Russia's Transition to a Market Economy & Introduction for REC's section on Competitive Strategy in the RAATP final project book
COMMENTS ON RUSSIAN REALITY versus THE FREE ENTERPRISE SYSTEM and THE IMPORTANCE of ECONOMIC COMPETITION for a VIABLE ECONOMY
Russian, with the help of the West, is in a transition period and experiencing the challenges of market reforms as it moves from a centrally planned command economy to a free enterprise market economy. Russia has chosen to make this transition after it, and other national centrally planned command economies, found that in experiments carried out around the world in real life national scenarios, that greater wealth was created when the factors of production (land, labor, capital and management) were allocated using a free enterprise system than in a centrally planned command economy.
Major efforts on both the part of Russians and Westerners have been expended to help facilitate these market reforms but not everyone involved really understands the basics of free enterprise and why it has worked so well when run properly and why it seems to "run-a-muck" when it is not done properly. It is important that the government, the participants and the customers understand the basic concepts and what is required to have an effective market economy. It is therefore helpful if the basic tenets of a free enterprise system are taught throughout the populace if establishing a viable free enterprise economic system is the objective.
The three pillars to a free enterprise system are 1. Private Ownership, 2. Competition and 3. Prices set in an open competitive market environment. The national interest in providing the highest standard of living possible for its citizens is achieved by people working for their selfish best interests in a free market economy by what Adam Smith has called "the invisible hand of the market place" where people with private ownership, working in a competitive market environment and working with the objective of making a profit, inadvertently and to the benefit of society, determine 1. What is produced, 2. How much is produced, 3. Who gets the production and 4. At what price.
To allow a free market system to work effectively, there must be rules by which the participants "play the game" and it helps if there are some ethics understood and adhered to by the players and the national citizenry.
In America we take much, if not all, of the above for granted and Americans (and Westerners) have been heard to say, "Doesn't everyone know that?". After working in Russia it is obvious that "not everyone knows that" and certainly, not everyone practices it. To help the Russians make the transition to a market economy, they, the students, and we the teachers, need to understand 1. Where is Russia now? 2. Where does Russia want to go? 3. How do they get there? and 4. How can we help?
Therefore, let's take an assessment of Russia, as measured by the above criteria, for establishing and enjoying the benefits of a free market economy. Unfortunately, upon a closer look, we find that much of what the West is preaching about a free market system is foreign to most Russians. In particular, our Western objectives may not be those of Russia and our methods of achieving the creation of national wealth may not be those with which Russians are comfortable. Let's take a closer look.
THE IMPORTANCE OF A PROFIT OBJECTIVE TO PROVIDE INCENTIVES
A free market economy is driven by the desire to earn a profit and yet for generations of Russians, the word "profit" has been a dirty word. We have had people in our Russian - American Agribusiness Training Partnership (RAATP) seminars who said that they cannot focus on profit as an honorable objective when they are studying financial decision making because "profit" was a swear word that was offensive to the state and to them and even mentioning it in the past could get you in more trouble than you could handle.
Previously, individual private people were not allowed to hire any one (except house servants) and it was a crime to sell anything for more than you paid for it. That just about takes out all the ways to earn a higher standard of living unless you resort to crime or corruption. No wonder the profit concept was held in such low social esteem. If you showed more wealth than your neighbor it raised suspicions about the source. It wasn't healthy to have a higher standard of living than your neighbor as it endangered your life and your property. I've heard private farmers in Russia talk about how their collective farm neighbors would burn the crops and homes of private farmers as those on the collectives believed that it was immoral to leave the collective and to work alone for personal profit.
Therefore, in trying to help Russia develop into a free market economy, we need to justify why the pursuit of profit is a wholesome and desirable national objective if there is a desire to increase the standard of living for a citizenry. Simply said, profit is how you keep score of who is doing the most efficient job of allocating the limited factors of production to satisfy the needs of consumers. Profits allow those who are successful to be rewarded and, if they so choose, they can re-invest in what they are doing and therefore increase their influence so that the efficient allocation of even greater quantities of resources can be achieved. Statues should be build to successful business managers rather throwing stones at them.
In contrast, continuing to operate at a loss may eventually lead to bankruptcy. This removes the inefficient managers and their businesses from consuming the factors of production and allows the resources that they control to be put under the management of more efficient managers and thus a population's standard of living can be improved.
