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Which way now when the world has shifted? | Observer

Which way now when the world has shifted? | Business | The Observer

Ruth Sunderland looks at the causes and consequences of a 10-year boom imploding, leaving Britain at a dangerous economic crossroads

• 
  The Observer,
  
• Sunday December 23 2007

If
you landed in London from another planet this month and picked up the
Financial Times's glossy How to Spend It magazine, you would not
suspect for a nanosecond that there was a crisis on the world money
markets. In 120 pages of unabashed haute consumerism, ads for Tiffany
ran alongside features on record couture sales at Christian Dior, with
scarcely a hint at harsh realities such as multibillion-pound bank
write-offs, smaller bonuses and lost City jobs.

The truth,
however, is that in 2007 the financial world was turned upside down:
the credit crunch has toppled a golden decade of extraordinary
prosperity in the UK and accelerated a shift in the global balance of
economic power. One consequence is that banks in the City and Wall
Street, the engine rooms of capitalism, have been so desperate for cash
that they have sold large chunks of their equity to China or Middle
Eastern states.

The credit crunch has spawned plenty of soul
searching about financial regulation, debt risks and the like. But more
thoughtful financiers acknowledge it has also prompted broader
reflection on the City's role in modern Britain.

David Buik of
spread betting firm Cantor Index says: 'The day the queues formed
outside Northern Rock branches marked a sea change. It was the end of
the illusion that we - individuals, companies and governments - could
go on running up debt with impunity. It was a wake-up call,
particularly for a younger generation which has never known financial
hardship, negative equity, high unemployment, never known the economy
to be less than benign. It also revealed the truth about our system of
financial regulation, that was supposed to be so brilliant, but did not
work when put to the test.'

With hindsight, the first signs of
a gathering financial storm came early in the year, when HSBC, which
owns the former Midland Bank in the UK, admitted that it had written
off $10.5bn of bad debts, a large chunk of it on home loans to poor
borrowers in America. The bank came in for a huge lashing from its
shareholders, but few, at that stage, made the leap to realising it was
a much wider problem.

Loans made to cash-strapped American
homebuyers had been packaged up into fancy investment vehicles and sold
to investors around the world; banks are unsure of the extent of their
rivals' - even possibly their own - exposure, and therefore are
unwilling to lend to each other.

That matters because it has
hit our high-street banks: Northern Rock is being supported by the
taxpayer to the tune of £55bn and looks to be heading for
nationalisation. It could also hit the wider economy. Mervyn King,
governor of the Bank of England, who prides himself on being calm and
understated, warned last week of a 'palpable sense of fear' that could
send the economy into free fall.

The City has in the past
decade turned itself from a comparative backwater into a genuine rival
to Wall Street. But the credit crunch means jobs will be lost and
bonuses smaller. In Covent Garden, Portland Place and Berkeley Square,
the private equity barons, who menaced FTSE 100 companies with
audacious takeover bids in the first part of the year, have watched
their flood of deals dry to a trickle. On the high street, tills will
not be ringing so loudly and, on Acacia Avenue, homeowners are worrying
about their mortgages.

Some will see the crisis as an overdue
humbling of City arrogance. The past 10 years have been stunningly good
for the super-rich. The wealth of high-net-worth individuals (Henwis) -
those with at least $1m at their disposal, not counting their main home
- increased by 11.4 per cent last year to $37trn worldwide. In the UK,
the number of Henwis rose from 448,000 to 485,000; you now need £70m to
get into the 'Rich List' of the 1,000 wealthiest people. Much of that
wealth inflation has come from the City, with a record 155 financiers
making it into the table.

That has fuelled middle-class envy of
the very rich, or what Harvard economist Martin Feldstein calls
'spiteful egalitarianism' - the idea that the increasing fortunes of
the uber-wealthy are bad, because it makes others feel poor.

The
middle classes are resentful because they are being priced out of
things they consider their birthright, including homes in desirable
areas and good schooling. Private fees, for example, have soared by 41
per cent in five years, taking the average costs of a day school to
more than £9,600 a year. The rising costs of education and home
ownership, coupled with the urge to consume, has driven record numbers
into insolvency (see chart).

Robert and Lisa, a professional
couple in their late forties living in London with two sons, are
typical of the families caught in the middle-class squeeze. Although
prosperous by most standards, they are beset by financial anxieties.

'We
live in a five-bedroom terraced house in north London and it has shot
up in value since we bought it in 1996,' says Robert. 'But our elder
son will soon go to secondary school. To get him into a good one, we'd
have to move a short distance and pay an extra £250,000 for the
same-sized property near the school. We're thinking seriously about
sending both boys to an independent school because the fees are about
the same as moving.

'Foolishly, I failed to join company
pension schemes in my twenties and thirties and now regret it. We're
wondering how we are going to juggle all these financial
responsibilities at our age. My parents were not enormously wealthy,
but my dad had a good job in an accountancy firm and was always home
for supper at 6.30 in time to read us stories. I can't do that with my
kids because I have to work such long hours. He lived in London all his
life after retiring at 65 on a generous final salary pension scheme - I
will have nothing like that.'

Middle-class financial woes could
be dismissed as the bleatings of the privileged but, at the bottom end
of the economic scale, things are also arguably worse. The rich have
become richer, but the poor are still relatively poor. The Institute
for Fiscal Studies reported this year that relative poverty has risen
for the first time since Labour came to power, with 12.7 million people
- more than a fifth of the population - living in households with
incomes lower than 60 per cent of the median after housing costs. A
shocking 3.8 million children are classed as living in poverty.

Schadenfreude
may be satisfying, but a downturn in the City hurts us all, because of
the massive increase in its influence on the UK economy as a whole
during the golden decade. Financial services has grown from 5.5 per
cent of the economy to more than 9 per cent last year and, over the
past three years, it has been responsible for a third of overall GDP
growth. Manufacturing has gone in the opposite direction, declining as
a proportion of the total economy from 23 per cent in 1990 to 14 per
cent in 2005. Employment in industry has plunged by more than a
million, while financial service sector jobs have grown (see chart).

A
report by the Ernst & Young Item Club this year described the City
as a 'cuckoo in the nest', crowding out manufacturing and other
industries. While it is good to specialise, the report said, this
process should be carefully managed. David Frost, director-general of
the British Chambers of Commerce, says: 'The government has no option
but to nurture the City because it is a huge economic driver. But
manufacturing is still important. It is not an either/or situation. You
should be able to have both, as they do in Germany, where they still
have world-class manufacturers. The economy is like a tripod: you need
strong services, strong manufacturing and a strong public sector. Ours
is unbalanced, with manufacturing the poor relation.'

The credit
crunch has also prompted more soul searching about our high-consumption
lifestyle. Edward Bonham Carter, of fund manager Jupiter Asset
Management, says: 'In every economic cycle, there are excesses on a
local level. People have been much better off in the previous decade,
but are they happier? Material accumulation does not improve our sense
of well-being, and that is intersecting with the climate change debate,
where people realise that they have to consume less. It is part of the
zeitgeist.'

Not that he is advocating a hair-shirt backlash: 'The
more redistributive you are, the less incentive people have for
creating wealth. On the other hand, if you have a rampant capitalist
state and do not redistribute it at all, you get rich ghettos and
ultimately revolution.'

The other great upheaval of 2007 is the
shift in the balance of power from the West to the developing world,
seen in the rise of sovereign funds investing trillions of dollars of
excess savings from China and the Middle East, a trend that accelerated
strongly due to the credit crisis. While Northern Rock was bailed out
by the government via the Bank of England, others courted rescue from
the Chinese state. Morgan Stanley, for example, received a $5bn
injection from the China Investment Corp in return for securities that
will convert into as much as 9.9 per cent of its stock. Abu Dhabi's
sovereign wealth fund invested $7.5bn in Citigroup last month, and the
Singapore government and an unnamed Middle Eastern investor has
ploughed SFr13bn (£5.7bn) into Swiss bank UBS.

'When you have a
sector that is bombed out but with high growth potential, the smart
money piles in,' says one chief executive. 'I think it is a healthy
part of globalisation, but there will be more protectionist noise in
America about it, which could be harmful.'

Chagrined though they
are, leading bankers don't believe their game is up. The same chief
executive adds: 'If you take a 10-year view, there is every reason to
believe the financial services sector will be one of the fastest
growing. Nothing that has happened in the past six months will change
some of the big long-term trends, such as the privatisation of the
welfare state, or the demographic drivers, such as people living
longer. These are behind the development of the financial services
industry.'

He goes on: 'The conditions we have now were created
by the pursuit for yield by investors in a low-interest, low-inflation
environment. Some of the opaque instruments have gone, but the quest
for yield has not vanished and that will drive innovation. The
performance of markets over time is being pushed by those very big
demographic drivers - it is completely unstoppable.'

In the
past 10 years, the City has sealed its transformation from a soporific
club for paunchy Old Etonians to a magnet for brilliant young talent.
It has unleashed innovations on an uncomprehending world and the pace
of financial evolution has far outstripped ability of the relatively
underpaid, and sometimes intellectually underpowered, financial
regulators to keep up.

Sober critics have been questioning the
vertiginous rise of the City for some time. During the good times, this
was brushed aside by practitioners and politicians, content to bask in
the reflected glory of London's rise as a financial centre. After
Northern Rock, those inconvenient voices have grown to a clamour that
must be heard.

Are we prepared to live in a less equal and more
divided society if that is the price of a booming financial sector? Is
it OK for the City to play such an overweening role in our economy,
while manufacturing struggles? How else, other than in financial
services, might Britain compete in a global economy against emerging
nations with cheaper labour and raw materials? Is it desirable for the
sovereign funds of sometimes undemocratic foreign governments to gain
more control over the levers of capital? All of these are issues for
2008 as we ponder how best to move forward in this chastened new world.

December 23, 2007 at 06:00 PM in Business Models | Permalink | Top of page | Blog Home

From 0 to 60 to World Domination - New York Times - Toyota

By JON GERTNER 1. Here Comes the Tundra For most of the January morning, the reporters at the Detroit auto show crisscrossed the Cobo convention center like a herd of livestock, moving at least once every hour to feed sometimes literally, since Lexus offered fresh fruit. All the world's car companies were unveiling this year's models. Often, the back-to-back corporate announcements required everyone to scurry clear across the exhibit floor to get a seat at the next press conference. It was hard not to lose yourself in the scenery, however, as you passed by a dazzling showroom exhibit of Maseratis, for instance, or encountered some gleaming Infinitis. The event was a place untroubled by thoughts of traffic jams, long commutes or gas prices. It was also a place where C.E.O.'s like Rick Wagoner of General Motors showed off electric cars like the Chevy Volt that cannot yet be produced at least until battery technology improves but that can nonetheless be driven slowly across a stage toward a cluster of photographers. In this context, it seemed, G.M. was not a company that posted a $10.6 billion loss in 2005, nor was Ford a manufacturer that announced plans last year to shed more than 30,000 employees. There were no overwhelming pension and health-care burdens.

Source: From 0 to 60 to World Domination - New York Times

Shortly after noon that day, in a ballroom just off the convention center’s main floor, the crowd was waiting for Toyota to unveil the latest (and largest) version of its new full-size truck, the Tundra. From where I stood, pinned against a back wall in the darkened room, it was getting hard to breathe. At this point I had been following Toyota and the Tundra for months; I visited the company’s new Tundra plant in San Antonio, its sales headquarters near Los Angeles, its executive offices in Manhattan and its Camry plant near Lexington, Ky. Apart from some recalls of faulty parts (an unusual and humiliating occurrence for the carmaker), Toyota had seemed as close to a juggernaut as any corporation in existence.

