(FORTUNE Magazine) – The economic expansion of Japan seems unstoppable. The U.S., once the paragon of productivity, continues to lag. Korea's prospects brighten as Britain's fade. Italy succeeds in spite of, or perhaps because of, being Italian. What accounts for these differences in the fortunes of the economies of the world? In his forthcoming book, The Competitive Advantage of Nations (The Free Press, $35), Michael Porter proposes a new paradigm to explain the dynamic relationships among a country's industries, institutions, and people that are pivotal to achieving economic advantage. Porter, a professor at the Harvard business school, is an internationally recognized expert on corporate strategy and the author of two best-selling works on the subject. This is his first comprehensive work on countries and the global economy. One conclusion: Classical theories about comparative advantage that emphasize only natural resources and other cost factors lost their validity long ago. In his paradigm, competition itself -- the fiercer the better -- is more likely to produce success. Porter's paradigm is based on a four-year study of ten countries that focuses on their patterns of winning and losing in international markets. His thesis is that a nation's ability to upgrade its existing advantages to the next level of technology and productivity is the key to international success. In his view, the U.S. is slipping, measured by its gains and losses of share of the world export market in specific industries or products. Between 1978 and 1985 the U.S. increased share by at least 15% in 82 critical industries but, ominously, lost 15% or more in 97 -- many of them in such advanced fields as transportation and technology. In this excerpt, Porter explains his theory / and how it accounts for both the rise of Japan and the rise and decline of the U.S. Applying his theory, Porter suggests what the U.S. can do to regain the competitive advantage it has been steadily losing since the 1960s. SWISS CHOCOLATES and Japanese robots, German high-performance cars and U.S. computers. Why does a nation achieve international success in a particular industry? Traditional explanations point to comparative advantage -- a nation's ability to export because it is blessed with natural or human resources that make its costs lower than other countries'. But the global scoreboard says otherwise. Switzerland is a land-locked nation with high-cost labor, strict environmental laws, and few natural resources -- least of all cocoa. Yet it is a world leader in chocolate, not to mention pharmaceuticals, banking, and specialized machinery. The story of modern industrial history is not exploiting abundance but creating it, not enjoying advantage but coping with disadvantage. Japan and West Germany, which have had the broadest success in sophisticated industries, both began the postwar period in shambles. How is this abundance and sophistication created? My theory says that four points form what I call the ''diamond'' of national competitive advantage (see diagram): -- ''Factor conditions,'' or a nation's ability to turn the basics -- e.g., natural resources, education, infrastructure -- into a specialized advantage. The Dutch do not lead the cut flower industry because of Holland's tropical weather. One advantage is the existence of highly specialized research organizations in flower cultivation, packaging, and shipping such as the Sprenger Institute and the Aalsmeer Research Station. -- ''Demand conditions,'' or the number and, most important, the sophistication of domestic customers for the industry's product or service. Consumer demands for convenience, disposability, utility, and affordability made the U.S. the first mass-market, mass-production society and put U.S. industry in a strong position to capitalize on subsequent demand all over the world for goods that have those qualities. -- Related and supporting industries, or the company a company keeps. An industry striding toward the top needs worldclass suppliers, and benefits from competition among companies in fields related to its own that march with it in lock step. These manufacturers and suppliers form an industrial ''cluster'' -- Silicon Valley is one -- that accelerates innovation. German advances in printing presses were accompanied by similar leads in paper manufacturing. This cluster is still centered near Wurzburg, where the king of Bavaria lured the first company around 1819. -- Company strategy, structure, and rivalry -- the conditions governing how a nation's businesses are created, organized, and managed, as well as the nature of domestic competition. The harsh domestic rivalry among Japanese companies -- not government, not cheap labor, not exports -- has been the key to that nation's success. Goals are also vital. Countries and industries committed to achieving long-term advantage are often the ones that get it. The fundamental lesson is that the quiet life is an enemy of competitive advantage. Industries thrive when they are forced to overcome high labor costs or a lack of natural resources, when their customers won't accept inferior or outmoded products, when their local competitors are many and murderous, and when government offers no protection from fair competition and sets tough technical and regulatory standards. In practice, the competitive diamond is a dynamo