In 1994 a student in Samara asked me the basic question of, "How do you get people to do what you want them to do?" My answer was, "Give them a profit incentive via private ownership in a free market system." Without a profit motive, resources are usually poorly allocated and thus the maximum creation of wealth is not achieved. It has been amply demonstrated that a command economy, with someone in authority allocating the resources as they see fit, can not compete in efficiency of production with a profit driven free market system. Russia has found this out during a seven decade experiment with a command economy. Running this experiment and learning this lesson has been disastrous for its people in more ways that just economical.
Since Russia didn't adequately acknowledge bankruptcy during the times of the Soviet Union, it took the entire USSR to go bankrupt before it realized that what was needed was to convert to a market economy and to allow inefficient enterprises to be replaced by efficient ones. Bankruptcy laws are developing in Russia and one of the major topics of current interest in management schools is "Crisis Management" or "Turn Around Management". Russia needs to speed up the reallocation of the factors of production and manage them more efficiently in order to improve their standard of living.
Russia is looking to the successful wealth producing market economies of the West to transfer market economy technology to Russia. Russia also needs and is asking for the money necessary to facilitate this technology transfer. Not only the Russian managers need this free enterprise technology. It is also needed by the government leaders and the entire population in general. Transferring to a market economy is not as easy as it looks.
GOOD ETHICS ARE IMPORTANT!
Besides the need for Russians to change their attitudes to accept a profit objective, they also need to take some lessons in ethics. A market economy works most efficiently to create wealth in the long run when the players play the game ethically. Using the phrase, "an ethical command economy" appears to be an oxymoron, particularly in Russia, because by its very nature, a command economy encourages corruption, special interests with special favors, the Mafia etc., that all reduce the ability of a country to create wealth.
Russia is particularly handicapped in the general learning of ethics because of the overt policy of the Communist Party to discourage the practice of religion. Lenin called religion, "The opiate of the people". Without the influence of the church, the teaching of ethics from the cradle to the grave, is compromised. While most people in Russia appear to be decent and honest, there are still too many who aren't, to allow the society to truly function appropriately. When I asked a private farmer in Krasnodar if he had trouble with theft of his property, his reply was, "If you aren't stealing you aren't Russian!". This was of course an overstatement but improved ethics is a challenge that Russia needs to face.
Unfortunately, market economies haven't perfected the practicing of great ethics either, although, as I've heard Russians say, "people don't steal from themselves", so there is less problem in a market than a command economy. It is heartening to see some of the churches that were destroyed by Lenin and Stalin being rebuilt and religion beginning to become more important in Russian life.
THE THREE PILLARS OF A FREE ENTERPRISE SYSTEM
Now lets look at the three pillars of a free market system and compare these pillars to present Russian reality. The Russian people in general have a "collective" mentality that does not accept and often rejects the concept of private ownership as we know it in the West. There is a general feeling, when talking about agriculture, that few people want to farm alone as you have to work too hard, there are no holidays, what happens if you get sick, who wants to live alone, who wants that much responsibility, who wants to take that much risk, etc.? This is even believed and taught by learned professors of economics and agribusiness management as well as collective farm managers and by some in government. The concept of private farming, as understood in the USA, is foreign to most Russians.
Lenin himself became aware of the need for private ownership by private farmers and moved to allow such in his New Economic Plan (NEP), saying that it was a mistake to try to collectivize the peasants, but when Stalin took over he did exactly that and collectivized Russia's farms into huge operations that they tried (unsuccessfully) to run like factories. Russian agricultural has never recovered. Agriculture is one of the hardest industries to collectivize and run from central planning. As a result, after decades and generations of collective farming, with inadequate results, the potential for Russian agriculture to increase its productivity through privatization is enormous. This potential is part of the attraction of Western "do-gooders" to work in Russia.
But how do you convert the primarily government owned agribusiness sector into a market economy complete with 1. Private ownership, 2. Competition and 3. Prices determined in the market place? That's the subject for another book or two and we won't discuss it here. It is being carried out however by various Western humanitarian efforts.
