanding of the forces external to the firm that influence that commercial-
ization. Internal factors that are well known from the business literature include
management recruiting, research and development, and manufacturing and mar-
keting and need no further detailing here. But external factors also influence the
evolution of management strategies, and the nature and channels of this influence
2See, for example, Lau (1996).
OCR for page 20
20
U.S. INDUSTRYIN2000
remain poorly understood. The technology of a firm depends in part on the per-
formance of institutions of learning, as well as scientific and engineering research
conducted by various public and private institutions. A firm's investment strate-
gies depend on the cost and availability of capital, the division of profits between
the owners of the company and the other stakeholders, and the efficient function-
ing of the labor market. Capital supply in turn depends on the functioning of the
external, and now largely international, capital markets, the intermediating insti-
tutions such as banks that allocate capital from savers to investors, and the com-
petition for capital by other firms and governments.
Government policy is essential in several areas. Government tax policies
affect the net returns to investors for the employment of their capital, which in
turn guides future investment. Government budgetary and monetary policies af-
fect national welfare and aggregate domestic demand as well as domestic savings
and the cost of capital. Governments set trade policies. Governments must main-
tain a legal order so that firms know what they and their competitors can and
cannot do. Governments provide for much of the education of the labor force and
promulgate a variety of regulations to control many aspects of the economy.
These factors are individually complex, and their interrelationships and in-
teractions, intended and otherwise, are even more so. We cannot hope to provide
a definitive description of these individual factors, let alone their interaction, for
such a lengthy period in four large industrial economies. The historical and ana-
lytic discussion that follows instead should alert economic theorists, policy-
makers, and managers to the complexity of the factors and forces that support
long-term growth. This discussion also should give pause to those who proclaim
the arrival of a "new paradigm" or the onset of an indefinite period of U.S. eco-
nomic dominance in chemicals or other industries. An exclusive focus on the
near term in such analyses will result in myopic conclusions and prescriptions.
THE CHEMICAL INDUSTRY
The history of the chemical industry offers clear illustrations of the interde-
pendence between the strategies of individual firms and the environment of eco-
nomic policy and institutions that their home-economy governments create. Three
characteristics illustrate the economic and technological significance of the
chemical industry as well as its long history.
First, chemicals was the first science-based, high-technology industry. More-
over, with the exception of this century's two world wars, this industry's research
and development has been financed almost entirely by private investment. Fig-
ure 2 gives the most recent data available in this form.
An estimation of 1997 expenditures is given in Figure 3, which also shows
federal funding of R&D by industry for 1996. It is evident that R&D in the
chemicals industry, which, along with transportation equipment, is one of the two
largest R&D performers in the U.S. economy, is virtually all privately financed.
OCR for page 21
THE DYNAMICS OF LONG-TERM GROWTH
21
1. Aerospace
2. Electrical Machinery & Communications
3. Machinery
4. Chemicals
5. Autos, Trucks, Transportation
6. Professional & Scientific Instruments
7. Computer Software & Services
8. Petroleum
TOTAL
16.63 16.12
13.42 13.55
14.78 15.14
14.65 16.71
10.80 10.37
8.71 9.65
5.77 6.66
2.50 2.34
87.26
90.54
6.25
9.69
14.07
16.42
9.48
7.43
3.89
2.33
69.56
39%
72%
93%
98%
91%
77%
58%
99%
Note: Total R&D in 1992 was $154.5 billion, of which R&D performed by industry was $107.6
billion so that the above are the bulk of R&D performers. Battelle estimates these figures for
1995 at $182 billion and $130.6 billion.
Source: National Science Foundation, Division of Science Resources Studies, "Selected Data on Re-
search and Development in Industry: 1992" and "National Paterns of R&D Resources."
FIGURE 2 The Major R&D Industries, 1991 & 1992 R&D Expenditures (billions of
current dollars)
1. Chemicals and Pharmaceuticals
2. Transportation
3. Telecommunications
4. Computers
5. Electronics
6. Software
7. Semiconductors
TOTAL
31.4
30.4
29.0
22.5
15.2
9.9
6.8
145.2
Note: Total R&D for 1997 is estimated by Battelle at $192 billion, of which 62.8 percent ($120.6
billion) will be financed by industry, 32.4 percent ($62.2 billion) by government, and 4.9 per-
cent ($9.4 billion) by others (such as non-profits, universities, research institutions). Numbers
have been rounded and may not add to 100.
Source: "1997 R&D Funding Forecast" by Battelle.
Transportation Equipment 52%
Professional & Scientific Instruments 17%
Electric Equipment 9%
Non-manufacturers 15%
Other Manufacturers 7%
100%
Source: National Science Foundation.
FIGURE 3 The Major R&D Industries for 1997 (top) (billions of current dollars) and
Federal Funding of R&D by Industry for 1996 (bottom).
