What is Porter's Diamond Theory? (Simple explanation with examples)

Michael E. Porter has developed many theories in his lifetime and Diamond Theory or National Diamond is amongst the best of those theories. 

What is Diamond Theory?

In a nutshell The Diamond Theory determines what factors gives a firm a comparative advantage over the other firms. On a national scale it determines what factors give a country a comparative advantage on an international market. So Diamond Theory can be applied on a both micro and a macro level.

Diamond Theory diagram

As the above diagram depicts, there are four main factors influencing a firm to gain a competitive edge over the other firms. You may also notice that all the arrows connect all the four factors - meaning that all four factors affect and support each other and the firm to create comparative advantages. If not for even one factor, the model fails.

(01) Factor Conditions

One of the most crucial aspects for a country or a firm to gain a comparative advantage is the 'factor conditions'. This means that a firm or a nation should possess some unique or rare factor (or a resource) that other firms or nations do not have (or have limited) access to. Or even easier access to a resource than another firm or country could give a firm a significant advantage too. These 'factors' could mean a raw material, machinery and tools, technology, unique labor and such.

Eg: Middle East has a natural endowment of oil deposits, hence Middle East (and it's firms) possess a significant competitive advantage over the other oil producing firms and countries.

(02) Demand Conditions

This means that there should be 'sufficient' demand for a product of the firm locally. Locally means the country the firm originated in. A sufficient demand for the product locally is necessary for a firm to grow beyond the geographical boundaries of the country and gain a comparative advantage. 

Eg: Sri Lanka is world famous for Tea production. Originally this specialization began as a result of heavy local demand for tea.

(03) Related and Supporting Industries

No firm or nation is able to survive on it's won in this globalized world. And what supportive industries a firms possesses affects the development of that firm to a great extent. Supporting industries are which provides additional services to a firm. For an example transportation for a manufacturing firm is a supporting industry. Communication in general is a supportive industry for all the firms. These supporting and related industries help a firm minimize it's costs and allows a firm to focus on it's core business activities - thus giving them a competitive advantage over their core business activities.

Eg:  Amazon.com uses DHL courier services to deliver high value products across the world. DHL is a supporting service.

(04) Strategy, Structure and Rivalry

Strategy means the strategy of the firm it uses to deal with the operations of the business. A sound strategy (incorporating flexibility) is vital for an organization to deliver a world class product and gain a competitive advantage. Structure is the setting within the firm - where organizational goals, culture, strategy and line of authority is enforced. Rivalry is also a crucial factor, because it gives incentives for a competing organization to be competitive and better than its competitor, by means of product, service and productivity. All these factors affect towards the competitive edge of a country or a firm.

However, as mentioned earlier, one or two of these factors will not be sufficient for a firm or a country to gain a significant comparative advantage over another firm or a country. 

Why Does Marginal Revenue (MR) Equals Marginal Cost (MC) Equals Price (P) in a Perfectly Competitive Market?

You may have heard, seen and written the formula MR = MC = P countless occasions. But have you even wondered what's the logic behind this? Well, let me explain...

First of all we will glance through what MR, MC and P means. 

• MR - Marginal Revenue - additional revenue generated by selling one additional unit of a product
• MC - Marginal Cost - additional cost to produce one additional unit of product
• P - Price - price of the product, selling price

So how does the price of a product (P) equals marginal revenue(MR) of that product? Well, it's pretty simple...

MR = MC = P condition only occurs in a perfectly competitive market, meaning there are a large number of suppliers in the market and none of them are large enough to influence the market price. All they can do is sell their product at the prevailing market price.

So in a perfectly competitive market, the firms engage in high competition and ultimately drive the price to a very low level. This is so low that practically there is no profits in the sales price (P). Hence the product will be sold at the same price as the cost of producing the product (MC). Since the price is market given, the firms are unable to sell at a higher price either. So P = MC...

When the firm is producing the product at a specific cost, in a perfectly competitive market, they can only sell the product covering the cost of production. Since they cannot force a profit on the selling price, they will be forced to sell the product merely covering their production cost so that they can survive in the market. So any revenue generated by selling one unit of product (MR) will be more or less equal to the cost of producing the same unit (MC). Hence we can deduct that MR = MC.

Since P = MC and MR = MC, we can derive that P = MR = MC formula...

However this situation is unique to a perfect competition, which, in a real world is difficult to find. But the logic holds true.