Getting Japan to capitalize on its innovation

by and

BOSTON/TOKYO — As they lament the West’s obsession with China and prepare to host the Group of Eight in July, Japanese fear becoming a minor planet in the Chinese orbit. Trouble is, Japan still sees manufacturing as the key to prosperity, despite the fact that it is vulnerable to offshoring.

To stay ahead of China, Japan needs to develop players who innovate at the top of the value chain — providers of things like software, content and services. But these sectors are the country’s Achilles’ heel, as exemplified by the absence of Japanese companies internationally in these fields as well as consulting, advertising and media. Unless it changes course, Japan could be crushed between the anvil of China’s manufacturing clout and the hammer of Western companies’ prowess in services.

Why can’t Japan lead in the industries of the 21st century, where success is no longer synonymous with manufacturing excellence? One key reason is that many of its sectors are still organized in rigid hierarchical structures, reminiscent of the keiretsu of the heyday of Japan Inc. in the 1980s. In a keiretsu, the industrial group’s top firms, linked by interlocking shareholdings, lead the conglomerate, while smaller players, often suppliers, depend on them for essential functions such as financing, marketing, export services and innovation. This practice can stifle entrepreneurship by creating a kind of planned economy within the keiretsu that fails to transmit market signals.

In contrast, in many modern industries, value is created through the coordinated efforts of constellations of interdependent firms — or “ecosystems” — organized in flatter and more flexible structures. The personal computer world is the paradigm of ecosystems that swiftly adapt to new technology and consumer tastes. Microsoft and Intel lead the PC ecosystem through their control of a critical set of standards, but numerous other players, such as original equipment manufacturers, software developers, Internet companies and wireless businesses not only remain innovative but control their destiny and even influence the evolution of the ecosystem., Moreover, the fear of U.S. antitrust litigation restrains Microsoft and Intel from abusing their power.

The Japanese hierarchical structure works well in industries where the ecosystem leader has the capabilities and incentives to conquer international markets. For example, Toyota makes it possible for its suppliers to sell in foreign markets they could never enter on their own. Similarly, Nintendo, Sega and Sony have created huge global opportunities for their affiliated game developers.

The situation is different in most “soft” goods and services where the Japanese environment has replicated the hierarchical structure of industrial ecosystems, but with leaders that are incapable or unwilling to export. Their inward orientation prevents innovative companies around them from spreading their wings abroad — the source of huge lost opportunities for Japan. Mobile telephony and animation illustrate our point.

Japanese mobile phones are technological wonders. They offer seamless access to a host of mobile Internet content and services, and enable their owners to use their handsets to pay for store purchases and train fares. But this success masks an environment that limits Japan’s mobile telephones to their home market.

The mobile operators — NTT DoCoMo, KDDI, and Softbank — dictate specifications to handset makers, running the ecosystem with an iron grip. Consequently, phone manufacturers, fairly passive subcontractors to the operators’ R&D, marketing and design teams, lack in-house marketing skills. As a result, they are ill-equipped to sell abroad.

Outside of Japan their sales lag far behind LG and Samsung (Korea), Motorola (United States) and Nokia (Finland), which have developed the skills to compete everywhere, since they originated in countries where they must be strong in marketing and skillful in negotiating with telecommunications conglomerates.

Japan is also missing opportunities in an important part of its entertainment industry. Although it is the Mecca of anime, there is not a single Japanese global heavyweight in this field. The largest producer, Toei, is 10 times smaller than Disney. While Disney and Pixar may spend upwards of $100 million on a new animated film, Japanese production budgets never exceed $10 million.

In this case, one obvious problem is weak protection of intellectual property rights and a reluctance on the part of Japanese banks to lend to businesses with no tangible assets as collateral. As a result, Japanese anime producers cannot build content-based empires like Disney or Pixar, whose revenues flow not only from films but also from the licensing of toys and other products. Instead, the Japanese anime ecosystem is one where producers are at the mercy of television networks, advertising agencies and DVD retailers that control financing and distribution.

Since these ecosystem leaders focus solely on the domestic market, it is impossible for producers to establish global brands. And ironically, Disney, that quintessential U.S. company, may conquer the Japanese anime market, as indicated by its recent deals with Japanese producers.

Japan can build globally competitive industries outside of manufacturing by adopting a number of changes:

* Strengthening intellectual property rights. This would alter the balance of power in favor of knowledge-intensive companies.

* Developing the venture-financing sector, which today is virtually nonexistent in Japan. This would ensure that access to capital is no longer a bottleneck for creative entrepreneurs, a situation that forces them to yield control over their ventures to large ecosystem leaders that have no incentive to turn these startups into corporate giants.

* Enforcing antitrust legislation more strongly to help smaller but creative companies grow, as in the U.S. and Europe, where businesses with dominant positions adjust their behavior with respect to smaller firms in their ecosystems to avoid the wrath of the courts and regulators.

* Lowering barriers to entry for foreign firms so that Japanese players can escape the grip of domestically oriented Japanese ecosystem mangers.

Implementing these changes would create flatter industry structures, leading to more entrepreneurial innovation and allowing existing Japanese companies to capitalize on their creativity on a global scale.

It is too late to build a Japanese version of Silicon Valley, but in industries such as mobile telephony and entertainment, where Japan already leads in innovation, such reforms could allow Japan to claim the value that today it is leaving on the table by finally creating the Toyotas and Sonys of the 21st century.

Andrei Hagiu is an assistant professor in the Strategy Unit at Harvard Business School. Robert Dujarric heads the Institute of Contemporary Japanese Studies at Temple University Japan.