OCR for page 22
22
U.S. INDUSTRYIN2000
Second, the chemicals industry has generated technological innovations for
other industries, such as automobiles, rubber, textiles, consumer products, agri-
culture, petroleum refining, pulp and paper, health services, construction, pub-
lishing, entertainment, and metals. In this regard, the chemical industry illustrates
the general tendency for the benefits of internationally competitive industries to
spill over to other industries.
Third, the chemicals industry is a U.S. success story. The chemicals industry
is one of only two major high-technology industries (aerospace being the other)
in which the United States has maintained its competitive lead in international
trade. Its growth rate has exceeded that of the overall U.S. economy since World
War II.
The output of the modern chemicals industry conveys some sense of the
diversity of activity. It includes paints and coatings, pharmaceuticals, soaps and
detergents, perfumes and cosmetics, fertilizers, pesticides, herbicides and other
agricultural chemicals, solvents, packaging materials, composites, plastics, syn-
thetic fibers and rubbers, dyestuffs, inks, photographic supplies, explosives, anti-
freeze, and many other kinds of chemicals more than 70,000 products. It is the
leading U.S. export industry, with a long-term favorable balance of trade. Very
few industries have the complexity of the chemical industry. The enormous size
of this industry in 1996 is shown in Tables 1 and 2 (Figures 4, 5, and 6 contain
other comparative data on the U.S. chemicals industry and other U.S. high-tech-
nology industries). In Europe, it is second only to the food, drink, and tobacco
industries in size and value added and has a consistently positive balance of trade.
TABLE 1 GDP by Industry (1996)
U.S. Manufacturing Sector
(17.4% of total GDP)
$1332 billion
$7636 billion
Chemicals and allied products
Industrial machines and equipment
Electronic and electric equipment
Food and kindred products
Fabricated metal products
Printing and publishing
Motor vehicles and parts
Paper products
Instruments
Other transportation
Petroleum and coal
Other
Total
$157.8
150.2
143.8
122.6
98.2
90.4
85.1
57.1
52.3
49.7
30.1
294.9
$1332.2
Source: U.S. Bureau of Economic Analysis, Survey of Current Business, November 1997.
OCR for page 23
THE DYNAMICS OF LONG-TERM GROWTH
TABLE 2 The World Chemical Industry in 1996
23
Sales volume
$ billion
% of total
United States
Japan
All others
Western Europe (includes EFTA) 445a
EFTA = (36)
372
216
533
28
(2)
24
14
34
Total 1566 100
a of which German sales value is about $117 billion and the U.K. is $56 billion.
The most important class of chemicals is the organic compounds, which are
much more varied and pervasive than the inorganic compounds (e.g., derived
from salt and minerals). Organic inputs like oil and natural gas contain hydro-
carbons, which form the backbone of final organic chemical outputs. In the first
stage of processing, chemicals such as chlorine and oxygen are added to the
hydrocarbon backbones to give the compounds certain desired charactenstics.
The final output may be nylon or polyester fiber, plastic, a pharmaceutical prod-
uct, or other products that are rarely considered to be chemical industry outputs.
Trade Balance (in billions of $)
40
20
o
-20
-40
-60
. ~
1992 1993 1994 1995
1989 1990 1991
| ~ AEROSPACE ~ CHEMICALS
~ ~ ~A ·c t~Y ~ ~ B'~ M~ Ms
~ SCIENTIFIC APPARATUS
~ ADPIOFFICE EQUIPMENT
`3 AUTOMOTIVE ~ PETROLEUM
FIGURE 4 U.S. Industries with heavy R&D.
Source: U.S. Bureau of Census.
OCR for page 24
24 U.S. INDUSTRY IN 2000
Return on assets and profit margin, % Operating rate, %
12
0
8
4
2
At, `N Aft ~ ~ -~-
~ ~ ''a ,-,,
^/ / ~ ~'%.Q
~ -\\~
~.,y /'
_
.,- I'm.
NET INCOME/SALES
NET INCOME/ASSETS
OPERATING RATE
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
I ,.~
'69 '71 '73 '75 '77 '79 181 '83 '85 '87 '89 '91 '93 '95
'70 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94
FIGURE 5 Return on assets and profit margin (%) and operating rate (my.
Source: Chemical Manufacturers Association.
A BRIEF HISTORY OF DYNAMIC COMPARATIVE ADVANTAGE
IN THE CHEMICAL INDUSTRY
100
80
60
40
20
o
To understand the development of comparative advantage in the chemical
industry it is useful to summarize the essential historical facts before offering a
~ . ~
~ . ~ ~ ~ . ~ ~ ~ ~ ~ ~ . ~ . . ~ . ~ ~
more detailed analysis. England already dominated inorganic chemicals when
William Henry Perkin discovered the first synthetic dye (mauve) in 1856 and
launched the modern organic chemical industry. England in the mid-1800s was
wealthy; it had the know-how, the largest customer base (textiles), and the largest
supply of raw material (coal). But the chemical industry let its advantages slip
away, and by the end of the 1880s the Germans dominated the organic chemical
industry. By 1913 German companies produced 140,000 tons of dyes, Switzer-
land produced 10,000 tons, and Britain produced only 4,400 tons. The American
industry depended mainly on German dyestuff and other chemical imports, al-
though it was a large producer of basic inorganic chemicals.