By any measure, Toyota’s performance last year, in a tepid market for car sales, was so striking, so outsize, that there seem to be few analogs, at least in the manufacturing world. A baseball team that wins 150 out of 162 games? Maybe. By late December, Toyota’s global projections for 2007 — the production of 9.34 million cars and trucks — indicated that it would soon pass G.M. as the world’s largest car company. For auto analysts, one of the more useful measures of consumer appeal is the “retail turn rate” — that is, the number of days a car sits on a dealer’s lot before it is turned over to a customer. As of November 2006, according to the Power Information Network, a division of J.D. Power & Associates that tracks such sales data, Toyota’s cars in the U.S. (including its Lexus and Scion brands) had an average turn rate of 27 days. BMW was second at 31; Honda was third at 32. Ford was at 82 and G.M. at 83. And Daimler-Chrysler was at 107. The financial markets reflected these contrasts. By year’s end, Toyota would record an annual net profit of $11.6 billion, and its market capitalization (the value of all its shares) would reach nearly $240 billion — greater than that of G.M., Ford, Daimler-Chrysler, Honda and Nissan combined.

When the Tundra finally arrived onstage in Detroit, Jim Lentz, one of the company’s North American executives, told the packed ballroom that this vehicle “changed everything” for Toyota. It was researched, designed, engineered and built in America, Lentz pointed out; and it seemed, from his presentation, to be the toughest, brawniest and most iconically masculine pickup truck anywhere, ever. Such boasts were in keeping with the spirit of car-dealership hucksterism at the show. Still, 50 years after coming to the U.S., Toyota views the Tundra, which arrived in American showrooms earlier this month, not only as another big truck but also as the culmination of a half-century of experimentation, failure, resurgence and domination. And as anyone with even a passing familiarity with Toyota’s strategic history knows, the company never makes rash moves or false promises.

Whether Toyota has evolved into the world’s most sophisticated modern corporation — one whose example has challenged the American model of manufacturing and management — happens to be a common topic of conversation among business analysts these days. “It’s influencing just about every major company in the world, in that they’re asking the question: What can we learn from Toyota?” says Jeff Liker, an engineering professor at the University of Michigan who has written several books on the company. Indeed, what you can learn from Toyota is something that even Bill Gates has pondered publicly. And yet deconstructing Toyota means breaking down a corporation that uses all its resources, and more than 295,000 employees worldwide, to construct things that are not meant to come apart.

2. Kaizen Means Never Being Satisfied

One of the Toyota executives attending the Tundra’s debut was Jim Press. A tall, lean Midwesterner, Press is the president of Toyota Motor North America, making him the company’s highest-ranking American. Toyota is governed by a large corporate board, which is made up of top executives in Japan and senior managing directors spread around the globe; Press is one of 49 managing officers of the company just below that level. For most of his career, Press worked on the West Coast, at Toyota’s North American sales headquarters in Torrance, Calif. More than half of Toyota’s profits now come from the U.S.; its success here, and its success globally, are so closely related as to be indistinguishable. In the view of one longtime Toyota watcher, Press’s high standing reflects the fact that, more than any single manager, he delivered the American market to Toyota. His efforts helped make the Camry the best-selling car and the Lexus the most popular luxury brand in the U.S.

Press, who is 60, never had an ambition to be an auto executive. When I first met him in his Midtown Manhattan office in October, he told me that after college he took a job working for Ford. “My family was in retail,” he said, “and this was a foray into the manufacturing side to kind of learn what goes on in the industry before I went on and became a car dealer.” In 1970, his boss at Ford moved to Toyota and encouraged him to join up too. At the time, Toyota sold a few Land Cruisers and was known mainly for one car, the Toyota Corona. It seemed like a poor career move. “When you’re young and your head is full of ideas, you don’t let facts get in the way,” Press said. So he took a flier, gave up his company car (a new Ford Thunderbird) and went to work at Toyota.

When he started, the Big Three completely controlled car sales in the United States. The only foreign company of any prominence was Volkswagen, and as Press recalled, Toyota’s modest sales were lumped with various tiny carmakers as “Other.” Still, soon after he arrived, Press realized he liked the company’s intimacy: he could meet face to face with top managers and exert some influence over marketing decisions. And he liked Toyota’s obsession with customer satisfaction. When he told me about his first trip to Japan, he seemed to be recounting a religious experience. “As a young person, you are searching for this level of comfort, you don’t know what it is, but you’re sort of uncomfortable,” he said. In Japan, as he put it, he found a home, a place where everything from the politeness of the people to the organization of the factories made sense. On that first trip, at a restaurant one evening, he tried a rich corn soup and asked the waitress for the recipe. She checked with the chef, who explained that there was no recipe; it had been handed down from his mother. The next morning, the waitress came to Press’s hotel room: she had found a cookbook with a recipe for the soup. Press, apparently, was still her customer. “That blew me away,” he said.

It can be simplistic, and often a distortion, to accept a corporate executive as the personification of a corporation, especially one as large and varied as Toyota. Yet Press serves as an apt representative, and not merely because his career arc mirrors the company’s ascendancy. Like Toyota, he expresses himself in private with modesty and care, yet in public his speeches are bold, declarative and effervescent. In his office, he has an informal, relaxed presence and exhibits just a hint of an avuncular stoop; yet he loves to race cars and sometimes swims 5,000 meters a day. Press also has a fluency in the company’s arcane systems and history. Toyota is as much a philosophy as a business, a patchwork of traditions, apothegms and precepts that don’t translate easily into the American vernacular. Some have proved incisive (“Build quality into processes”) and some opaque (“Open the window. It’s a big world out there!”). Toyota’s overarching principle, Press told me, is “to enrich society through the building of cars and trucks.” This phrase should be cause for skepticism, especially coming from a company so adept at marketing and public relations. I lost count of how many times Toyota executives, during the course of my reporting, repeated it and how often I had to keep from recoiling at its hollow peculiarity. And yet, the catch phrase — to enrich and serve society — was not intended, at least originally, to function as a P.R. motto. Historically the idea has meant offering car customers reliability and mobility while investing profits in new plants, technologies and employees. It has also captured an obsessive obligation to build better cars, which reflects the Toyota belief in kaizen, or continuous improvement. Finally, the phrase carries with it the responsibility to plan for the long term — financially, technically, imaginatively. “The company thinks in years and decades,” Michael Robinet, a vice president at CSM Worldwide, a consulting firm that focuses on the global auto industry, told me. “They don’t think in months or quarters.”

Certainly the most obvious example of Toyota’s long view is the Prius hybrid. Press said he believes that every automobile in the U.S. will eventually be a hybrid. I asked how soon. Not in five years, he replied, “but I think at some point in the not-too-distant future.” I asked whether Toyota developed and marketed the technology years ahead of the other major automakers because it possessed better technical skills. Press instead framed the issue as a matter of philosophy. Ten years ago, he said, at about the same time the Prius made its debut, Ford rolled out the huge S.U.V. franchise. “Both of us had the same tea leaves, the same research,” he said. “One of us bet on hybrid, one of us bet on big S.U.V.’s.” In his view, the wisdom of making big S.U.V.’s — Press left unacknowledged that Toyota eventually brought out its own line of S.U.V.’s — seemed dubious: “First of all, long term, is fuel going to get cheaper or more expensive? Is oil going to become more plentiful or less plentiful? Is the air going to become cleaner or more polluted? And so, do you do something proactive and innovative, to be in tune with where society is going? Or do you hold on to where it has been, and then don’t let go, to the bitter end?” It was never a matter of altruism, he seemed to be saying, but an example of how corporations survive in society. “What’s the right thing to do to sustain the ability to sell more cars and trucks?” he asked. The Prius was not about a fast return on investment. It was about a slow and long-lasting one.

The Tundra is hardly green like the Prius, yet it, too, illustrates Toyota’s characteristic patience and belief that it should serve every kind of customer. The biggest-selling vehicle in the United States is not the Camry (448,445 sold last year) or the Accord (354,441) but Ford F-Series trucks (796,039). Not far behind in sales are the full-size trucks from Chevrolet. These are among the most lucrative consumer products around, yielding anywhere from $6,000 to $10,000 in profit for every unit sold. “To the American automakers, that’s their bread and butter,” Jeff Liker, from the University of Michigan, explains. “They break even on passenger cars, lose money on small cars. But all their profits come from large S.U.V.’s and trucks. For the American auto companies, this is the last hill that they dominate.” Several auto analysts pointed out to me that G.M. and Ford trucks not only have an extremely loyal customer base; they’re also widely regarded as extremely well built and engineered (often in contrast to their passenger cars). When I asked Jim Press how long the company had been thinking about creating a full-size truck, he said it had been a priority dating to the early 1990s, when Toyota failed with its first big truck, the T100. The company failed again in 2000 when its first (and smaller) Tundra came out; only 124,508 units were sold last year.

Within Toyota, there is a rare and secretive designation for certain development projects known as irei, which is roughly translated as “not ordinary” or “exceptional” and refers to vehicles that the company will spend any amount on and go to almost any lengths to engineer, market and perfect. In the early 1990s, the Prius had this designation. When it came time several years ago to begin redesigning the new Tundra, it received the classification, too. The success of G.M. and Ford suggested that it was a product that could eventually reap tremendous profits. It was also a vehicle that could conceivably cement Toyota’s reputation, once and for all, as an all-American company.

3. The Engineers Open the Window on the Big World Out There

It’s often noted that American carmakers are hobbled by their obligations to pay health care “legacy costs” to their ranks of retirees. Toyota has only about 1,600 retirees in the U.S., and many of its factories have never been successfully organized by a union. Yet Toyota has other strategic advantages too. For one thing, its enormous cash reserves allow it to spend billions on the pursuit of market share in the U.S. — designing a new car or significantly redesigning an old one usually costs $1 billion, and building a new plant costs between $1 billion and $2 billion — and at the same time to think deeply about where society will be in 20 years.

These two pursuits, which might appear contradictory, actually reinforce each other. “Toyota has always gone where the money is, and there’s money in trucks,” says John Casesa, an industry consultant and a former automotive analyst at Merrill Lynch. “This is a company that has, as its mission, to serve any customer. But the other reality is that you’ve got to make a lot of money to develop the research and development for hybrids.” Toyota spends $20 million a day, Jim Press told me, on research and factories. “They are outspending G.M. in R.&D., product development and capital spending,” says Sean McAlinden, an economist at the Center for Automotive Research, a not-for-profit consulting firm in Ann Arbor. “If that trend continues, we’re dead. The problem is, suppose we made a car” as good as a Toyota. “Then we only have a car as good as they do. It’s not just about catching up, or getting into the game. You’ve got to get ahead somehow. But how?”

Toyota itself keeps pushing ahead. Under its system, an engineer appointed to lead a new project has a huge budget and near absolute authority over the project. Toyota’s chief engineers consider it their responsibility to begin a design (or a redesign) by going out and seeing for themselves — the term within Toyota is genchi genbutsu — what customers want in a car or a truck and how any current versions come up short. This quest can sometimes seem Arthurian, with chief engineers leading lonely and gallant expeditions in an attempt to figure out how to beat the competition. Most extreme, perhaps, was the task Yuji Yokoya set for himself when he was asked to redesign the Sienna minivan. He decided he would drive the Sienna (and other minivans) in every American state, every Canadian province and most of Mexico. Yokoya at one point decided to visit a tiny and remote Canadian town, Rankin Inlet, in Nunavut, near the Arctic Circle. He flew there in a small plane, borrowed a minivan from a Rankin Inlet taxi driver and drove around for a few minutes (there were very few roads). The point of all this to and fro, Jeff Liker says, was to test different vans — on ice, in wind, on highways and city streets — and make Toyota’s superior. Curiously, even when his three-year, 53,000-mile journey was finished, Yokoya could not stop. One person at Toyota told me he bumped into him at a hotel in the middle of Death Valley, Calif., after the new Sienna came out in 2004. Apparently, Yokoya wanted to see how his redesigned van was handling in the desert.