whose parts push each other forward -- or backward. For instance, the Italian shoe industry is prodded by sophisticated consumer demand that encourages entry by many firms, lots of them family owned, that compete jealously. The shoemakers spew out new models continually and must keep improving efficiency to stay competitive within Italy's quirky, high-cost infrastructure. These manufacturers develop stringent raw-material and machinery requirements, giving rise to an equally sophisticated supplier industry: Italian companies are leading makers and exporters of tanned leather and shoemaking machinery, undergirding the shoemaking industry's ability to innovate. When the home market gets saturated, firms must look to exports, as the Italian shoemakers have done with notable success. Competitive advantage based on only one or two points of the diamond usually proves unsustainable because global competitors can easily circumvent it. South Korea's construction industry grew rapidly by applying low-cost labor to projects that did not require sophisticated engineering. It lost out when other countries with even lower-cost labor -- India, for example -- jumped in. Resource-based advantages frequently suffer the same fate. Sustained success in the more sophisticated industries important to advanced economies often reflects a national environment in which all four points are favorable. TWO ADDITIONAL VARIABLES, chance and government, have an important effect. Chance developments outside the control of companies, such as wars or embargoes, can reshape industry structure in a country's favor or against it. Government, at all levels, can improve or detract from the national advantage. Vigorous enforcement of antitrust laws encourages competition and stimulates innovation. The Reagan Administration's hands-off antitrust policy did the opposite.

Sustained national advantage in an industry reflects a properly functioning diamond, but the whole system is rarely in place at the start. The formation of a local industry is normally triggered by a single factor, such as natural resources or domestic demand. For an industry to flourish, however, domestic rivalry is nearly always necessary. It drives companies to move beyond whatever initial advantage led to the founding of the industry and to begin developing their international potential. To maintain competitive advantage, the industry must normally broaden and upgrade from the original source of success. For example, Japan began exporting cars in the 1950s but did not reach international prominence until the late 1970s. The Japanese auto industry moved through four distinct phases. Its initial success reflected a number of circumstances: low-cost skilled labor and cheap steel; home demand conditions that led Japanese firms to concentrate on small cars; an emphasis on ''fit and finish'' to satisfy Japanese consumers sensitive to appearance; and a succession of new entrants that created intense domestic rivalry by the 1960s. IN ITS SECOND PHASE, Japan also demonstrated the benefits of being disadvantaged in natural resources, capital, or labor. Faced with labor shortages and higher wages in the 1960s, Japanese automakers took labor out of manufacturing, achieving wide gains in productivity. In its third phase, prodded somewhat by the high-priced yen, Japan took process technology to a unique level -- the use of robots, just-in-time supply, and redesigning parts for more efficient manufacturing. As an industry develops advantages at several points of the diamond and especially as mutual reinforcement within the diamond begins, it can maintain remarkable rates of improvement and innovation for years or even decades. In its fourth phase, the Japanese industry has introduced cars such as the Honda Acura, Toyota Lexus, and Nissan Infiniti that are competing in the high- performance and luxury segments. The automakers continue to improve their manufacturing skills. In the book, Porter analyzes in detail the postwar competitive history of eight nations: the U.S., Japan, Sweden, Switzerland, West Germany, Italy, South Korea, and Great Britain. The explanations of each country's successes and failures are not what we suppose, he says. Here he talks about the U.S. and Japan, and how their competitive postures evolved: After the war the U.S. enjoyed a unique combination of circumstances that spawned and sustained internationally competitive industries. It had a large, uniquely affluent home market and modern plants and equipment poised to supply burgeoning international demand against little or no foreign competition. But these commonly cited reasons for U.S. dominance in postwar competition only begin to explain the American success, which may have been too great and may have come too easily for the nation's long-term economic health. A much broader set of forces was at work. World War II represented an investment in technology of unprecedented scale, driven by the spur of a national emergency. During the war and for years thereafter, a huge defense program funded research in core technologies and provided a market for advanced goods. Some of these were adapted for civilian use. The U.S. pushed mass-production technology to new heights and emerged well entrenched as the leader. The war also contributed to human resource development in fields such as aviation and electronics. Long