World War I brought a change in the relative position of the four countries.
The United States built its own organic chemical industry, and the German indus-
try fell on hard times. With the tacit support of the German government, their
competitive difficulties contributed to the merger of the leading German chemi-
cal companies to form the I.G. Farben company. Britain and the United States
took advantage of the military defeat of Germany, refusing to give back prewar
patents to German firms. Further, by sanctioning the merger that created Impe
OCR for page 25
THE DYNAMICS OF LONG-TERM GROWTH
US o US
CO CO Cal
S)EIIOp 10 SU°!II!O
25
US o US o
Cal
·_.
Cal
·_.
Cal
Cal
o
=
.~
o
;~. ¢
Cal ~
·0 Cal
_ ~
.e
~ .
~ a=
~ V
. .
o
V,
OCR for page 26
26
U.S. INDUSTRYIN2000
rial Chemical Industries (ICI) in 1926, Britain avoided falling further behind Ger-
many. At the same time, the United States was gaining strength through the
development of a large petroleum refining industry and was creating new skills in
the design of large-scale continuous processing plants through the use of chemi-
cal engineering. These skills, largely in the hands of specialized engineering
firms, were readily transferable to the burgeoning petrochemical industry, which
was based on the cheap petroleum and natural gas feed stocks with which the
United States was abundantly endowed. The European chemical industry contin-
ued to use coal, rather than petroleum, as its main feedstock through the 1940s.
World War II resulted in the physical destruction of a significant portion of
the German chemical industry. During the postwar period, the U.S. industry
developed uses for petrochemicals in the production of fibers, plastics, and many
other products, while dyestuffs shrank in importance. America's chemical indus-
try grew enormously and dominated the market at least until the 1970s. As world
prosperity returned, however, so did a successful chemical industry in Germany
and in Europe more generally. Petrochemical industries were soon well-estab-
lished in Asia, in the oil-exporting countries, and elsewhere. No longer did one
country dominate; the industry's growth had made it a truly global industry. Com-
petitive advantage at the firm level came to the fore, with different companies in
different countries excelling at what they did best. Japan was the one exception.
Although the Japanese chemical industry grew to become the second largest in
the world, it never became a major player in international markets for products or
technology.
TRACING THE DEVELOPMENT OF COMPARATIVE ADVANTAGE
THROUGH THE MATRIX
We now discuss briefly how each level of the matrix in Figure 1 has affected
comparative advantage and growth in the chemical industry over the last 150
years.
National Governance and Socio-Political Climate
How do factors related to national political and social factors help to explain
the shift in comparative advantage from Britain to Germany after the 1 870s until
1914? To begin with, the national governmental structures were very different in
the two countries. Britain had a parliamentary system of government; Germany
was a collection of 39 political entities that had a customs union but otherwise
differed widely in their governmental structures and policies. The competition
among the various states contributed to the rise of many German dyestuff compa-
nies. Germany's political unification in 1871, under Chancellor Otto von Bis-
marck, a Prussian, not only created a common market and an investment boom
OCR for page 27
THE DYNAMICS OF LONG-TERM GROWTH
27
but also produced a foundation for a unified patent system that proved to be very
important.
Much has been written about the reluctance of British investors to undertake
the higher-risk organic chemical investments that their counterparts in Germany
did. Britain had many opportunities for low-risk investments throughout its own
empire, the United States, and South America. Germany in contrast had no em-
pire and, even with the creation of a larger domestic market, had a limited market.
German senior industrial managers, supported by their investors who were re-
ceiving rich dividends, accordingly took bigger risks, including investments in
scientific and technological developments of the second (electrical and chemical)
industrial revolution.
Political and social factors also influenced the relative positions of the Japa-
nese and U.S. chemical companies, particularly during and after the two world
wars. In Japan, the feudal regime was replaced in 1868 by the Meiji restoration,
yielding a somewhat more democratic society. But the Japanese military' s politi-
cal influence expanded in the early twentieth century, partly as a result of victo-
ries in wars with Korea and Russia, and the military assumed control of Japan's
government by 1931 with the invasion of Manchuria.
The two world wars led to major governmental changes in Germany and
Japan and influenced the subsequent direction of their chemical industries. The
war also led to changes in the U.S. chemical industry. The two world wars,
however, drained Britain of much of its economic strength and, as the history of
ICI, its largest firm shows, had an influence on its chemical industry. The rise of
consumerism and the substitution of natural materials as a result of the depriva-
tions of the war in the West led to the creation of new products and an enlarged
demand for the newly developed plastics and other synthetic materials, some of
which had been discovered in the interwar years. These developments allowed
the chemical industry to grow for many decades much faster than gross domestic
product.