When I spoke not long ago with the Tundra’s chief engineer, Yuichiro Obu, and its project manager, Mark Schrage, both of whom work in Ann Arbor, they characterized their research for the Tundra as quite unlike what was done for the Sienna. For starters, designing a full-size pickup truck for the American worker is more complex than designing a van for a soccer mom. The way a farmer uses a truck is different from the way a construction worker does; preferences in Texas (for two-wheel drive) differ from those in Montana (for four-wheel drive). Truck drivers have diverse needs in terms of horsepower and torque, since they carry different payloads on different terrain. They also have variable needs when it comes to cab size (seating between two and five people) and fuel economy (depending on the length of a commute). In August 2002, Obu and his team began visiting different regions of the U.S.; they went to logging camps, horse farms, factories and construction sites to meet with truck owners. By asking them face to face about their needs, Obu and Schrage sought to understand preferences for towing capacity and power; by silently observing them at work, they learned things about the ideal placement of the gear shifter, for instance, or that the door handle and radio knobs should be extra large, because pickup owners often wear work gloves all day. When the team discerned that the pickup has now evolved into a kind of mobile office for many contractors, the engineers sought to create a space for a laptop and hanging files next to the driver. Finally, they made archaeological visits to truck graveyards in Michigan, where they poked around the rusting hulks of pickups and saw what parts had lasted. With so many retired trucks in one place, they also gained a better sense of how trucks had evolved over the past 30 years — becoming larger, more varied, more luxurious — and where they might go next.

Obu’s team, which drew on hundreds of engineers, ultimately produced a pickup model with 31 variations that include engines, wheelbases and cabs of different sizes. Design engineers, however, cannot simply create the best truck they can; they need to create the best truck that can be built in a big factory. In other words, Tundra’s design engineers had to confer with Tundra’s manufacturing engineers at every step of the way to create a truck — or 31 trucks, really — that could be assembled efficiently and systematically. To that end, Toyota spent $1.28 billion to build its San Antonio plant; it has the capacity to produce about 200,000 vehicles a year. The company considers it one of the most advanced manufacturing plants in the world.

I visited San Antonio in late November, after the factory had just begun operating. Management theorists who study Toyota’s production system tend to say that it is difficult to replicate, insofar as the company’s methods are not simply a series of techniques but a way of thinking about teamwork, products and efficiency. Still, some aspects of the system were clearly visible in San Antonio. In the Tundra plant, there is no real inventory of parts, which is a hallmark of Toyota’s approach. Once a truck chassis begins its run on the factory line, an order goes out to, say, an on-site parts supplier that provides seats for the interior. At Avanzar, an independent company located in a large workroom adjacent to the assembly line, I watched workers build a car seat from scratch. They chose a raw steel frame with springs, put it on their own minifactory assembly line to add padding, then leather, and then they transferred it (via pulley, over a partition wall) to the Tundra assembly line, where it was installed in the truck. If the front seat had not been ordered 85 minutes earlier, it would not exist.

The idea of actually situating a parts supplier inside an assembly plant is wholly novel. But the methods of low inventory — or what’s known as “just in time” production — are hardly unique to Toyota; these have been emulated with great success by other automakers. The same goes for other processes at the San Antonio plant: the line stoppages and quality checks, the time spent by workers discussing hand and body movements in the hope of shaving a crucial half-second from their work. Over the years, Toyota has assisted competitors, especially G.M., in helping to adopt its system, believing it to be in its interest to share practices, especially in exchange for insights into a rival’s methods. Toyota’s true technological advances, however, are another matter. In San Antonio, for instance, recent innovations in the paint shop that significantly cut production time were considered proprietary and off-limits to journalists.

It is a challenge to convey the scale of the Camry plant in Georgetown, Ky., which comprises 7.5 million square feet, or the orchestral complexity of its shop floor, where 7,000 workers assemble some 5,000 parts into 2,000 cars a day. I couldn’t help wondering if a glitch in the flow of door handles, or a broken welding robot, would put a crimp in the entire enterprise. “But that’s what the Toyota Production System is,” Gary Convis, the head of the plant, countered. “You actually create the conditions where things have to work to make it work.” Convis, like most Toyota engineers, mostly wanted to talk to me about Georgetown’s ceaseless drive for improvement. When a plant changes over to a new car design, as Georgetown did for the 2006 Camry, production slows down as parts and systems are updated. The last time Georgetown overhauled the Camry, in 2001, 59 days were needed to fully convert the factory to new-car production; last year, the new model took 16 days. The extra cars probably meant additional revenue of about $100 million.

Improving efficiency in the factory, though, doesn’t necessarily lead to greater profits. Savings on the assembly line can mean a nicer dashboard without making the customer pay more for it. “If you’re efficient in the things the customer doesn’t see, then you can put it into the things the customer does see,” Ron Harbour, a consultant whose company rates the efficiency of auto plants, told me. A result is a car more popular with customers. Success on the assembly line, in this way, begets success in the showroom.

4. The Long Road From Rural Japan to California and Beyond

Over the past few years, in an effort to amass a physical record of its business experience in the United States, Toyota has been tracking down and collecting automobiles it has sold here since the late 1950s. The Toyota USA Automobile Museum, as it’s known, is located in an unmarked white-brick building on a side street in Torrance, Calif., a few blocks from Toyota’s corporate sales campus. When I visited in early December, I took a leisurely stroll through the museum’s main room, a spacious, high-ceilinged garage filled with Toyotas, Lexuses and Scions, all in immaculate condition, all parked aslant on a concrete floor. The museum is open only by appointment; there were no other visitors. Time was compressed into a few strides. I passed a Toyota Corona (1966), a Corolla built in California (the first Toyota made in the U.S., 1986), a Camry from Kentucky (1989), an early Prius (2000) and an early Tundra (2003). To walk along the rows undermines any notion that Toyota’s success has been sudden; the progression of cars — in styling, popularity and increasing Americanization — was methodical and incremental. “We don’t move in an unpredictable manner,” Jim Press told me a few weeks before my visit to the museum. “We move jojo, a Japanese term, meaning step by step.”

Toyota grew out of an entrepreneurial foray by the Toyoda family — which made a fortune building textile looms early in the last century — in the 1930s under the leadership of Kiichiro Toyoda. (That’s also when it was decided that the car company would be better served by replacing the family’s “d” with a “t,” in part because it was deemed easier to write and pronounce. The Toyoda loom works did not change its name.) Toyota’s success has often been attributed to a Japanese quality of persistence and ingenuity. One of the first Western academics to look deep inside the company, Michael Cusumano, now a professor of management at M.I.T., debunked that notion when he compared Toyota and Nissan in the early 1980s. “The founders and the managers created and refined Toyota company culture, which is far more powerful than Japanese culture,” he says. “It does build on many things that are Japanese — precision, quality, loyalty. But the Toyota culture dominates.” Cusumano adds that Toyota’s origins, in a rural prefecture, hours from the international influences of Tokyo, provided a beneficial insularity. The company began growing just after World War II, nurtured by government regulations that effectively shut out big American automakers. Still, the devastated postwar economy in Japan necessitated extraordinary resourcefulness: because there was a lack of materials and parts suppliers, for example, Toyota had to create them from scratch. Since the early 1930s, Toyota engineers have looked everywhere for inspiration while tearing apart American products to see how they work. Toyota’s systems and worldview derive from an economy of scarcity. In 1950, the company’s near-bankruptcy during a difficult year further defined its philosophy of frugality. Toyota soon began to focus obsessively on reducing muda — or waste — and building up a vast storehouse of cash for security.

If history teaches another lesson, it is that Toyota’s executives recognized early on that improving the process by which cars are designed and built is just as important as improving the vehicles themselves. In the 1950s and 1960s, this conviction was famously driven by Taiichi Ohno, an engineer who never earned a college degree but who revolutionized modern manufacturing. Ohno was in awe of Henry Ford, but he recognized that the market for cars in postwar Japan — the market for any modern consumer product, he later posited — required greater flexibility as much as the traditional means of mass production. For Toyota to compete with American companies, it had to make small batches of many models (think of those 31 Tundras) that could satisfy all kinds of customers. Ohno, who died in 1990, took an anthropomorphic view of raw materials: just as an employee shouldn’t wait around without a task, neither should sheet metal or molded plastic. And so, at his factories in Japan, parts were created only in response to demand. Every worker was to focus on improving his efficiency, too (along with that of his co-workers). There was no best way to do something, but there were always better ways. John Paul MacDuffie, a Wharton professor of management, points out that the system was a “cognitive reframing of what is possible.” It showed that quality and productivity were not mutually exclusive; Toyota could indeed produce a greater variety of more durable cars more quickly than anyone else. Some of Ohno’s and Toyota’s ideas also had a deeply subversive quality. It is human nature to cover up a problem rather than call attention to it. At a Toyota plant, the identification of a problem became imperative and exciting. Because then it could be addressed.

Toyota’s production system first gained wide notice in the U.S. in the early 1990s, after the publication of “The Machine That Changed the World,” which was written by James P. Womack, Daniel T. Jones and Daniel Roos and serialized in this magazine. According to Womack, whom I visited in his Cambridge office, creating a new product like the iPod or even the Prius is a far more modest achievement than developing a new process. The former are what we normally think of as inventions, of course. But the latter, at least in Toyota’s case, presents a novel way of thinking about work and the capabilities of human organizations.

Womack notes that Toyota’s managerial competence has extended well beyond Taiichi Ohno; the company has been fortunate that the Toyoda family’s descendants, especially the former chairman Eiji Toyoda, have demonstrated tremendous leadership abilities. “They got very lucky with genetics,” Womack says of Toyota. The company also benefited from the savvy of an early sales-and-marketing executive, Shotaro Kamiya. In the 1950s, when Toyota could barely sell its cars to the Japanese public, Kamiya decided Toyota could drive up demand by investing in Japanese driving schools. Kamiya also decided to send three employees to California in the summer of 1957 on a survey mission; a few months later, Toyota set up a small dealership in Hollywood to sell an austere, ugly and underpowered vehicle called the Toyopet Crown — “Toyopet is your pet!” its ads claimed. The car went on sale in 1958 for $1,995; only 288 were sold. That year, the Christmas party, held in the new company’s garage in Hollywood, consisted of about 30 people. The custodian’s wife cooked the food.

The first years in the U.S. were in fact a disaster. Toyota sold a few Land Cruisers but eventually withdrew the Toyopet from the market. Meanwhile its engineers in Japan tried to create a passenger car that American customers would actually want. The result was the 1965 Corona, an air-conditioned and modestly priced vehicle. After that, sales grew steadily. A variety of factors helped — currency differences often made Japanese car imports cheap (for consumers) and profitable (for Toyota). Labor costs in Japan were lower, too. But perhaps the most important factor was timing. A few years after Jim Press began working at Toyota Motor Sales in California, the gas crisis of the early 1970s brought legions of customers to Toyota’s more fuel-efficient cars. By the time the company began setting up factories in the U.S. in the mid-1980s (just over half of the Toyota cars sold in North America are now built here), it was gaining respect for the quality as well as the gas economy of its vehicles. Then came the success of Lexus in the early 1990s. “When they really went at the U.S. market seriously, in the late 1970s and 1980s, the product they brought out was far superior to what the Big Three were producing,” Ron Harbour, the efficiency expert, says. “They created this impression and reputation early on. And in the ensuing years, Ford and G.M. have made great strides to make it up. They’ve narrowed a lot of those gaps. But when you lose that reputation, it’s very hard to recover.” Catching up is even harder, moreover, when Toyota’s cars, like those from Honda and BMW, have consistently higher resale values.