At present, Russia is expecting another poor grain crop and Russian agriculture, by all reports, is, in general, in economic chaos. The attempts at privatization of Russian agricultural production, as implemented by various Western programs, are yielding encouraging results of increased productivity, efficiency and profitability. This is a tricky transition as 90% of the farming is still done collectively and any more disruption of Russia's agricultural production during its transition to a market economy could prove disastrous for Russian food supplies and the country's economic and political stability.
PILLAR # 1. PRIVATE OWNERSHIP
Private ownership supplies the incentive for people to work hard and to work smart. As mentioned earlier, without private ownership, there is the encouragement of corruption, the Mafia, crime etc. that reduces national wealth production. (For a more detailed commentary by the author on the Russian reality of the inefficiency of collective farms, please read my 26 page report and commentary written after I visited a collective farm NE of Moscow in October of 1996.)
One of the consistent concerns expressed by managers of joint stock companies (former collectives) is trying to figure out how to motivate their employees. Nothing does this like private ownership. They can see this but they don't often acknowledge it. How else do you explain the high production of private plots of land, such as at dachas, where a disproportionately high level of production occurs when compared to the amount of land involved? I heard a joint stock company manager say, in answer to a question as to whether he encouraged his employees to have private garden plots, that no, he didn't encourage private plots as then the employee was more interested in his own farming than in that of the collective. Russia is losing a lot of productivity because the workers don't have the incentive to work hard and to work smart and to strive to increase their performance that private ownership of the factors of production, including the ownership of land, would encourage. Without private ownership a lot of other negative human activities result, such as corruption, crime, alcoholism and sloth.
PILLAR # 2. COMPETITION
The second pillar of a free enterprise system is competition. Monopolies and oligarchies, with their lack of competition, don't provide adequate incentives for the business to improve customer satisfaction and thus the allocation of the factors of production is not as efficient as where there is competition and a population's standard of living is reduced.
One of the primary differences in effectiveness of a command economy versus a market economy is that in the former, the major effort of the people involved in an activity is to satisfy their superiors in central planning and thus customer satisfaction is secondary to striving to please the bosses in central planning. In a market economy, in a successfully run business, everyone from the ownership and management on down to the employee that interfaces with the customer concentrates on satisfying the customer better than the competitors. In a free market system the customer is king.
Usually, when you study competition the emphasis is on how a firm in the industry can be more competitive than all others and therefore improve market share and profitability but with the bigger concern of national interest, the study of competition is a study on how land, labor and capital are efficiently allocated to improve the creation of wealth.
The major objective of this section on competition is to discuss competitive strategy and learn how to gain competitive advantage. Much of the material presented has been taken from texts by Michael Porter. Before we proceed with this lesson and the discussing of the overheads, let's look at Russian reality as it affects competition and wealth generation.
Historically in the USSR, the state owned almost everything and as a result there was usually only one supplier of an input to an industry and one buyer in the market place to purchase what was produced. Since the supplier, producer, processor and market were all owned and controlled by one entity, the state, with a quota system etc. there wasn't much if any competition and the efficiency of the system was appallingly low. The customer didn't have choices for either supplies or markets.
During the last decade in Russia, as this government owned system broke up, the number of choices didn't increase adequately so private farmers (and joint stock companies run basically like the former collectives) didn't have a choice of suppliers and thus their costs of inputs generally remained higher than world prices while the quality of the supplies was usually lower. Also of importance, the agricultural producer was generally left with the same single buyer (such as a flour mill), that was now called a joint stock company where what the farmer received for his crops was below world market prices and the receipt of payment for his produce was months late. This price disparity between inputs and outputs has worsened until Russian agriculture is in dire straits. Giving the producer more choices among suppliers and markets is a function of competition and Russia needs a lot more of it. Without competition the entire infrastructure of a country, and particularly its business sector, operates below Western standards, making it impossible for Russia to compete effectively in the world market with processed goods.
Russia is the largest and richest country in the world when it comes to natural resources but the living conditions of its people don't reflect this natural wealth because the economy has not been properly managed. You would think that great natural resources would convert to a high standard of living for the country that has them. History shows that this is usually not the case. A study of almost 100 developing economies shows that great natural wealth of a country is often negatively correlated with a high standard of living for its population. Great natural wealth appears to be a curse rather than a blessing to a country. Countries like Japan, which are poor in natural resources, have developed a very high standard of living for its people because they "create" wealth by value adding to the natural resources purchased from other countries, while countries rich in natural resources, such as Russia, sell their natural resources to other countries and let the buying country process them into valued added products and thus Russia loses out on this creation of wealth that comes from adding value. As a consequence, most of the Russian population does not enjoy a high standard of living and many are doomed to living in poverty or just above it. Japan creates wealth. Russia mines it and sells to. It doesn't have to be like that. Improved management and a properly functioning free enterprise system in Russia can dramatically improve the living standards for Russians.