Macroeconomic Factors: Monetary and Fiscal Policies
Prevailing government and sociopolitical conditions profoundly influence
macroeconmic policies, which have affected the growth pattern of our four na-
tional chemical industries in important ways. Macroeconomic policies during the
period before the World War I favored British capital exports. Most major indus-
trialized countries sooner or later adhered to the gold standard before World War
I. Britain had control of much of the world's gold supply and therefore was able
to maintain clear leadership in the international flow of capital. British investors
preferred low-risk foreign investment opportunities to the riskier domestic in-
vestment options offered by the nascent chemical industry. German investment
overseas was constrained by these British policies, and so Germany was forced to
export goods instead of capital.
OCR for page 34
34
U.S. INDUSTRYIN2000
elsewhere in the United States. Britain had some engineering curricula but lacked
one specifically adapted to the chemical industry. In nineteenth century Ger-
many, engineers were treated like second-class citizens. Engineering was taught
not in universities but in technical institutes (technische hochschulen), which
were not allowed to grant advanced degrees until the early part of the twentieth
century. Consequently, German chemists dominated the German chemical com-
panies in this period and used engineers, primarily mechanical engineers, to help
them design plants, relying on fairly direct scale-up from laboratory apparatus.
This U.S. engineering tradition in the early part of this century led directly to
the development of the chemical engineering profession, which came to fruition
in 1920 when M.I.T. established the first independent department of chemical
engineering and developed a new engineering model called unit operations
(Walker et al., 1923~. At about the same time, as a consequence of their close
inspection of the German chemical industry after World War I, American univer-
sities became much more concerned with improving chemistry education. Brit-
ain, Germany, and Japan were much later in developing the chemical engineering
profession, and so the United States was able to gain an important lead in design-
ing and operating large, continuous process chemical plants.
Another important factor in the rise of chemical engineering in the United
States was the growth in consumer demand for low-cost gasoline to fuel the auto-
mobiles that more and more people were buying. U.S. chemicals and petroleum
firms were compelled to develop new techniques for refining unprecedented quan-
tities of petroleum. The oil companies had anticipated the growth in automobiles.
The first major petroleum industry R&D organization, Esso Research and Engi-
neering, was established by Standard Oil of New Jersey in 1919. ESSO worked
closely with M.I.T. faculty to establish chemical engineering as a genuine intel-
lectual field at the university level, and many institutions adopted it. The pio-
neers in the creation of petrochemicals were two oil companies, Standard Oil of
New Jersey (now Exxon) and Shell, and two chemical companies, Union Carbide
and Dow (Spitz, 1988~.
At the same time the German universities, even technical universities, began
to withdraw from close contact with industry. Although BASE had developed the
Haber-Bosch process to produce synthetic ammonia in 1913, a remarkable feat of
chemical engineering, this accomplishment was never shared with the educa-
tional institutions, and as a result no chemical engineering discipline arose in
Germany before World War II. The absence of a strong engineering tradition in
Germany contributed to a lag when the new petrochemical era dawned after the
war. Japan's first chemical engineering department was established in 1940; but
it had little influence for several years and remains less advanced than Japanese
electrical engineering, materials science, and other fields.
A major post-war change in university and government relationships took
place in the United States, following the publication of Vannevar Bush's Science:
The Endless Frontier in 1945. For the first time the federal government became
OCR for page 35
THE DYNAMICS OF LONG-TERM GROWTH
35
the main source of undergraduate scholarships through the GI Bill and granted
fellowships and research grants to faculty in the sciences. Compared with the
United States and Britain, German spending on universities has declined since
the war, particularly in the last quarter century. The German states support higher
education, but the relationship between universities and industry has cooled. A1-
though German chemical firms appear to get all the chemists they need in Ger-
many, many of the brightest students now go to the United States to receive their
postdoctoral training, and German universities have lost their leading position in
chemistry to American universities.
The Industry and Firms
As noted earlier, Britain dominated inorganic chemicals by the mid-1800s.
The British industry, with many firms competing intensely, was efficient and able
to hold down prices. The incumbent firms, however, failed to make investments
in the newer alkali technologies, such as the Solvay process, because of thin
profit margins and their reluctance to scrap investments in older processes. The
rapidly growing U.S. domestic market gave American firms the incentive to build
large and efficient inorganic chemical plants, eliminating the competitive advan-
tage of foreign firms in this segment. The German firms also had more efficient
technologies than did the British and also freed themselves from British imports
in the late nineteenth century. The organic chemical industry, however, showed a
completely different pattern, as German dyestuff companies proved to be extraor-
dinarily innovative and very profitable and soon dominated world markets. In the
late 1880s the Germans drew on their dyestuff technology to enter the pharma-
ceuticals industry and became strong players in this area well before the United
States and Great Britain. Japan had no strength in chemicals in this period.