Let’s go back in time and say you’ve got a guy who in 1985 bought a Camry, Harbour says. That Camry buyer was surprised to find he never had to get his car fixed at the dealership. “That guy never, ever looked back,” he adds. “G.M., Ford, Chrysler — they’ve basically lost a whole generation of Americans.”

You might figure that Toyota is elated at the way things have gone lately: its market share in the U.S. has risen in the past couple of years while American automakers like Ford (and to a lesser degree, G.M.) have been in a tailspin. But this assumption is probably only partly correct. “We want them to be strong,” Jim Press says, referring to Ford and G.M. “When you play a ball game, you don’t want to win by errors.” Jim Womack puts it more bluntly: “The last thing Toyota wants is for any of those guys to collapse.” For one thing, it could be politically disastrous for the Japanese company if it were considered responsible for the death of a grand American institution. “But it’s also completely worthless to Toyota in the market,” Womack adds. “They’re selling all the vehicles they can make already. What they actually want is just continuous, slow decline — decline at the same rate that they have the ability to organically expand. That’s the ideal world for them.”

5. Toyota Has It Made in America

McAllen, Tex., is a small city in the state’s southernmost tip, which has among the highest numbers of pickup-truck sales in any U.S. market, according to Toyota’s research. That made it an ideal location for focus groups and marketing research: What did these people need? What did they think of Toyota? And what would actually get them to drive a Tundra? Toyota ultimately decided to pursue customers it calls “true truckers.” True truckers aren’t ordinary pickup owners; rather, these men are the Platonic ideal of truck-driving authenticity. They might work on the ranch or the construction site; they might fish for bass every weekend. “They’re the taste makers, the influentials,” Ernest Bastien, a vice president of vehicle operations, told me in San Antonio. “I think all consumers are influenced by professionals. The professional uses a certain tool, and then they want it, too.” What Toyota needed was to find the true truckers, get them behind the wheel of a Tundra and then hope that Obu and Schrage’s engineering would take care of the rest. If the true truckers bought it, their followers would, too.

Toyota expects that some buyers will be moving up from its smaller truck, the Tacoma; others will be trading in their weaker, older Tundra for the new model. Still other buyers may be families that view pickup trucks with big back seats (so-called double cabs) as an alternative to an S.U.V.’s But building a new factory in the U.S. for the truck, locating the plant in the heart of Texas pickup country and then flying the Texas flag outside all speak to the company’s focus on severing truck owners’ blood ties to Ford and G.M. These loyal owners are the hardest to woo. Indeed, they may be beyond reach. Just as G.M. and Ford may have lost a generation of car buyers, Toyota may have put off a generation of full-size truck buyers with the T100 and the first Tundra.

The company doesn’t think so. In recent years, Toyota has successfully marketed cars like the Prius and brands like the Scion through grass-roots endeavors, which often meant showcasing the Prius to an audience of influentials. With Scion, the company wanted to get the cars in the hands of hipsters who would make them seem desirable and rare to young drivers, a strategy backed by limiting production this year to 150,000 vehicles, even as demand will probably exceed that amount. Some of these techniques seemed appropriate for the Tundra too. “There are so many of these buyers that probably will feel uncomfortable going into a Toyota dealer because they don’t see a Toyota on the construction site and never have and they don’t want to be the first one to show up with one,” Brian Smith, the head of Toyota’s truck operations, told me. So for the past year, the company’s marketers have tried to “soften” resistance to the brand. “Street teams” drive Tundras to big construction sites with water in the summer and coffee and doughnuts in the winter. “We say: ‘Hey guys, you ever been in a Toyota before? Just take a moment to sit in it and tell us what you think,’ ” Smith says. Already Toyota has sent its street teams on hundreds of runs.

Toyota focused the marketing of the Tundra on what Smith calls five “buckets”: 1) fishers and outdoorsmen; 2) home-improvement types; 3) Nascar fans; 4) motorcycle enthusiasts; and 5) country-music lovers. Anyone wondering why Toyota has become a major booster of Nascar or a sponsor of bass-fishing tournaments can see the logic. It’s also why Toyota is sponsoring Brooks and Dunn, the country-music duo. And dealers are taking new Tundra trucks to Nascar events, country-music concerts, fishing tournaments and the like. “Parking lots tend to be a long ways away from where the events are,” Smith explains, referring to motocross competitions, “so we have our dealers setting up shuttles.” The plan is to pull up in a Tundra, offer visitors a ride but have them drive to the event on a slightly indirect course (laid out by a Toyota dealer). “At the end,” Smith says, “we say, ‘Thank you, you’re guests of Toyota, here’s a bottle of water, take a lanyard.’ ”

Based on the company’s track record, it’s tempting to predict a resounding victory — if not a quick one, then a slow and steady one. But Toyota is by no means infallible. It failed in the large-truck market in the 1990s, and it faltered in the youth market until it came up with the Scion strategy. Its vehicles are sometimes outranked in Consumer Reports in safety and customer satisfaction by other automakers, especially Honda. The company’s growth has sparked tremendous internal concerns about quality-control problems.

And Toyota has worries abroad too. Many auto analysts wonder if Toyota has the ability to succeed in emerging markets. “Toyota is fairly weak in what we see as the second-largest growth market in the world, which we consider India,” Ashvin Chotai, a London-based auto analyst for Global Insight, told me. In China, the largest growth area, Toyota expects to have 10 percent of the market by 2010, but the company faces intense competition, from both its American and Asian rivals. Jim Press often says that Toyota is not doing as well as the headlines suggest. The trustworthiness of this claim is debatable — Press also says that G.M. is doing just fine — but it’s undeniable that the company will soon assume leadership in a market that’s both global and brutal.

However the Tundra does in the next few months, the company’s history suggests that it never relinquishes a goal before reaching it. And what’s striking is that if Toyota succeeds, it won’t necessarily be because the company has done anything different this time. Toyota has never really caught the Big Three by surprise. Its marketing strategists have been trying to establish an aura of American authenticity since the early 1970s, when Toyota’s TV ads featured four Dallas Cowboys squeezing into a Corolla. When I asked Takahiro Fujimoto, a management professor at the University of Tokyo and a longtime Toyota observer, whether the company’s victories — or the fact that it is now the world’s largest automaker — were hard to envision, he said no: “Since almost everything that happened to this company in the past several decades has been evolutionary rather than revolutionary, there have been few surprises.”

Toyota’s triumphs are often reduced to spare inventory and just-in-time productivity, but that’s too simplistic; there are many factors at work. Among management theorists, success derives from what they call the Toyota Way — the company’s culture of efficiency and problem-solving. Among historians, Toyota’s supremacy is a product of happenstance, specifically its early years in the rural precincts of ravaged, postwar Japan. For those in the marketing world, Toyota has triumphed in its packaging of brands like Lexus and Scion. On Wall Street, its success is defined by huge profits and driven by low retiree costs and close relationships with parts suppliers. Toyota’s prosperity also owes a large debt to its dealers, the true links to the consumer, who are very good at letting company executives know what customers like and don’t like. And to the fact that Toyota does not award huge stock-option grants or bonuses to its executives. Our culture of excessive compensation has never really caught on there.

All this doesn’t make Toyota virtuous. But it does make Toyota different — in some deep, cellular way — from many American companies. Nothing in its DNA, to borrow a fashionable term among business-school academics, is focused on short-term gains. What’s more, the long view as a business outlook seems to link so many aspects of the company’s success. The long view took Toyota to California, and to its most important market, in 1957 and kept it in the United States even after the Toyopet failed miserably. The long view allowed Toyota to understand the need for improvement and the potential rewards of meeting a higher standard. And when it met higher standards, the company looked ahead at the evolution of its American customers, marshaled its resources and tried to figure out what should come next.

6. Getting the Carbon Out of Cars

Toyota’s president, Katsuaki Watanabe, who like all of the company’s top executives is based in Japan, recently declared that his dream for Toyota is to build a car that does not hurt anyone and cleans the air when it’s running. This is not quite as fantastical as it sounds. Several automakers are developing cars with sensors that literally prevent them from crashing (though not from being crashed into). And in the heavy intersections in Tokyo where air quality is poor, Takahiro Fujimoto told me, part of Watanabe’s vision is already real: “The emission gas of some advanced cars is in fact cleaner than the intake air.” The most vexing challenge, though, is what fuel cars will run on in a future where oil is too scarce or tailpipe emissions too dangerous on account of global warming. About 10 percent of global carbon emissions come from cars, S.U.V.’s and pickup trucks. Many automakers, Toyota included, now trumpet their vehicles as “clean,” but this label, while by no means unimportant, refers to engine technology that reduces smog-forming emissions like nitrogen oxides or unburned hydrocarbons. But every gallon of gas burned still produces more than 19 pounds of CO2.

What I found within Toyota is that its engineers and executives all take environmental issues seriously, but on their own terms. For many consumers, of course, Toyota’s hybrid innovations established a green halo over the company. Yet the environmental community is more wary of the company’s lauded progressivism than you might expect. Many environmental advocates are dismayed by Toyota’s participation (as a member of the Alliance of Automobile Manufacturers) in a suit to block California’s new laws curtailing greenhouse-gas emissions. And some view Toyota’s strenuous efforts, especially in the U.S., to sell gas-guzzling trucks and S.U.V.’s as counterproductive. “I think the reality is that Toyota’s focus on the truck market has been to make them look as American as possible, rather than be the global environmental leaders they are on the car side,” Jason Mark, the former head of the vehicle program at the Union of Concerned Scientists, told me. As Mark sees it, Toyota’s activities matter more than any other automaker’s. “First, they’ll be the biggest car company very soon,” he says. “Second, they’ve demonstrated a knack for innovation with the Prius. And third, they’ve demonstrated a commitment for stewardship that I don’t think one could attribute to the domestic automakers.”

When I spoke with John DeCicco, an automotive specialist at Environmental Defense, a New York-based advocacy group, he said that in the near term, at least, it’s better not to count on a silver bullet — a drastic changeover to hydrogen-powered vehicles, for instance. There are many reasons that this will remain a long-term goal. One is that cars, especially ones of good quality, last a long time. Another is that automakers are profit-driven public corporations, and any new technology has to be competitive in the marketplace. To see just how long that can take, consider that Toyota began developing the Prius at a time, 1991, when gas was plentiful and cheap. Today, seven years after its introduction in the U.S., it has less than 1 percent of the car market. Higher gas prices or gas taxes may alter this. But for now, environmental advocates like DeCicco urge carmakers to focus on making modest changes to popular vehicles (making S.U.V.’s lighter, for example, thereby increasing fuel efficiency), which could have a more significant environmental impact than a sophisticated new technology. When DeCicco began analyzing total greenhouse-gas emissions from each car company’s American fleet, he noticed that in 2003, for instance, there was a significant change for the better in Toyota’s rate. This wasn’t because of its hybrids but because of its redesign of the Corolla. “When you make a small change in efficiency in a high-volume product like that,” DeCicco told me, “it can have a bigger net effect in your carbon than a major change in a small-volume seller.”