PILLAR # 3. PRICES SET IN THE MARKET PLACE
The third pillar of a free enterprise system is to have prices set in the market place rather than by central planners. In the past under a command economy environment there was always a market for what was produced as the state would buy it but there were also either excesses and shortages of most products. Without prices set in the market there was usually either too much or too little of a commodity produced and the quality was often below world standards. Working on a quota basis rather than with a profit incentive did not encourage either quality or efficiency and made the central planners king rather than the customer.
Russia today finds itself with "predatory" capitalism or "robber" capitalism as practiced by "New Russians". [Before we in the West get too smug, we need to remember that much of the economic development of the United States wasn't so fairly competitive either, with the term "Robber Barons" applied to many prominent industrialists whose names (and descendants) are still common in the American language.] The Russian state, in an effort to privatize, has allowed the selling of major state assets at substantially below market value to insiders (such as major banks) who have connections to the government. Oligarchies and monopolies have resulted in many industries. The Mafia, crime and corruption are flourishing. What Russians see as capitalism is not the way Western capitalism works and many Russians oppose it, longing for the "good old days".
Karl Marx said that capitalism would destroy itself and it probably would have if the capitalists themselves hadn't made rules, such as anti-trust legislation, to preserve the competitiveness of capitalism and thus keep the wealth creating engine of a free market economy running well. Russia needs to pay major attention to its macro economic policy, its banking system, its legal system, it's laws affecting business, improving democracy by reducing the almost Czar-like power of the government and to decide what role government is to play in the economy. I suggest that less is generally better than more.
There needs to be more political and economic stability in Russia to encourage the inflow of foreign capital and the investing in Russia of the twenty five billion U.S. dollars that Russians are reported to be hoarding under their mattresses because they're afraid of depositing it in a bank (where it could be accumulated and invested in the economy) or the Russians hoarding the funds are afraid to invest their savings in their own country.
The author would suggest that the government should own less of the factors of production and make laws favorable to business productivity that are strongly and fairly enforced. That would encourage private business to compete and to allow prices to be set in the market place with more choices for the buyers. This would let the private sector create the wealth. The private sector could then fund the government by paying taxes rather than having the government obtaining money by the running of businesses. There are positive signs that all these things are improving in Russia but it will take a long time.
In summary, when you analyze the components of a free market system, in comparison to what you find in Russia, it is easier to understand the problems that Russia is facing as it attempts to convert to a market economy. Even today after almost ten years of reforms, a profit incentive is not universally accepted, ethics are inadequate, the government owns too much of the factors of production and thus has too much control over the allocation of resources, there is little competition among suppliers and buyers, prices are not always set in the market place and crime, corruption and the Mafia are flourishing.
In the past, the government owned virtually everything, the government set the prices, there was little or no competition, meeting the quota was more important than efficient or quality production or working for a profit and ethics were severely compromised. Changing all of that is a mighty big challenge and will take Russia generations, but you can see that improvements are being made.
With that narrative background, let's looks specifically at our topic of competitive strategy, which is an important part of the field of marketing. Let's look at how to gain competitive advantage and to consider why competition is important for a country (and the world) in order to have a properly functioning wealth creating free market system. We must remember that customer wants are usually greater than their and their country's ability to satisfy them and thus an efficient allocation of the factors of production is important to maximize a nation's standard of living.
A bibliography of source material on this subject is provided. Michael Porter of Harvard is the main guru for information on competitive strategy from the standpoint of the industry and the individual competitor. I have added some other perspectives as shown in the first overhead and as stated in the above narrative and have used agricultural examples and wherever possible, Russian examples. Reading of the Russian newspapers will continually uncover examples for teaching of this material.