Three major firms BASE, Bayer, and Hoechst soon dominated the Ger-
man industry. Companies like BASE, which was the largest in the world in the
last part of the nineteenth century, were enormously profitable, encouraging even
further growth. These German firms maintained close relationships with univer-
sities and proceeded in developing a new corporate function the R&D labora-
tory. After the passage of the unified patent law in 1877, German firms further
cemented their lead in organic chemicals by organizing systematic, large-scale
efforts to create new chemical products. In contrast to British firms, German
chemical firms developed strong marketing capabilities, which aided their pen-
etration of export markets. Neither Britain nor the United States replicated this
industrialization of innovation until after World War I, giving German firms a
strong comparative advantage. Britain's slower growth rate in the chemical in-
dustry was to a large extent the result of its inability to compete against the con-
stantly innovating German firms.
The economic difficulties of the interwar years, such as protectionism and
macroeconomic turbulence, triggered a wave of mergers that created large chemi
OCR for page 36
36
U.S. INDUSTRYIN2000
cat firms in Germany (I.G. Farben) and Britain (ICI) and several large firms in the
United States. The American chemical firms had made large profits during World
War I, which enabled them to diversify and invest in R&D and acquisitions. Du
Font, for example, purchased a 25 percent interest in General Motors that subse-
quently gave the chemical company substantial profits both from dividends and
the ultimate sale of that stock under an antitrust decree after World War II. Union
Carbide was formed by such mergers, as was the Allied Chemical Company.
Japan still had very little new activity in chemicals, except in fertilizers.
British and American companies profited from the tariff protection they had
sought after World War I. The technical excellence and the long traditions of the
German companies, however, permitted I.G. Farben to continue extensive re-
search and investment in new fields such as polymers, even though they were still
based on coal and would prove to be ultimately noncompetitive. Despite I.G.
Farben's virtual monopoly of the domestic market, innovation in the German
chemicals industry did not die out, in part because of the need for substantial
exports to make up for the weak domestic market.
Dow Chemical Company, started in 1920, grew rapidly during the interwar
period as did Union Carbide. Du Pont invested in the research and development
that produced nylon, its most profitable polymer discovery, and its numerous
acquisitions greatly strengthened the company. I.G. Farben was strong in several
chemical sectors but under Carl Bosch, who had been head of BASE before World
War I, I.G. Farben pursued an ambitious synthetic-fuels development program
that consumed enormous amounts of capital. Dyestuffs and pharmaceuticals pro-
vided most of the profits of I.G. Farben until the Nazi government came to power.
From that point on, the firm focused more and more on the creation of synthetic
fuel from coal as a part of Hitler's autarchy policies, and I.G. Farben was no
longer able to dictate its own policies as it had before (Plumpe, 1990~.
After World War II, the big three German chemical companies, profiting
from their long tradition and the favorable circumstances created by the German
government, grew very rapidly to become the three largest chemical companies in
the world today. Only in the last few years has it become obvious that some parts
of their businesses are unprofitable, and the first steps are being taken toward
divestiture and acquisitions in order to produce a better overall profit picture. The
entry of the major U.S. oil companies, including Exxon, Amoco, and Mobil,
created stiff competition in the basic commodity. Britain's two oil companies,
British Petroleum and Shell, also entered the petrochemical industry after World
War II.
The Recent Influence of Financial Markets on Corporate Governance
The conditions prevailing in Britain in the early 1990s created intense stock-
holder pressure on ICI, which split at the beginning of 1993 into the pharmaceu-
ticals firm Zeneca, and ICI, which retained the traditional chemicals products.
OCR for page 37
THE DYNAMICS OF LONG-TERM GROWTH
37
The American firms, especially Du Pont and Dow Chemical, remain among the
leaders in the global chemicals industry. After a serious plant explosion in India
in 1984, Union Carbide was the object of a hostile takeover that resulted in a
significant diminution of its presence in the chemical industry. Likewise, Allied
Chemical, which in 1920 was the largest chemical company in the world, has
virtually exited the industry as a result of short-sighted policies in the interwar
years when its managers paid high dividends while virtually neglecting R&D.
Aside from the new startup companies that have been responsible for the first
commercial biotechnology products, established pharmaceutical companies in the
United States continue to dominate the industry because of their strong marketing
capabilities, whereas in Europe the conventional chemical companies are still
very large in pharmaceuticals. In fact, the influence of the shareholder value
philosophy can be seen in the consistently higher profitability, return on assets,
and market capitalization of the major American chemical companies compared
with their European competitors, where management control has persisted until
recently.