Still, more economical cars for the short term cannot solve the long-term problem. Toyota expects to be in business 100 years from now, one person in the company’s West Coast office told me, long after oil has been depleted or rendered unusable because of its carbon content, and for that reason it has placed all its bets on hybrid technologies. Indeed, Toyota created its hybrid systems not so much with the current era in mind, but because it views hybrids as more practical and energy-efficient. Whether the future is in biodiesel, ethanol or hydrogen doesn’t seem to matter; the hybrid system could be adapted to any of those fuels, says Bill Reinert, Toyota’s U.S. engineer in charge of advanced vehicle planning. Reinert also told me that the current Toyota system already has the ability to accommodate the larger battery capacity of a plug-in hybrid, which would use electric power for local trips and fuel only for longer excursions. But those large batteries don’t yet exist. Was that extra capacity put there on purpose? “Hell, yes,” he says. “This company is not stupid.”

Reinert adds that every Toyota engineer designing a new car gets an environmental-impact budget as well as a financial one. Designers must consider the total amount of carbon dioxide produced in the design, production and lifetime operation of a new vehicle. This sounds both encouraging and socially responsible. But you have to wonder too if it’s really an equation for sustainability. Right now, Reinert says, there are about three-quarters of a billion cars worldwide; by 2050, if market trends continue, “we could conceivably have 2 billion or even 2.5 billion cars.” Accommodating those cars will entail building new roads and new factories and spending vast amounts of energy to make shipments. All those activities will create enormous emissions on their own. So even with giant strides in clean-vehicle technology, just doubling the number of vehicles could increase the overall environmental effect by a factor of three.

To their credit, engineers at Toyota like Reinert do not soft-pedal the immensity of the challenge. And they argue, sometimes convincingly, that Toyota will be a large part of the solution. Jim Press does, too, but his is a different kind of optimism. A few days after the new Tundra made its debut, Press gave a speech to the Society of Automotive Analysts in Detroit in which he seemed confident that this would be Toyota’s century. New technologies are on the way, he promised. And the demographics of the American market look good: boomers are buying more cars. Americans are living longer. And the growth rate of the U.S. population is greater than China’s. Even in the face of what looks like a difficult year for car sales, the industry is on the verge of a golden era. “This is one of the few countries on earth where we have more cars per household than drivers,” he said. “Isn’t that great?”

At the beginning of his speech, Press joked to the audience that he was about to reveal the secret of Toyota’s success. He never really did, except to look ahead with relentlessly bright expectations.

Jon Gertner, a contributing writer, last wrote for the magazine about the economics of making comedy movies in Hollywood.

February 27, 2007 at 12:06 AM in Business Models | Permalink | Top of page | Blog Home

Apple - Thoughts on Music

Steve Jobs February 6, 2007

With the stunning global success of Apples iPod music player and iTunes online music store, some have called for Apple to open the digital rights management (DRM) system that Apple uses to protect its music against theft, so that music purchased from iTunes can be played on digital devices purchased from other companies, and protected music purchased from other online music stores can play on iPods. Lets examine the current situation and how we got here, then look at three possible alternatives for the future. 

To begin, it is useful to remember that all iPods play music that is free of any DRM and encoded in open licensable formats such as MP3 and AAC. iPod users can and do acquire their music from many sources, including CDs they own. Music on CDs can be easily imported into the freely-downloadable iTunes jukebox software which runs on both Macs and Windows PCs, and is automatically encoded into the open AAC or MP3 formats without any DRM. This music can be played on iPods or any other music players that play these open formats.

Source: Apple - Thoughts on Music

The rub comes from the music Apple sells on its online iTunes Store. Since Apple does not own or control any music itself, it must license the rights to distribute music from others, primarily the “big four” music companies: Universal, Sony BMG, Warner and EMI. These four companies control the distribution of over 70% of the world’s music. When Apple approached these companies to license their music to distribute legally over the Internet, they were extremely cautious and required Apple to protect their music from being illegally copied. The solution was to create a DRM system, which envelopes each song purchased from the iTunes store in special and secret software so that it cannot be played on unauthorized devices.

Apple was able to negotiate landmark usage rights at the time, which include allowing users to play their DRM protected music on up to 5 computers and on an unlimited number of iPods. Obtaining such rights from the music companies was unprecedented at the time, and even today is unmatched by most other digital music services. However, a key provision of our agreements with the music companies is that if our DRM system is compromised and their music becomes playable on unauthorized devices, we have only a small number of weeks to fix the problem or they can withdraw their entire music catalog from our iTunes store.

To prevent illegal copies, DRM systems must allow only authorized devices to play the protected music. If a copy of a DRM protected song is posted on the Internet, it should not be able to play on a downloader’s computer or portable music device. To achieve this, a DRM system employs secrets. There is no theory of protecting content other than keeping secrets. In other words, even if one uses the most sophisticated cryptographic locks to protect the actual music, one must still “hide” the keys which unlock the music on the user’s computer or portable music player. No one has ever implemented a DRM system that does not depend on such secrets for its operation.

The problem, of course, is that there are many smart people in the world, some with a lot of time on their hands, who love to discover such secrets and publish a way for everyone to get free (and stolen) music. They are often successful in doing just that, so any company trying to protect content using a DRM must frequently update it with new and harder to discover secrets. It is a cat-and-mouse game. Apple’s DRM system is called FairPlay. While we have had a few breaches in FairPlay, we have been able to successfully repair them through updating the iTunes store software, the iTunes jukebox software and software in the iPods themselves. So far we have met our commitments to the music companies to protect their music, and we have given users the most liberal usage rights available in the industry for legally downloaded music.

With this background, let’s now explore three different alternatives for the future.

The first alternative is to continue on the current course, with each manufacturer competing freely with their own “top to bottom” proprietary systems for selling, playing and protecting music. It is a very competitive market, with major global companies making large investments to develop new music players and online music stores. Apple, Microsoft and Sony all compete with proprietary systems. Music purchased from Microsoft’s Zune store will only play on Zune players; music purchased from Sony’s Connect store will only play on Sony’s players; and music purchased from Apple’s iTunes store will only play on iPods. This is the current state of affairs in the industry, and customers are being well served with a continuing stream of innovative products and a wide variety of choices.

Some have argued that once a consumer purchases a body of music from one of the proprietary music stores, they are forever locked into only using music players from that one company. Or, if they buy a specific player, they are locked into buying music only from that company’s music store. Is this true? Let’s look at the data for iPods and the iTunes store – they are the industry’s most popular products and we have accurate data for them. Through the end of 2006, customers purchased a total of 90 million iPods and 2 billion songs from the iTunes store. On average, that’s 22 songs purchased from the iTunes store for each iPod ever sold.

Today’s most popular iPod holds 1000 songs, and research tells us that the average iPod is nearly full.  This means that only 22 out of 1000 songs, or under 3% of the music on the average iPod, is purchased from the iTunes store and protected with a DRM. The remaining 97% of the music is unprotected and playable on any player that can play the open formats.  Its hard to believe that just 3% of the music on the average iPod is enough to lock users into buying only iPods in the future.  And since 97% of the music on the average iPod was not purchased from the iTunes store, iPod users are clearly not locked into the iTunes store to acquire their music.

The second alternative is for Apple to license its FairPlay DRM technology to current and future competitors with the goal of achieving interoperability between different company’s players and music stores. On the surface, this seems like a good idea since it might offer customers increased choice now and in the future. And Apple might benefit by charging a small licensing fee for its FairPlay DRM. However, when we look a bit deeper, problems begin to emerge. The most serious problem is that licensing a DRM involves disclosing some of its secrets to many people in many companies, and history tells us that inevitably these secrets will leak. The Internet has made such leaks far more damaging, since a single leak can be spread worldwide in less than a minute. Such leaks can rapidly result in software programs available as free downloads on the Internet which will disable the DRM protection so that formerly protected songs can be played on unauthorized players.

An equally serious problem is how to quickly repair the damage caused by such a leak. A successful repair will likely involve enhancing the music store software, the music jukebox software, and the software in the players with new secrets, then transferring this updated software into the tens (or hundreds) of millions of Macs, Windows PCs and players already in use. This must all be done quickly and in a very coordinated way. Such an undertaking is very difficult when just one company controls all of the pieces. It is near impossible if multiple companies control separate pieces of the puzzle, and all of them must quickly act in concert to repair the damage from a leak.

Apple has concluded that if it licenses FairPlay to others, it can no longer guarantee to protect the music it licenses from the big four music companies. Perhaps this same conclusion contributed to Microsoft’s recent decision to switch their emphasis from an “open” model of licensing their DRM to others to a “closed” model of offering a proprietary music store, proprietary jukebox software and proprietary players.

The third alternative is to abolish DRMs entirely. Imagine a world where every online store sells DRM-free music encoded in open licensable formats. In such a world, any player can play music purchased from any store, and any store can sell music which is playable on all players. This is clearly the best alternative for consumers, and Apple would embrace it in a heartbeat. If the big four music companies would license Apple their music without the requirement that it be protected with a DRM, we would switch to selling only DRM-free music on our iTunes store. Every iPod ever made will play this DRM-free music.

Why would the big four music companies agree to let Apple and others distribute their music without using DRM systems to protect it? The simplest answer is because DRMs haven’t worked, and may never work, to halt music piracy. Though the big four music companies require that all their music sold online be protected with DRMs, these same music companies continue to sell billions of CDs a year which contain completely unprotected music. That’s right! No DRM system was ever developed for the CD, so all the music distributed on CDs can be easily uploaded to the Internet, then (illegally) downloaded and played on any computer or player.

In 2006, under 2 billion DRM-protected songs were sold worldwide by online stores, while over 20 billion songs were sold completely DRM-free  and unprotected on CDs by the music companies themselves. The music companies sell the vast majority of their music DRM-free, and show no signs of changing this behavior, since the overwhelming majority of their revenues depend on selling CDs which must play in CD players that support no DRM system.

So if the music companies are selling over 90 percent of their music DRM-free, what benefits do they get from selling the remaining small percentage of their music encumbered with a DRM system? There appear to be none. If anything, the technical expertise and overhead required to create, operate and update a DRM system has limited the number of participants selling DRM protected music. If such requirements were removed, the music industry might experience an influx of new companies willing to invest in innovative new stores and players. This can only be seen as a positive by the music companies.

Much of the concern over DRM systems has arisen in European countries.  Perhaps those unhappy with the current situation should redirect their energies towards persuading the music companies to sell their music DRM-free.  For Europeans, two and a half of the big four music companies are located right in their backyard.  The largest, Universal, is 100% owned by Vivendi, a French company.  EMI is a British company, and Sony BMG is 50% owned by Bertelsmann, a German company.  Convincing them to license their music to Apple and others DRM-free will create a truly interoperable music marketplace.  Apple will embrace this wholeheartedly.

February 6, 2007 at 06:58 PM in Business Models | Permalink | Top of page | Blog Home

Living a Second Life

Virtual online worlds | Living a Second Life | Economist.com

Sep 28th 2006 | SAN FRANCISCO
From The Economist print edition
A Californian firm has built a virtual online world like no other. Its population is growing and its economy is thriving. Now politicians and advertisers are visiting

PETER YELLOWLEES, a professor of psychiatry at the University of California, Davis, has been teaching about schizophrenia for 20 years, but says that he was never really able to explain to his students just how their patients suffer. So he went online, downloaded some free software and entered Second Life. This is a “metaverse” (ie, metaphysical universe), a three-dimensional world whose users, or “residents”, can create and be anything they want. Mr Yellowlees created hallucinations. A resident might walk through a virtual hospital ward, and a picture on the wall would suddenly flash the word “shitface”. The floor might fall away, leaving the person to walk on stepping stones above the clouds. An in-world television set would change from showing an actual speech by Bob Hawke, Australia's former prime minister, into Mr Hawke shouting, “Go and kill yourself, you wretch!” A reflection in a mirror might have bleeding eyes and die.