after the war, the GI bill continued to pay for further education and training for vast numbers of veterans. American companies did not face an entirely benign environment, and some disadvantages served useful purposes: Wartime scarcity of materials spurred breakthroughs in plastics and metal alloys. In the early postwar period, the real wages of workers and managers in the U.S. were high compared with those in other nations and grew rapidly. As a result, U.S. companies moved aggressively to automate their production. Every facet of the diamond favored the U.S. in the 1950s and 1960s. Consider the demand factor. The U.S. was at the leading edge of where world demand was going. It was the first mass-consumption society. American companies pioneered low-cost, standardized, mass-produced, and mass-marketed products in industries such as appliances and food. Affluence made the U.S. an early market for many other types of consumer goods, particularly as the population headed to the suburbs. Black & Decker, for example, achieved world leadership in power tools on the strength of low-priced, mass-marketed tools targeted to the do-it-yourself homeowner. The company exported this concept to Europe and gained huge market share in many countries. Industrial demand was equally sophisticated. Moreover, many of the techniques of modern marketing were pioneered in the U.S. Privately owned mass media, including radio and television, were the vehicles for the first truly large-scale advertising. Commercial television was introduced in America 12 years before it appeared anywhere else. IN ANOTHER PART of the diamond -- related and supporting industries -- emerging and established clusters were numerous and often concentrated in one or two geographic areas: autos, machinery, and parts around Detroit, electronics in Silicon Valley, mainframe computers in Minneapolis and New York, minicomputers in Boston, and oil field equipment and services in Houston. These clusters reinforced each other: Hewlett-Packard, the leader in testing and measuring, also became No. 1 in medical electronics. But it was competition -- fed by a sense of limitless opportunity -- that most set America apart. Active rivalry in the home market characterized the most important U.S. industries. Government policy encouraged it: The U.S. had a firm commitment to antitrust, in contrast to Europe's cartels and Japan's traditional zaibatsu, the huge combines that ran its trade before World War II. Was American confidence misplaced? Did the U.S. emerge from the 1960s as an environment in which many industries could renew and regenerate themselves? When did American companies, once so preeminent, become so complacent? Data suggest that all was not well in the upgrading of U.S. industry for many years. A low rate of net capital investment, disappointing productivity increases, and a slow rate of growth in per capita income relative to other nations -- all these date back to the 1950s. America had no incentives to upgrade. Labor became more plentiful, holding down wage increases. Instead of automating, American companies simply added more cheap workers. Today the U.S. is losing its ability to create the specialized factors that lead to competitive advantage. Although its elite universities are still outstanding, America's basic educational system is faltering badly. R&D growth has lagged. American consumers are no longer the most affluent or the most | demanding. They tolerate products and services that no Japanese or German would accept. Rather than fight competitors, U.S. companies prefer to buy them or get the government to establish quotas and other trade barriers. The story of Japan's economic success usually assigns a starring role to government and emphasizes Japanese management practice. But neither management nor government can explain it. Japan has strong global positions in an extremely wide array of industries, rivaled only by Germany and, to a lesser extent, the U.S. Nowhere else do the four points of the diamond reinforce each other so successfully, though Italy is a close second. In fact, Japan and Italy give credence to the theory partly because they are so different. Japan is dominated by large multi-industry corporations, Italy by midsize family-run companies. Japan's telecommunications system is a marvel, Italy's a nightmare. Japan's government is a model of consistency, Italy's a revolving door. But like Japan's, Italy's successful global industries are fiercely competitive, form dense clusters of suppliers and end users, and serve extremely tough home customers. Except for an abundance of natural harbors, Japan has little in the way of natural resources. It more than makes up for that in human resources: With a long tradition of respect for education that borders on reverence, Japan possesses a large pool of literate, educated, and increasingly skilled people. Japanese companies upgrade and specialize that education through an intense commitment to training. Much of Japan's success can be traced to the country's economic disadvantages. Lacking resources, Japanese firms were forced to develop the skills and technologies needed to process its precious resources into higher- value goods. Japan began with a large pool of unemployed workers after World War II. By the late 1960s, however, labor shortages forced wages up. The paradoxical result: Many Japanese companies automated away one of their early advantages over Western companies -- cheap labor. The shortage of usable land makes real estate costs extremely high. This not only affects demand conditions by favoring compact and space-efficient goods, but also leads Japanese companies to shorten production lines and avoid unnecessary inventory. Hence just-in-time manufacturing. Finally, the rise of the yen and a succession of two oil shocks advanced Japanese efficiency rather than retarding it. Conversely, U.S. companies often exported their problems, moving production offshore to take advantage of low-cost labor rather than figuring out more efficient ways of manufacturing. Revaluation and high energy prices led Japanese companies to compensate feverishly. Japan's rebound from the oil shocks happened with remarkable speed. Indeed, had the shocks not occurred, Japan would have been wise to invent them. In a remarkable number of the industries in which Japan has achieved strong positions, the home market -- large, homogeneous, and concentrated -- provides a unique stimulus to Japanese companies. Japan's secret weapon may be its consumers and the way they live. The Japanese have a voracious appetite for the latest gadgets. They are constantly seeking something new and different, and, of course, they insist on absolute quality. Japan also has a curious combination of advanced and backward infrastructure. For instance, telecommunications are superb, but poor Japanese roads -- and the tendency to overload vehicles -- means that trucks built for the Japanese home market are well suited to developing countries elsewhere in Asia. Japan's crowded living conditions stimulate demand for products that are compact, light, and multifunctional -- characteristics of Japanese consumer electronics that now appeal to customers around the world. CULTURAL HOMOGENEITY contributes to strong bandwagon effects. Among industrial buyers, if one important company buys a new product or service, competitors quickly follow. Among consumers, rapid information from Japan's highly developed media feeds the desire for the latest models for status reasons. That in turn causes companies to turn out ever newer and better products. Japanese companies do particularly well in industries where introducing new models frequently is important to competitive advantage -- notably cars and consumer electronics. The corollary of rapid market penetration is early saturation, which invariably provides the impetus for a major export drive as companies scramble to replace lost domestic volume and fill excess capacity. In nearly every Japanese industry we studied, exports increased substantially only when the domestic market became mature.

As Japanese industry has developed, the quality of domestic demand has improved even further. In a growing number of industries, such as robotics and advanced materials, Japanese companies are the world's most sophisticated buyers of industrial goods. Related and supporting industries play a striking part in the Japanese , national competitive advantage. Strong clusters characterize Japanese industry. Relationships between suppliers and manufacturers are enduring. That encourages cooperation on innovation. Even though workers have lifetime employment, companies become more efficient and generate excess labor. To protect employees, many companies in the base industry then enter a related industry almost simultaneously. (Remember the tendency of Japanese companies to imitate each other.) This produced a flood of new entrants into fax machines, for instance. Some came from cameras (Canon, Ricoh, Minolta, Konica), some from office machines (Matsushita, Sharp, Toshiba), some from telecommunications (NEC, Fujitsu, Oki). Each company brings with it a reservoir of skill and technology -- optics, for example, in Canon's case -- that it then transfers to the new business. Such is the intensity of domestic rivalry that companies continually compare market share. Loss of share is cause for embarrassment and evokes an aggressive response. Too much has been made of cooperation between Japanese companies, some of it in concert with government, as a key to success. Cooperative R&D projects were primarily important in stimulating a research race by individual companies for leadership in the same technology. IT IS THE PROLIFERATION of domestic rivals, coupled with heavy demand and a strong orientation toward market share, that creates a tinderbox of innovation in Japan. There are 112 major machine-tool makers. In the past three years, three different companies have led in fax market share. Rivalries are intensely personal. At Sony a popular slogan uses the English initials BMW, for ''beat Matsushita whatever.'' While domestic rivalry is intense in virtually every industry in which Japan is internationally successful, it is all but absent in large sectors of the economy that fail to measure up to the standards of the best worldwide competitors. In fields such as construction, agriculture, food, paper, commodity chemicals, and fibers, Japan has little competitive advantage. These industries have one thing in common: cartels and other restrictions on competition, some sanctioned by government. Japan is also weak internationally in services of nearly all types. All this is a growing constraint on future Japanese prosperity.