The strong Japanese chemicals industry has not been influential in interna-
tional markets. The reasons are not only the absence of shareholder control but
also an intrusive government bureaucracy, protected markets, and capital con-
trols in the earlier decades; a weak domestic university system; and the fierce
rivalries of the many keiretsu groups, which led to too many similar plants of less
than world scale. In a society traditionally resistant to change, the international
weaknesses of Japan's chemical firms also reflect the nation's historic lack of
participation in international markets.
The historical and expected future performance of these large chemicals
firms, like industrial firms in other sectors, is reflected in their market valuation,
especially for those firms whose shares are widely held and traded in liquid, effi-
cient equities markets. This valuation also reflects investor expectations of
management' s commitment to increase shareholder value, and international com-
parisons of the relationship between sales and market capitalization reflect na-
tional differences in the power of "mass shareholder" (as opposed to manage-
ment, "main bank," or keiretsu shareholder) influence on management.
The comparisons in Figure 7 illustrate how changes in corporate governance
have changed the strategies of the major chemical companies, particularly in Eu-
rope.6 In a well-rounded chemical company, sales volume should approximately
equal the firm's total market capitalization. As the figure shows, however, the
ratio of sales to market capitalization differs widely among five leading chemi-
cals firms. The figure shows the market value of ICI before its 1993 spinoff of
Zeneca as well as the combined market value of the two firms since 1993. The
market obviously values the new versions of ICI much more favorably than it did
6The Appendix to this chapter compares the relationship between sales and market valuation for a
number of U.S. firms in various industries.
OCR for page 38
38
4
3
2
1
o
U.S. INDUSTRYIN2000
x:~ ICI ~ ZENECA ~ ICI incl. ZENECA ~ BAYER
\ ~ BASE ~ HOECHST -*I INTEL ~ MICROSOFT
-\\
_
~ ~ ~A
it, ~
$1 in sales requires $1.25 inve~men~ in ~ red assess ~ ~
~ ~ ~ -~ ~ ~- ~~~ ~ ~ a- j
1 992
1 993
1994
1 995
FIGURE 7 Sales/market capitalization.
Note: Sales for Microsoft are estimated based on results for the six months ended 12/31/96.
Source: Chemical Manufacturers Association.
1 996
the original unified ICI. Zeneca has joined the ranks of high-technology compa-
nies with a high price-earnings multiple, whereas the new ICI has drifted toward
a lower level that is comparable to some of the German firms today. The new ICI
is less internally balanced than the German companies, a factor that contributed
to ICI's 1997 purchase of the specialty chemical businesses of Unilever and its
divestiture of remaining commodity businesses. What the markets, which have
valued Zeneca favorably, will think of the remainder of the old ICI that is focused
on chemicals remains to be seen.
In contrast the stock market was treating two of the three German firms with
caution, because their total sales exceed their capitalization by almost 2:1. Bayer
is exceptional in this regard, because its heavy emphasis on health care and phar-
maceuticals has led the market to value the company's prospects somewhat more
favorably than either Hoechst or BASE. Other factors are involved, however.
Pharmaceutical companies have higher earnings per dollar of sales revenue, and
therefore price/earnings ratios will be higher despite the lower sales to market
capitalization ratios. German chemicals firms now are attempting to increase
shareholder value amid discussion of methods to realize the underlying values of
the different businesses by various devices that will not add heavy tax burdens.
Corporate governance issues have now become a major factor in establishing
firm strategies. In Japan, where the trend toward mergers of rather small compa-
nies by international standards has been very slow to develop, these issues are
gathering steam. Mitsubishi has finally succeeded in uniting its two chemical
firms, and Mitsui has announced a comparable move. Such rationalization is
OCR for page 39
THE DYNAMICS OF LONG-TERM GROWTH
39
proceeding at a much more rapid pace in the European industry, where there has
been a great deal of divestiture and acquisition of divisions and businesses and
the formation of many joint ventures or alliances. The industry is in the midst of
a major shakeup but the traditional trajectories of the major companies, influ-
enced by their corporate capabilities and history, will continue to exert a domi-
nant influence over their strategies. Nevertheless, these strategies differ from
firm to firm, and the recent wave of mergers, alliances, and restructuring reflects
the varying ways managements are striving to increase their profitability and
shareholder values.
CONCLUSIONS
This historical survey of the chemicals industry yields conclusions that largely
complement, rather than conflict with, the findings of other chapters in this vol-
ume. Competitive strength in the long run, as in the two or at most three decades
covered in the other chapters, rests on a robust institutional infrastructure and
supportive government policies that are general, rather than highly sector spe-
cific, in their target and intent. A stable, predictable, macroeconomic environ-
ment and a pro-investment policy lead to higher long-term growth. The case of
the chemical industry over 150 years suggests that high-technology industries
develop better in a country when they can draw on strong national research and
teaching universities in science and engineering. For this industry at least tar-
geted government science and technology policies do not matter very much com-
pared with the constellation of institutions and policies incorporated in the matrix.