When Mr Yellowlees invited, as part of a trial, Second Life's public into the ward, 73% of the visitors said afterwards that it “improved [their] understanding of schizophrenia.” Mr Yellowlees then went further. For about $300 a month, he leases an island in Second Life, where he has built a clinic that looks exactly like the real one in Sacramento where many of his students practise. He gives his students “avatars”, or online personas, so they can attend his lectures inside Second Life and then experience hallucinations. “It's so powerful that some get quite upset,” says Mr Yellowlees.

Second Life, as Mr Yellowlees illustrates, is not a game. Admittedly, some residents—there were 747,263 as of late September, and the number is growing by about 20% every month—are there just for fun. They fly over islands, meander through castles and gawk at dragons. But increasing numbers use Second Life for things that are quite serious. They form support groups for cancer survivors. They rehearse responses to earthquakes and terrorist attacks. They build Buddhist retreats and meditate.

Many use it as an enhanced communications medium. Mark Warner, a former governor of Virginia who is considered a possible Democratic candidate for president in 2008, recently became the first politician to give an interview in Second Life. His avatar (also named Mark Warner) flew into a virtual town hall and sat down with Hamlet Au, a full-time reporter in Second Life. “This is my first virtual appearance,” Mr Warner joked, “I'm feeling a little disembodied.” They then proceeded to discuss Iraq and other issues as they would in real life, with 62 other avatars attending (some of them levitating), until Mr Warner disappeared in a cloud of pixels.

By emphasising creativity and communication, Second Life is different from other synthetic online worlds. Most “massively multi-player online role-playing games”, or MMORPGs (pronounced “morpegs”), offer players pre-fabricated or themed fantasy worlds. The biggest by far is “World of Warcraft”, by Blizzard Entertainment, a firm in California, which has more than 7m subscribers. These worlds are the modern, interactive, equivalents of Nordic myths and Tolkien fantasies, says Edward Castronova, a professor at Indiana University and the author of “Synthetic Worlds: The Business and Culture of Online Games”. They allow players to escape into their imaginations, and to take part by, say, joining with others to slay a monster.
Making, not slaying

Second Life, by contrast, was designed from inception for a much deeper level of participation. “Since I was a kid, I was into using computers to simulate reality,” says Philip Rosedale, the founder of Linden Lab, the San Francisco firm that launched Second Life commercially three years ago. So he set out to construct something that would allow people to “extend reality” by building a virtual version of it, a “second life” not unlike that envisioned by Neal Stephenson in “Snow Crash”, a science-fiction novel published in 1992.

Unlike other virtual worlds, which may allow players to combine artefacts found within them, Second Life provides its residents with the equivalent of atoms—small elements of virtual matter called “primitives”—so that they can build things from scratch. Cory Ondrejka, Linden Lab's product-development boss, gives the example of a piano. Using atomistic construction, a resident of Second Life might build one out of primitives, with all the colours and textures that he would like. He might add sound to the primitives representing the keys, so the piano could actually be played in Second Life. “Of course, since these are primitives, the piano could also fly or follow the resident around like a pet,” says Mr Ondrejka.

Because everything about Second Life is intended to make it an engine of creativity, Linden Lab early on decided that residents should own the intellectual property inherent in their creations. Second Life now allows creators to determine whether the stuff they conceive may be copied, modified or transferred. Thanks to these property rights, residents actively trade their creations. Of about 10m objects created, about 230,000 are bought and sold every month in the in-world currency, Linden dollars, which is exchangeable for hard currency. Linden Lab estimates that the total value (in “real” dollars) this year will be about $60m. Second Life already has about 7,000 profitable “businesses”, where avatars supplement or make their living from their in-world creativity. The top ten in-world entrepreneurs are making average profits of just over $200,000 a year.
By emphasising creativity and communication, Second Life is different from other synthetic online worlds

Second Life's total devotion to what is fashionably called “user-generated content” now places it, unlike other MMORPGs, at the centre of a trend called Web 2.0. This term usually refers to free online services delivered through a web browser—for example, social networks in which users blog and share photos. Second Life is not delivered through a web browser but through its own software, which users need to install on their computers. In other respects, however, it is now often held up as the best example of Web 2.0. “It celebrates individuality,” says Jaron Lanier, who pioneered the concept of “virtual reality” in the 1980s and is now “science adviser” at Linden Lab. And it connects people, he says, because “the act of creation is the act of being social.”

The Web 2.0 crowd also extols Second Life for its highly original business model. Most Web 2.0 firms try to build audiences around user-generated content in order to sell advertising to them. This assumes the availability of unlimited advertising dollars, a notion that is increasingly ridiculed.

Linden Lab does not sell advertising; instead it is a virtual property company. It makes money when residents lease property—an island, say—by charging an average of $20 per virtual “acre” per month. Only about 25,000 residents, or about 3% or the population, lease property, but that already amounts to 53,800 acres, which, in real life, would be bigger than Boston. This works out to monthly revenues of $1m, not counting the commissions that it takes on currency exchanges between Linden dollars and hard cash. As a private company, Linden Lab does not disclose its exact revenues, although Mr Rosedale says the firm is “close to profitability”.

A common reaction to such numbers is astonishment that anybody should pay anything at all for something that exists only in a metaphysical sense. But “there's actually no economic puzzle in this; all kinds of things derive their economic value only from the realm of the virtual,” says Indiana University's Mr Castronova. The American dollar, for instance, is virtual (aside from the value of the paper used for the bills) in that it requires consumers to have faith in its worth. In the context of online games, virtual economies much bigger than Second Life's have existed for years. Many people in poor countries, called “gold farmers”, play games such as “World of Warcraft” professionally to score weapons, points or lives to sell to lazier players in rich countries. But Second Life is unique in that residents conceive what they sell. As such, says Mr Lanier, it is “probably the only example of a self-sustained economy” on the internet.

For all these reasons—its ability to change the real lives of its residents, its innovations in technology and in its business model—Second Life has become a darling of Silicon Valley. It promises to be “disruptive”, says Mitch Kapor, the inventor of the Lotus spreadsheet that played a big role in the personal-computer revolution of the 1980s and 1990s. He is now chairman of Linden Lab. To him, Second Life is comparable to both the PC and the internet itself, which started as something “quirky” for geeks, and then entered and transformed mainstream society. “Spending part of your day in a virtual world will become commonplace” and “profoundly normal,” says Mr Kapor. Ultimately, he thinks, Second Life will “displace both desktop computing” and other two-dimensional “user interfaces”. As “a hothouse of innovation and experiment,” he says, Second Life may even “accelerate the social evolution of humanity.”
Back to this reality

It is bold and early to make such predictions. After all, Second Life is still a relatively small virtual world—only about 9,000 residents are usually logged in at any one time, for example. About two-thirds create content from scratch, but mostly they customise things that they find or browse passively. And a lot of the wares on offer are banal. Whereas a few residents choose very innovative bodies for their avatars, most have shapes, male and female, that hew to the default templates and look, predictably, like cosmetically enhanced porn stars. Among the artefacts, there is some genuine art but quite a bit of junk.
Endless possibilities: Donna Meyer, a grandmother from New York, and her avatar

Is Second Life a nirvana where unknown talent can prove its creative mettle and make it in the real world? “You can create your own island and people come to it,” said Bill Joy, a co-founder of Sun Microsystems and now a prominent venture capitalist. But “I don't see any correlation between that and what it's going to take to be a designer and have a skill set to succeed in the world.”

Mr Castronova also cautions against overestimating the depth and breadth of Second Life's economy. Yes, people do create clothes and games and spacecraft in Second Life and then sell them. But most of the big money comes from the virtual equivalent of land speculation, as people lease islands, erect pretty buildings and then rent them to others at a premium. Tongue in cheek, Mr Castronova compares Second Life's in-world boom to America's house-price bubble. In artistic terms, there is not always much difference between building an in-world house and designing a personal web page.

There are also stirrings of discontent among some of the “older” (if one can use that term in a three-year-old metaverse) and more purist residents of Second Life about what they see as a menacing trend toward commercialism. One avatar, for example, has created “MetaAdverse”, a network of advertising billboards inside Second Life to which property developers can feed images of their creations. More controversially, Second Life is also attracting the attention of corporations and advertisers from the real world hoping to attract the metaverse's residents. Publishers now organise book launches and readings in Second Life. The BBC has rented an island, where it holds music festivals and parties. Sun Microsystems is preparing to hold in-world press conferences, featuring avatars of its top executives. Wells Fargo, an American bank, has built a branded “Stagecoach” island, where avatars can pull Linden dollars out of a virtual cash machine and learn about personal finance. Starwood, a hotel and resort chain, is unveiling one of its new hotels in the virtual world.

Toyota is the first carmaker to enter Second Life. It has been giving away free virtual vehicles of its Scion brand and, in October, will start selling all three Scion models. The price will be modest, says Adrian Si, the marketing manager at Toyota behind the project. Toyota really hopes that an “aftermarket” develops as avatars customise their cars and sell them on, thus spreading the brand “virally”. Toyota will be able to observe how avatars use the cars and might, conceivably, even get ideas for engineering modifications in the real world, he says.

Those Scion cars have “great driving performance for in-world physics,” says Reuben Steiger, the boss of Millions of Us, a company he founded this year to bring companies like Toyota into Second Life for marketing and brand-building. “How it corners and makes sounds when it changes gears is great.” So Toyota, which is a client of his, along with Sun Microsystems and even Mr Warner, shows that Second Life is “perfect for creating experiences around a brand,” says Mr Steiger. “We don't think that conventional advertising will be very prevalent,” he says, because it would “be badly received culturally”. Advertising in Second Life is not about “trapping people” but about captivating and stimulating them. A good campaign in Second Life costs about $200,000 dollars, he reckons, of which only a tiny part is property leases and most goes to paying the talented designers to create great virtual stuff.
Virtual strip mall?

Inevitably, this sort of thing turns some residents off. Will Second Life, that realm of individualism and pure creativity and spontaneity, get plastered over by the same mega-brands and mass culture that have, arguably, made the physical world such a homogenous place? In real life, many avatars argue, big business tends to push out small artisans. If the same happens in Second Life, the metaverse will lose its raison d'être.

Mr Rosedale, Linden Lab's founder, empathises with the concern, but thinks it is misplaced. “That is a fear which comes from the real world that is not likely to be borne out in Second Life,” he says. His arguments are all economic. In the physical world land is scarce, so big brands can buy up much of it; in Second Life, Linden Lab simply allocates more computer-processing power and makes even more islands available. The world is infinitely expandable, in other words. If one patch did become homogenous and drab, avatars would simply fly off to the next.

Another economic difference, says Mr Rosedale, is the lack of economies of scale in Second Life. In real life, a shoemaker, say, can reduce the average cost of making a pair by producing huge amounts, and the average cost of marketing by buying advertising in bulk. In Second Life, however, scale means nothing. There is no manufacturing cost to minimise. Gimmicks, such as giving away free shoes, are useless because nobody actually needs shoes at all. Nike, say, has no inherent competitive advantage over a hobbyist who likes to design shoes (or feet, paws, wings or claws) for fun. Thus, says Mr Rosedale, whereas the physical world has relatively few things that are sold in huge numbers, Second Life has huge numbers of things that are sold in relatively small quantities. In the statistical jargon, Second Life's economy trades in “the long tail” of things.