The first overhead (OH13-1) - Why Study Competitive Strategy? - shows the objectives of studying competitive strategy. Notice the broad aspects presented that help the student learn about a free market economy and thus to accept it as being able to produce a higher standard of living in comparison to a command economy. It is important that students understand comparative economic systems in order for them to make intelligent decisions as to which economic system they choose for their country. If they aren't convinced that a free market system is the one of choice, then much of what has been taught in our Russian - American Agribusiness Training Partnership workshops concerning making good financial decisions to maximize profit and the need for the preparation of business plans will lose its meaning.
OH13-2 - Business Functions to Consider in Developing Competitive Strategy - looks at the various functions a business performs and should consider in developing a competitive strategy. I have arranged the functions to show a logical progression from the starting of a business to satisfying the customer with a good or service. This systems analysis approach aids in breaking down the various business functions so that each can be studied to see how customer satisfaction can be improved by focusing on how to reduce the cost of production and/or increase the differentiation of the product. Understanding this OH13-2 is important later when we look at using value chains to improve competitiveness. Please keep in mind that becoming more competitive actually means satisfying the customer better than the competition and thus the consumer benefits by having a higher standard of living.
OH13-3 - Considerations in Formulating Competitive Strategy - shows factors to consider in formulating competitive strategy. It incorporates SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis and considers factors that are internal and external to the company. Student learning will be improved if a specific company or industry can be discussed. Observing what can be controlled by management versus what is external to the control of management may be helpful.
OH13-4 - Stages of the life Cycle of a Business or Industry - looks at the various stages of the life cycle of a business (or an entire industry). The instructor can give Russian examples, such as how kiosks became very popular a few years ago but are now being replaced by walk-in markets. Ask the students to think of other examples. Ask about specific industries and ask the students to place them on this life cycle chart. Talk about the consequences on the decision making process of investing versus selling out, profitability, management decisions, etc. based upon where the investors and managers perceive the industry to be placed on this life cycle line.
OH13-5 - Entry and Exit Barriers and Profitability - shows the effect of barriers to enter and/or exit an industry on the profitability within that industry. Point out how this affects the ease of reallocation of resources. Give examples such as comparing the entry and exit barriers (ease of entering or exiting a business) of selling cigarettes near the Metro (easy in and out) to that of raising pigs in simple vs. elaborate facilities to manufacturing cars (hard to get in and to get out). Talk about the effect that government can have through its laws and policies concerning entering and exiting a business (labor notification of plant closure, etc.) and how this affects competition and the reallocation of the factors of production.
Entry barriers that can be discussed include the effect of economies of scale, product differentiation, capital requirements, the cost for a customer to switch to your product, access to distribution channels, proprietary product technology, access to raw materials, government involvement (such as licenses, environmental standards, health considerations, subsidies), learning curves, favorable locations, expected retaliation of competitors, etc.
Exit barriers to be considered include alternative uses or salvage value of specialized assets, labor agreements, strategic interrelationships, emotional barriers of management, government and social restrictions, etc.
OH13-6 - Strategic Advantage - The Four Generic Strategies - shows the generic approaches to competition, which are 1. Being the least cost producer, 2. Differentiation of the product, 3. Focusing and 4. Being the best value. Talk about different competitive approaches in the same industry such as the competitive techniques of hotel and motel facilities that appeal to either economy or opulence. Both approaches can be profitable but they appeal to customers with different buying profiles.
Be sure that the students understand the meaning of differentiation. Point out that the cost of producing a product should be reduced as long as it doesn't hurt differentiation and that differentiation should be done as long as it doesn't increase cost. Past these points the management must make a decision of what profile of customer they are trying to attract - least cost buyers or customers who want a differentiated product. Give examples of the aspirin industry where Bayer Aspirin has differentiated their product in the minds of consumers, even though all aspirin are the same. The different prices and qualities of dog food are a good example of the different generic approaches to competing - price, differentiation, focus, best value.
OH13-7 - The Five Competitive Forces that Determine Industry Profitability - pulls all the concepts of the previous overheads together to look at the five competitive forces that work together to determine the profitability of an industry and a specific business within that industry. This allows the instructor to really look at the consequences and benefits of competition versus no competition in an industry. You can point out what happens when the state owns everything including the supplier (example - grain), the manufacturing facility (example - feed mill) and is the buyer (example owns the dairy) and how this reduces competition and thus negates good efficient management. This was of course the situation in the USSR for many industries and the whole country went broke.