Although abundant natural resources may help a domestic industry get
started, they do not afford a lasting lead. In a peaceful world where natural re-
sources can be shipped all around the world, know-how and economies of scale
are decisive factors in maintaining competitive advantages. But the climate main-
tained by the national government institutions and policies is probably of equal
importance. Despite the widespread diffusion of technology and capital, national
interests are not always the same, and the constellation of these policies and insti-
tutions contributes to or detracts from comparative advantage and growth. Thus,
for example, the cost of capital in recent decades has differed in the four countries
considered here, with Japan's low cost contributing to its investment boom and
subsequent bust.
The development of a large and sophisticated home demand in the beginning
of an industry life cycle has several advantages. It allows more than one national
firm to develop competitive skills and to build large-scale plants that give them a
cost advantage over producers with smaller plants. Of course, readily accessible
foreign markets can make up at least in part for a relatively small home market.
Competition among firms has generally led to higher levels of innovation in
the chemical industry. A high-technology industry seems to be most innovative
when there is just enough competition to spur the creation or improvement of
OCR for page 40
40
U.S. INDUSTRYIN2000
products and processes and yet allow firms to make sufficient profits to provide
the ability and incentives to invest in R&D.
In an industry with increasing returns to scale and no tariff protection, early
entry into the business is an important factor for long-term competitive success.
Many of the firms that became early leaders in the chemical industry continue to
dominate it today, despite a dramatic proliferation of new products and processes.
Expansion outside the home country to newly developing countries serves to pro-
vide competitive advantages to large profitable companies in the industrialized
nations but is not enough to maintain dominance without continuing develop-
ments in technology.
As capital markets have been internationalized, corporate governance issues
have become a prime concern to shareholders and managements. Thus, technical
specialists, who have historically dominated the senior management of most
chemical firms, may give way to more finance and business managers. Neverthe-
less, technology remains a prime driving force for gaining and retaining competi-
tive advantage in this industry.
REFERENCES
Abramovitz, M. (1956). "Resource and Output Trends in the United States since 1870." American
Economic Review 46(2):5-23.
Arora, A., R. Landau, and N. Rosenberg, eds. (1998). Chemicals and Long-Term Growth: Insights
from the Chemical Industry. New York: John Wiley & Sons.
Bush, V. (1945). Science, The Endless Frontier. New Hampshire: Ayer.
Carson, R. (1962). Silent Spring. Greenwich, CT: Fawcet Crest.
Jorgenson, D. and R. Landau, eds. (1993). Tax Reform and the Cost of Capital. Washington, DC: The
Brookings Institution.
Krugman, P. (1996). "A Country is not a Company." Harvard Business Review 74(1): 40-51.
Landau, R., T. Taylor, and G. Wright. (1996). The Mosaic of Economic Growth, Stanford: Stanford
University Press.
Lau, L. (1996). "The Sources of Long-Term Economic Growth: Observations from the Experience of
Developed and Developing Countries." In The Mosaic of Economic Growth, R. Landau, T.
Taylor, and G. Wright, eds. Stanford: Stanford University Press, 63-91.
Plumpe, G. (1990). Die I. G. Farbenindustrie AG: Wirtschaft, Technik und Politik 1904-1945. Berlin:
Duncker & Humblot.
Romer, P. (1994). "The Origins of Endogenous Growth." Journal of Economic Perspectives 8(1):20.
Spitz, P. (1988). Petrochemicals. New York: John Wiley & Sons.
Walker W., W. Lewis, and W. McAdams. (1923). Principles of Chemical Engineering. New York:
McGraw-Hill.
APPENDIX
The analysis of market capitalization and sales for selected companies, to-
gether with industry averages provides insights into corporate performance in
other U.S. industries. A preliminary assessment reveals similar interfirm and
interindustry differences in investors' assessments of the prospects for future
OCR for page 41
THE DYNAMICS OF LONG-TERM GROWTH
41
growth. The data discussed in this appendix are taken from the Business Week
issue of March 30, 1998, and are shown in Appendix Table 1. Complete financial
analysis is, of course, more sophisticated than this simplified approach, but these
results are still useful. As mentioned, in some industries such as pharmaceuticals,
profits are higher per dollar of sales than in others. Although the stock markets
have risen substantially since March 1998, the relative positions have been main-
tained and this may continue to be the case when the markets decline. Of course,
the wave of mergers and acquisitions will affect the relative positions of some of
these companies.
What can be deduced from these data? One must bear in mind the observa-
tions of Albert D. Richards in our volume on Chemicals and Long-Term Eco-
nomic Growth: Insights from the Chemical Industry markets do a pretty good
job of forecasting the future of companies.