This is why, for the time being, Mr Rosedale prefers to rule Second Life with Adam Smith's “invisible hand” only. To him that means treating every resident the same, whether it happens to be Toyota or “an 80-year-old woman from India.” Both will pay the same price for their acres; what they do with it is up to them. If it ever became necessary, he adds, Linden Lab could “become a regulator and break up monopolies”, but this does not seem likely to come about.

How, then, is one to make sense of Second Life? For those new to it, it appears to be too mind-boggling to have much relevance to real life. For those who spend time inside, however, Second Life ironically tends to resemble the real world even as its obvious differences become clear. Mr Kapor, Linden Lab's chairman, is the first to agree. “People bring all their karma” into the world, he says. Alongside benevolence, there is harassment. If Second Life were ever to become truly mainstream, there is no guarantee that residents would not pollute it with racism and hatred. Perhaps crime too: residents had to reset their passwords after a recent hacking attempt.

These things may be a criticism of human nature, but it cannot be blamed on Second Life. Henry Jenkins, a professor of media studies at the Massachusetts Institute of Technology, thinks that Second Life deserves credit as “a world of hypotheticals and thought experiments.” From new approaches to corporate branding to education, Second Life is a petri dish for innovations that may help people in real life. Already, therapists are using Second Life to help autistic children, because it is a safe environment to practice giving signals to others and interpreting the ones coming back. Other organisations are using Second Life for long-distance learning. Overall, says Jaron Lanier, the veteran of virtual-reality experiments, Second Life “unquestionably has the potential to improve life outside.”

November 1, 2006 at 09:11 PM in Business Models | Permalink | Top of page | Blog Home

Word of web makes British writer US bestseller

Word of web makes British writer US bestseller - Sunday Times - Times Online

Richard Brooks, Arts Editor
AN unknown British author has topped America’s fiction bestseller lists after news of her debut novel spread over the internet.

Diane Setterfield, 42, a former university lecturer, took six years to write The Thirteenth Tale after she gave up her career teaching French.

The mystery, published just three weeks ago in America, has beaten established US authors such as James Patterson and Anna Quindlen as well as the latest Frederick Forsyth to top the bestseller lists of The New York Times, The Wall Street Journal and Publishers Weekly.

Setterfield, who lives in Harrogate, North Yorkshire, is the first debut British novelist to reach number one in America since Nicholas Evans in January 1996 with The Horse Whisperer. That book had already been bought in a film deal by Robert Redford before publication, giving it a significant headstart.

The Thirteenth Tale had few reviews in conventional media and seems to have taken off because bloggers recommended it. “I suppose it’s a new form of word of mouth,” said Setterfield, who tomorrow leaves for a book tour of America.

Despite the book’s success in America, where it has sold about 70,000 copies, it has had a less enthusiastic reception in Britain, selling 600 last week.

The development of Setterfield’s fan base on the internet is similar to that which gave a kick-start to musicians such as the Arctic Monkeys, Lily Allen and Sandi Thom. Setterfield has gone from a tiny income to deals worth nearly £1.5m.

She became a lecturer in the 1990s at the University of Central Lancashire in Preston. “In the end I hated it,” she said. “Not the students but the whole admin thing. So I moved with my husband to Yorkshire. I knew I had a book in me.”

After giving up teaching in 1999, she began The Thirteenth Tale, which tells the story of a novelist who employs a biographer to write her life story, resulting in the unearthing of family secrets.

September 24, 2006 at 09:48 AM in Business Models | Permalink | Top of page | Blog Home

Universal backs free music rival to iTunes

FT.com / Companies / Media & internet - Universal backs free music rival to iTunes

y Joshua Chaffin and Aline van Duyn in New York

Published: August 29 2006 05:02 | Last updated: August 29 2006 05:02

Universal Music, the world’s largest music company, is backing a start-up that will allow consumers to download songs for free. It will rely on advertising for its revenues, offering a different business model from that of Apple Computer’s popular iTunes music store.

The move reflects music companies’ willingness to experiment as they try to capture some profit from the boom in digital distribution still dominated by illegal file-sharing networks.

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The service, SpiralFrog, represents a departure from Apple’s 99 cents-a-song business model and other legal download services which charge a subscription fee by being completely free. It is due to start up in December.

A report released last month by the International Federation of Phonographic Industries revealed there were still 40 illegal downloads for every legal one.

Although Apple’s iPod and its iTunes music download service has 80 per cent of the market for legally downloaded music, competition is expected to hot up in the run-up to Christmas.

This year, the IFPI has predicted that 60m music players will be sold worldwide, many of them MP3 players not compatible with Apple’s services.

As well as start-ups such as SpiralFrog, established companies are getting ready to flex their muscles. Microsoft is to launch Zune, which will offer music players and a music download store. MTV has launched Urge, a service that has downloadable music and music videos via subscription.

“Offering young consumers an easy-to-use alternative to pirated music sites will be compelling,” said Robin Kent, SpiralFrog’s chief executive and the former head of the Universal McCann advertising agency.

Mr Kent has held talks with labels Warner, EMI and Sony-BMG and hopes they will be lured by the surge in online advertising.

Merrill Lynch last week raised its forecast for the sector’s growth, predicting it would expand by 35 per cent this year in non-US markets to $11.6bn (£6.1bn). US growth is expected to increase by nearly 30 per cent to $16bn.

Perry Ellis, the fashion company, said it would advertise on SpiralFrog. Levi’s, Aeropostale, Benetton and others have expressed interest. “Our audience is into music and can be more easily reached on the web,” said Oscar Feldenkreis, president of Perry Ellis International.

Other music services are looking to advertising for their revenues. The new Napster allows consumers to listen to up to five tracks for free while they view advertising. Meanwhile, video-sharing sites, such as YouTube, have held talks with music companies about showing music videos, which would then be supported by advertising.

Mr Kent said his research revealed that young consumers would be willing to endure advertising as long as the brands and products were relevant to them.

Copyright The Financial Times Limited 2006

August 29, 2006 at 09:48 PM in Business Models | Permalink | Top of page | Blog Home

The Power of Productivity (McKinsey)

Poor countries should put their consumers first.

William W. Lewis

2004 Number 2

After the Second World War, a vast array of international and national institutions—the United Nations, the World Bank, the International Monetary Fund, and a host of nongovernment and government aid organizations—was created to better the lot of the world's poor. Conventional wisdom came to hold that improvements in infrastructure, technology, capital markets, education, and health care would eliminate the stark distinctions between rich and poor nations.¹ Fifty years and billions of dollars later, this wisdom has proved wrong.

At the beginning of the 1990s, the Soviet Union's fall precipitated a new conventional wisdom. This "Washington consensus" focused heavily on macroeconomic policies, such as flexible exchange rates, low inflation, and government solvency, while also embracing microeconomic elements—for instance, price decontrol, privatization, and good corporate governance and market regulation. Market reform swept through the world, including countries as diverse as Argentina, Brazil, India, Mexico, New Zealand, Poland, and Russia. Most were thought to be doing virtually everything needed to spark rapid growth.

But once again the results were disappointing. By the end of the 1990s, most of these countries' growth rates had returned to levels so low that the profile of the global economic landscape wasn't changing at all. Today more than 80 percent of the world's people still get by on less than a quarter of the average income in rich countries, much as they did 50 years ago.

Even worse, only a handful of countries, having moved out of dire poverty into the middle ground, enjoy a real prospect of joining the rich ones (Exhibit 1). This failure is worrisome because it means that today's poor countries will probably be poor 20 years from now. Economic development is a slow process. Even if poor countries grew at the extraordinary rate of 7 percent a year, it would take them 50 years to catch up. At current rates, it would take them a couple of centuries—if they ever did. As the tenacity of oppressive regimes and the rise in terrorism in these poor countries amply demonstrate, this gap between rich and poor is a major threat to global stability.

 

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Conventional solutions have failed because they don't address the real causes of persistent poverty. The Washington consensus, like the 50 years of development economics before it, is grounded in an analysis of economies at the aggregate level. But that's like trying to learn about the physical universe by using only the telescopes of astronomy; most real understanding in physics has actually come from studying the interaction of the tiniest particles in the universe. In economics, it is necessary to understand why individual companies operate as they do, since they are the ultimate sources of growth and job creation. Most economists can't afford the time and resources needed to look, in detail, at the way an entire country's economy works. They rely instead on broad national data sets and complex econometric tools that yield qualified answers at best.

At the McKinsey Global Institute (MGI) we have had, since 1990, the luxury of studying the dynamics and evolution of a representative group of industries in 13 countries: Australia, Brazil, France, Germany, India, Japan, the Netherlands, Poland, Russia, South Korea, Sweden, the United Kingdom, and the United States. In each, we analyzed the performance of 6 to 13 industries and compared it with the performance of the same industries in a handful of other countries. Our work is thus based on detailed studies of individual businesses, from state-of-the-art auto plants to black-market street vendors. It builds an understanding of the economy from the ground up, not the top down—a grassroots rather than a bird's-eye view.

This research has produced a new and unexpected understanding of the persistence of income disparities among nations. Economic progress depends on increasing productivity, which depends on undistorted competition. When government policies limit competition, even unintentionally, more efficient companies can't replace less efficient ones. Economic growth slows and nations remain poor.

It's productivity

GDP per capita is widely regarded as the best single measure of economic well-being.² That measure is simply labor productivity (how many goods and services a given number of workers can produce) multiplied by the proportion of the population that works. This proportion varies around the world—though, interestingly, not by much.

Economists must understand how individual companies—the sources of job growth—function

Productivity, however, varies enormously and explains virtually all of the differences in GDP per capita (Exhibit 2). Thus, to understand what makes countries rich or poor, you must understand what causes productivity to be higher or lower. This understanding is best achieved by evaluating the performance of individual industries, since a country's productivity is the average of productivity in each industry, weighted by its size. Such a micro approach reveals the important fact that the productivity of industries also varies widely from country to country.

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This approach yields two crucial insights. First, to understand why some countries are mired in poverty, it is necessary to look beyond broad macroeconomic policies, such as interest rates and budget deficits, and also consider the myriad zoning laws, investment regulations, tariffs, and tax codes that hold back the productivity of industries and thus a nation's prosperity. Of course, macroeconomic stability is necessary. MGI's studies of Brazil, India, and Russia show that without it companies concentrate on making money by exploiting the instability rather than by raising their productivity. Yet a stable economy alone isn't enough to make countries prosper and grow: Japan has had a stable economy for decades but has suffered from ten years of stagnation.

The second insight is the realization that the income level of a country is determined, above all, by the productivity of its largest industries. High productivity in the unglamorous "old-economy" sectors—retailing, wholesaling, construction—is most important, since more people work in them. The fabled high-tech enclaves and financial markets are less so. MGI's study of rapid US productivity growth in the 1990s found that it was caused by just six industries, including retailing and wholesaling, not by the vaunted "new economy."³ IT investments played a modest role. In India, the fast-growing IT industry has yet to raise the living standards of more than a minuscule part of the population.

Differences in productivity also explain the persistence of disparities in wealth among rich nations. Twenty-five years ago, the economies of the United States, Europe, and Japan were generally expected to converge because technology, capital, and business practices flowed freely among them and their workforces were healthy and well educated.