This overhead helps explain a lot about why a state owned centrally planned economy does not compete well, is not efficient and therefore the customers are not well served and the citizenry must settle for a lower standard of living than where competition in a market economy is allowed to flourish.
An example of the potential of substitute products to destroy an industry would be plastic baling twine replacing hemp and thus putting natural twine producers out of business. An example of buyers entering the industry would be dairy farmers doing home mixing rather than buying prepared feed from a fee mill. An example of potential entrants would be McDonalds versus Russian Bistro or Pepsi versus Coca Cola in Russia. The strength of suppliers could be demonstrated by talking about Intel, the leading manufacturer of computer chips, and the leverage Intel has over the computer industry. The instructor should point out how Overhead 13-7 looks at the overall profitability of an industry and asks who earns most of the profit in an industry based on the relative strengths or weaknesses of the suppliers, the industry competitors and the buyers and acknowledges the threat of new entrants or the possibility of substitute products.
This OH (OH13-7) really allows a major discussion of the dynamic workings and favorable results of a market oriented, competitive, privately owned economy versus the static, under performing industries of a government owned centrally planned economy. If the students can understand the concepts of this overhead, they will have come a long way towards understanding the workings of a market economy. Don't rush them. Russians didn't grow up with these concepts. In fact, a lot of Westerners don't understand them adequately either. The poor performance of command economies has focused those operating in market economies to look at ways to fine tune the free enterprise system.
OH13-8 shows what is called a "Value Chain". It takes the business functions of OH13-2 and rearranges them as to being 1. Support or 2. Primary business activities. Each function can be further divided, such as marketing and sales into literature, advertising (radio, TV, bill boards, direct mail, etc.) direct or indirect selling, etc. It allows the manager to take a systems analysis approach and to dissect and look at each function of the business and to ask repeatedly, how can I reduce costs and how can I differentiate the good or service to serve the customer better and more competitively than my competitors?
Point out that a manager should look at the value chains of suppliers and buyers and see if there is an overlap of functions, that if eliminated, would increase competition if either a supplier or a buyer did less or more than they are doing presently in the preparation of a good or a service. For example, perhaps the processor of potatoes should cut and package the French fries for a fast food restaurant rather than the restaurant slicing them themselves. Perhaps profitability can be increased if you hire a distribution service to distribute your products rather than run your own fleet of trucks. Look at everything you, your suppliers and customers do to see if changes can be made to reduce costs and/or differentiate the product so as to become more competitive in satisfying customer needs.
A good class exercise is to have each student (or a group of students) take a specific company and then, with two sheets of paper, list how they can 1. Reduce costs and 2. Differentiate the product. This can really get their entrepreneurial creative juices flowing. I've seen classes come alive with this exercise, particularly with managers who can analyze their own business and come up with ways to become more competitive. Professors usually don't get as excited as managers. Perhaps there is a difference in the profit incentive that affects the excitement level of one group more than the other.
The instructor should try to encourage entrepreneurial thinking by the students and convey how a country's standard of living is benefited when management is able to improve customer satisfaction by reducing costs and improving the good or service. Competition encourages all of this.
The student may want to be a business analyst versus climbing into the arena to be an actual competitor. The study of competitive strategy and looking for competitive advantage allows one to evaluate various businesses and to make judgments on which one to invest in, how to advise improvements, etc. Understanding these concepts and knowing what to look for makes reading the paper, listening to the news and observing a specific business, industry or a country's entire economic system much more exciting.
The amount of class time needed to teach this section will vary with the examples given and the class participation in various exercises but I would suggest that at least two to three hours, without translation, be allocated to teaching this section on competition and the free enterprise system. More learning will take place if class exercises and participation are encouraged and the time allotted is increased to four or five hours or more. The instructor needs to be up to date on current economic events and to use current agribusiness examples to stress the important points.
Class participation and case studies greatly facilitate the learning of competitive strategy and the understanding of how a free enterprise system functions, including what characteristics are needed to have a viable free market economy.
Hopefully, this section on Competitive Strategy will help students meet the objectives originally stated in the first overhead (OH 13-1).
Roy Chapin, Ph.D., Animal Nutritionist
11145 Chapin Lane, Amity, Oregon 97101
E-mail: <[email protected]>