1. Some chemical companies, such as DuPont and Monsanto, are seen as not
having reached maturity, despite their large size. In both cases, these
favorable valuations reflect the firms' increased emphasis on R&D and
product development in the life sciences. By contrast, Dow is more
heavily committed to basic commodity chemicals and is seen as average
and relatively mature, while Union Carbide's prospects are not as bril-
liant.
2. Among pharmaceutical companies, which clearly are the favorites of in-
vestors for the reasons stated earlier, Merck and Pfizer shine. Among the
other firms in this industry, particular note should be taken of Amgen, the
most successful of the biotechnology companies. Its successes are seen as
giving it the potential to rank eventually with the major pharmaceutical
companies, but it is at an earlier stage of development.
3. Investors see good prospects in the financial services industry and are
watching smaller, well-managed banks, such as Bank of New York.
4. In the steel industry, the decline of the former colossus USX-US Steel
illustrates the diminishing outlook for a mature company in an industry
where technological innovation is modest and the focus is on cost cutting.
The newer minimill Nucor comes out as much better in the eyes of inves-
tors. Alcoa is an example of a large metals company that continues to
innovate and manage well.
5. The extraordinary records of Microsoft and Intel are noted in Figure 7.
Nonetheless, the more traditional computer companies such as IBM and
Hewlett-Packard still find much favor in investors' eyes. The improved
valuation of IBM is a particularly dramatic example of the effects of a
management shakeup.
6. The retailing industry presents a wholly different picture; the large groups
are unable to improve their market capitalizations greatly, with the excep-
tion of specialty retailers, such as the Gap.
OCR for page 42
42
APPENDIX TABLE 1 Capitalization Ratios
U.S. INDUSTRYIN2000
Capitalization Sales
Ratio $ billion Feb. 27, 1998 $ Billion 1997
Chemical companies
DuPont 1.5169,37345,079
Monsanto 4.0330,3177,514
Dow 1.0420,74820,018
UCC 0.885,7226,502
Industry average 1.6212,6677,801
Pharmaceutical companies (health care)
Merck 6.48153,37423,670
Pfizer 9.15114,45312,504
Bristol-Meyers-Squibb 5.9699,61516,701
Johnson & Johnson 4.46100,81322,629
American Home Products 4.2960,86914,196
Amgen 5.8213,9832,401
Industry average 3.7627,5397,329
Financial services: Banks
Citicorp 1.9860,06230,300
Chase Manhattan 1.9752,23127,365
Bank America 2.5053,32421,318
Bank of New York 4.2821,9555,124
J.P. Morgan 1.7121,07012,353
Industry average 2.7320,5597,533
Financial Services: Non-banks
Morgan-Dean Witter 1.5341,51827,132
Merrill-Lynch 1.6963,69637,609
Industry average 1.7416,3789,394
Metals and Mining
USX-U.S. Steel 0.443,0266,871
Nucor 1.084,5274,185
Alcoa 0.9512,65513,319
Industry average 0.913,4363,782
Computers and Software and Office Software
Microsoft 15.67205,26513,098
IBM 1.29101,53278,508
Hewlett-Packard 1.5769,75044,416
Intel 5.85146,73025,070
Industry average 2.6323,3118,875
Retailing
Walmart 0.88104,015117,958
Gap 2.7117,6596,508
Federated Dept. 0.639,83515,608
Sears Roebuck 0.5020,77641,469
Industry average 0.8014,57318,182
Aerospace
Boeing 1.1552,81045,800
Industry average 0.9922,13422,359
Transportation
FedEx 1.867,33512,571
Ryder Systems 0.562,8654,894
Industry average 1.009,1379,097
Miscellaneous
GE 2.80254,45590,840
Exxon 1.29157,201122,089
OCR for page 43
THE DYNAMICS OF LONG-TERM GROWTH
43
7. Aerospace, the other major manufacturing industry with a significant posi-
tive balance of payments in the United States, is led by Boeing whose
performance is comparable to some of the large chemical companies that
continue to innovate.
8. The transportation stocks are too few in number to be very meaningful,
but, with the exception of Fedex, they fall into an average that suggests
no great promise for growth.
9. A few exceptional companies are shown for purposes of comparison. The
case of GE is especially interesting. A relatively old, highly diversified
manufacturing company, GE has become the largest company on Wall
Street in terms of its market capitalization, with a capitalization/sales ratio
that is remarkable for such a giant. Exxon, another large capitalization
company, is more normal, perhaps, but still shines by comparison with
some of the others in the table.
The overall conclusion from this table is quite clear. Investors are rewarding
those companies and industries that they perceive to have a technological and
managerial capability for growth. This table does not present foreign companies
because the data are more difficult to locate, but there is little doubt that the same
general trends prevail there too. The influence of the financial markets is spread-
ing, and so is shareholder value. As capital becomes more and more global, this
trend is inevitable.
OCR for page 44
Representative terms from entire chapter:
german chemical