In fact, significant disparities of wealth remain even among rich countries. Despite Japan's world-class automotive and consumer electronics industries, for example, its average per capita income⁴ is about 30 percent below the US average. Japan has followed a path different from that of the United States and Europe (Exhibit 3): economic growth during the past 30 years has been generated more by massive increases in the number of hours worked and the amount of capital equipment used than by an increase in the productivity of the workforce. South Korea has followed a similar path. But there is a limit to the number of hours that can be worked, and massive inputs of capital that don't earn an economic return eventually lead to diminished growth. Since 1990, Japan's real per capita income has barely grown. South Korea's tiger economy is running out of steam as well.

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Barking up the wrong tree

Many economists still attribute differences in the productivity of countries to differences in their labor and capital markets. These economists therefore believe that big investments in education and health and generous development loans and grants are the keys to economic growth. MGI's research, however, found that these factors explain few, if any, differences in economic performance.

Consider education. In the early 1990s, Germany and Japan seemed to be passing the United States in economic performance. One of the principal reasons cited was the poor education of the US workforce. Since then, Japan's carmakers have built US factories that achieve 95 percent of the productivity these companies enjoy at home. Whatever the faults of the US education system, on-the-job training clearly compensates for them.

This truth holds for poor countries as well. Some of Brazil's private retail banks are as efficient as any in the world. South Korea's POSCO (formerly Pohang Iron & Steel) may have the highest productivity of any integrated steel producer. Carrefour operates with nearly the same efficiency in emerging markets and in Europe. Poor education systems haven't hindered these companies. If illiterate Mexican immigrants can reach world-class productivity levels building apartment houses in Houston, illiterate Brazilian workers can do so in São Paulo.

Similarly, MGI found that a lack of capital to finance investment isn't the main constraint on growth in poor economies. If local businesses organized and managed themselves as the world's best companies do, they would unleash rapid productivity growth. About 20 percent of India's people work in companies that are structured somewhat like those in the developed world, but their average labor productivity is only 15 percent of what their US counterparts achieve. MGI calculated that these companies could increase their productivity to about 40 percent of the US average without any additional capital investment,⁵ just by reorganizing the way they conduct work. In 1983, the high-performing Japanese auto company Suzuki Motor invested in a joint venture to make cars in India. Suzuki, which had operational control, built plants like the ones in Japan, organized the work as it is organized in Japan, and trained employees to work as they do in Japan. As a result, the productivity of these facilities is 55 percent of the US auto industry average.

Poor nations don’t have to wait to build school systems and educate a whole generation of workers

Poor countries thus don't have to wait until they build bigger and better school systems and educate a whole generation of workers. Nor do they need to wait for more development aid from rich countries. If local businesses followed the proven approaches for organizing production and managing a workforce, poor countries could grow much faster than most people realize. Domestic savers and foreign investors hungry for good returns would also supply these countries with plenty of capital for new investments.

Competition is the key

If differences in labor and capital markets don't matter, what does? In each of 13 country studies, MGI found that the primary answer was the nature of competition in product markets.

Competition is the mechanism that helps more productive and efficient companies expand and take market share from less productive ones, which then go out of business or become more efficient. Either way, consumers benefit as companies offer better goods at lower prices, and this may in turn unleash a burst of new demand.

But government policies sometimes stand in the way of competition and prevent innovation from spreading. Such policies might exclude potential competitors, such as start-ups or foreign companies, or might favor particular classes of companies, such as mom-and-pop retailers. Often, policies (zoning laws, for example) have unintended consequences for business. When they do, competition is less intense and inefficient companies aren't pressured to change. Productivity growth is slower and countries remain poor.

The Washington consensus of the 1990s profoundly underestimated the importance of a level playing field for competition. Over and over again, MGI found industries in which more productive innovators were excluded and less productive companies favored. In much of Europe, for instance, zoning laws prevent large retailers from expanding as fast as they could and therefore from replacing less efficient small retailers. Because retailing is one of the largest sectors in most economies, it has important ramifications for a nation's standard of living. For instance, Tesco, the United Kingdom's largest food retailer, has failed to obtain planning permission to build a modern supermarket on the site of a derelict hospital—broken windows and all—near central London because the building is over 100 years old. The result of such failures is lower productivity for the UK economy and higher food prices for consumers.

In Japan, a combination of zoning laws, tax policies, and government subsidies has allowed the smallest, most inefficient retailers to thrive. Today they account for slightly over half of all retailing employment, compared with less than 20 percent in the United States. In one small shop in central Tokyo, I have seen the same hat sit unsold on a store shelf gathering dust for the past 15 years. Every time I'm in Tokyo, I check to see if the hat is still there. It is. The proprietors don't have to sell it to stay in business, since they get subsidized loans. Their shop sits on some of the world's most valuable land, so they know their estate will repay the loans.

Even the United States isn't immune to policies that limit competition. The 2002 steel tariffs, which have since been declared illegal by the World Trade Organization and withdrawn, protected US steel producers from lower-cost foreign competitors. The recent increase in US agricultural subsidies does the same.

Poor countries, however, have adopted much more severe market-distorting measures. After the Soviet Union's fall, a flurry of new business activity took place in Russia. It was assumed that more productive companies would replace the unproductive Soviet ones and that Russia would rapidly become rich. But MGI found that the new Russian companies were no more productive than their Soviet predecessors. Why? More productive companies either tried to enter the market and failed or didn't bother to try. For instance, Carrefour, perhaps the best international retailer, concluded that it couldn't make money in Russia. Like virtually all multinationals, Carrefour pays taxes. The competitors it would face in Russia—the open-air markets—don't and thus have a decisive tax advantage. Before the ruble crashed in 1998, open-air markets also sold smuggled or counterfeited goods at prices Carrefour couldn't match.

A similar situation exists in Brazil. About 50 percent of its workers aren't registered with the government. Although many of these people are poor and wouldn't be taxed heavily, the total revenue forgone is substantial because of the number of workers involved. As a result, Brazil must collect twice as much in profit, employment, value-added, and sales taxes from corporations as the United States does to finance its government.⁶ When taxes are included, it costs more productive companies as much to do business as it costs less productive, informal ones, which don't pay taxes. Modern, productive enterprises can't easily take market share from their unproductive counterparts, and the economy's natural evolution is stymied.

Meanwhile, in India the government has directly limited competition by insisting that several hundred consumer goods can be manufactured only in small-scale plants. As a result, Indian consumers pay higher prices than they should, and India, unlike China, hasn't become a global center of low-cost manufacturing. (China actually exports to India.) Moreover, in housing construction, competition among developers and construction firms is based not on cost and productivity advantages but on gaining control of scarce parcels of land with clear ownership titles. Over 90 percent of land titles in India are subject to dispute, and nobody is going to invest in land someone else might claim.

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If poor countries eliminated the policies that distort competition, they could grow rapidly. India's government, for instance, abandoned many of the limits on foreign investment in the country's automotive industry during the early 1990s. Subsequently, prices fell, demand for cars exploded, and output nearly quadrupled (Exhibit 4).

The barriers to growth

The main obstacles to economic growth in poor countries are the many policies that distort competition. Why are they so pervasive?

For one thing, most people favor the social objectives that inspire high minimum wages, small-business subsidies, and other business policies. They may not be aware of the unintended adverse consequences that create major barriers to growth. Instead of attempting to achieve social objectives by limiting competition, countries should allow fair competition and thereby generate more national income, which can then be redistributed through taxes and government subsidies for the desperately poor.

Countries follow bad policies, above all, because they benefit powerful or well-connected people

Even more important, countries have bad policies because they benefit certain people. In rich countries, special interests generally aren't allowed to have their way so much that they can significantly undermine the common good. Most poor countries lack these limits. Moscow's government officials, for instance, allocate housing contracts to their cronies in the old Soviet construction companies. As a political favor to small companies that can't pay their bills, local governments in Russia prevent energy companies from cutting off their power. India's domestic retailers are wholly protected from foreign direct investment by global best-practice retailers.

In poor countries today, every domestic firm is a potential special interest that stands to lose from more competition. These unproductive firms' workers often think, mistakenly, that they too stand to lose. Certainly, the prospect of finding new work in an economy where most jobs pay near-subsistence wages is frightening. But to have healthy economies, countries must allow unsuccessful owners and managers to fail so that more productive ones can take their place. In that healthier economy, workers will find a better job market.

Think consumer

Undoubtedly, dismantling barriers to economic growth is difficult. Some firms must be allowed to go out of business, thus forcing workers to find new jobs. Industries must be opened to foreign competition, and the enforcement of tax codes and other regulations must be strengthened. And governments must stand up to special interests.

How can countries muster the political will to do all these things? The answer lies in focusing on consumers, not producers. Many people think that production itself creates economic value—an idea that sometimes makes governments protect businesses regardless of their performance. This approach is mistaken. Such people and governments fail to understand the link between production and consumption. Goods have value only if consumers want them. Otherwise sheer production does little to raise standards of living.

Most poor countries are far from having a consumption mind-set. Their governments and leaders, like those of the former Soviet Union, focus instead on output. A consumption mind-set requires some notion of individual rights, including the right to buy what you want from anybody who wishes to sell it to you. Consumers want to patronize companies that offer better products and services or lower prices. Those are the companies that survive if competition is equal. Thus, consumer interests are served when competition isn't distorted.

If policy makers in poor countries—and the many development experts who advise them—can accept this overlooked fact, those countries could unleash rapid growth. Only then will the shape of the global economic landscape begin to change for the better.

About the Authors

Bill Lewis, a McKinsey alumnus, was the founding director of the McKinsey Global Institute. This article was adapted from chapter 1 of his new book, The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability (Chicago: University of Chicago Press, 2004).

Notes

¹ For more on the failure of development economics, see William Easterly, The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics, Cambridge, Massachusetts: MIT Press, 2002.

² Some people argue that indicators of health, life expectancy, and social well-being are just as important, if not more so. But men and women the world over want more than a subsistence living, and that is why millions of them emigrate from poor countries to rich ones, even doing so illegally and risking their lives in the attempt. The Soviet Union achieved military power but ultimately collapsed because it didn't provide enough consumer goods.

³ See William W. Lewis, Vincent Palmade, Baudouin Regout, and Allen P. Webb, "What's right with the US economy," The McKinsey Quarterly, 2002 Number 1, pp. 30–40.

⁴ Measured at purchasing power parity, not current exchange rates. PPP compares standards of living in different countries more accurately because it measures the amount of goods and services different currencies can command in their home markets.

⁵ Because of low labor rates, the lack of automation would prevent them from matching US productivity.

⁶Brazil's bloated government contributes to the high tax burden and thus is an obstacle to growth. It currently spends 39 percent of the nation's GDP, compared with 37 percent in the United States. Back in 1913, when the United States had the same per capita income Brazil has now, the US government spent only 8 percent of the country's GDP.

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August 16, 2006 at 11:27 AM in Business Models | Permalink | Top of page | Blog Home

The green machine

The green machine - August 7, 2006

Lee Scott is no tree-hugger. But Wal-Mart's CEO says he wants to turn the world's largest retailer into the greenest. The company is so big, so powerful, it could force an army of suppliers to clean up their acts too. Is he serious?
FORTUNE Magazine
By Marc Gunther, Fortune Magazine
July 31 2006: 2:00 PM EDT

(Fortune Magazine) -- "Doesn't it feel good to have this kind of commitment made by the company that you are part of? Don't you feel proud?"

The 800 Wal-Mart Stores employees gathered in the home office for an all-day meeting were used to this kind of rah-rah talk. Top executives from Fortune 500 companies regularly trek to Bentonville, Ark., to pay homage to one of the world's most powerful companies and to shout out the Wal-Mart (Charts) cheer.

This time, though, the cheerleading was coming from an unlikely source: Al Gore.