Porter concludes with an agenda for each of the nations he studied. His prescription for the U.S., in part: American policy in recent decades has often been based on the implicit premise that the value of the dollar, the intrusion of government, and unfair practices by foreign nations are the causes of any difficulties facing U.S. industry. Such a view is incomplete, to say the least. It has led to relaxing regulatory standards and allowing horizontal mergers, which usually undermine rather than help U.S. industry. Both American firms and the government need a new and richer view of the underpinnings of national advantage. Nothing has contributed to the drift in American industry more than ebbing rivalry. A long period during which U.S. companies faced little challenge from foreign competitors led to sleepy oligopolies. In the 1960s mergers began consolidating many industries. Relaxation of antitrust enforcement allowed leading competitor to buy leading competitor. Ironically, such transactions are justified as enhancing competitiveness. AMONG THE MOST important questions facing American industry: What should be the goals of investors, managers, and employees? All three have been focused entirely on short-term rewards. A new approach to corporate governance and taxation is necessary that makes long-term prosperity a central concern. Revision or elimination of long-term capital gains taxes is a good place to start. Permitting banks to own equity shares would promote deeper long-term relationships between investors and managers. In Germany, for example, Deutsche Bank is a major investor in companies such as Daimler Benz. Companies must make a greater investment in employees and not treat them like disposable assets. Mergers and alliances among leading competitors should be prohibited. The same standards for mergers among U.S. companies should be applied to acquisition of U.S. companies by foreign companies, and vice versa. At the same time, antitrust constraints on the activities of trade associations should be loosened, with safeguards against collusion or monopolization. The associations can play a constructive role in training and research. Demand conditions in the U.S. must improve if American industry is to regain the knack of innovation. The regulatory environment, or lack of it, has seriously hindered the demand side. The U.S. has backed away from advanced and stringent standards in areas such as product safety, environmental quality, energy efficiency, and working conditions, based on the erroneous view that these hurt industry. A good example was the Reagan Administration's move to relax federal gas mileage standards at a time when energy imports are substantial and gasoline combustion is creating major environmental problems. Without advanced regulations, U.S. industry will lose the innovation race in the affected industries and U.S. products will not sell well to sophisticated customers abroad. Stringent standards for products, environmental quality, and the like not only serve the public good but are vital to economic success. By the same token it is time for a systematic overhaul of the U.S. product liability system. The ease of filing lawsuits -- often of little merit -- combined with huge and unpredictable damage awards, goes well beyond the point of benefiting either the consumer or U.S. industry. Liability law as it is now structured causes companies to slow the rate of innovation. More emphasis is also needed on stimulating demand for innovative new products. Experience in other nations has demonstrated that selective investment tax credits for purchases of advanced factory and office automation equipment are a powerful stimulus to innovation in those industries. In research and development, the U.S. has an unequaled university system and a substantial public investment in basic science. The core of American public R&D should be the universities, not federal laboratories. A much higher level of interchange between companies and universities is necessary, in part to stimulate more applied research. The country can no longer rely on defense as the engine of all research and development. The goals of the Defense Department are skewed toward preserving domestic competitors. University research has the added effect of training new scientists and acting as an incubator of new businesses. American trade policy has failed to deal with protectionism in many other nations. Yet it has moved in the direction of ''orderly marketing agreements'' that undermine the very essence of competition. This approach to dealing with trade difficulties is fundamentally flawed. Managed trade is cartelized trade, and not a real solution. ''Temporary'' protection to provide the opportunity for adjustment also rarely succeeds. In semiconductors, for example, the agreement with Japan to limit its exports has led to rising prices, improved Japanese profits, and chip shortages in the U.S. Trade policy must focus on truly unfair subsidies and trade barriers in foreign countries and counter them with compensating tariffs and restrictions on investment in the U.S. by the nation's competitors until foreign practices are modified. Where do we learn to be competitive? In school, of course. America cannot regain preeminence in innovation without human resources at least on a par with those in other advanced nations. We particularly need a new national effort to upgrade technical and vocational schools, which are a vital link in developing specialized human resources for industry. Companies and trade organizations must lead the way here, as electronics companies have done in California. Yet improving the general education system in the U.S. is not enough. What is required for competitive advantage is specialized skills tailored to particular industries. Companies must play a greater role in training and continually upgrading their work force. IN MANY WAYS, what the U.S. needs most is a philosophical shift. Defensiveness and a loss of confidence have crept into American industry and government. A mind-set has developed that U.S. industry is helped by devaluation, feeble antitrust enforcement, lax regulation, cooperation among leading competitors, policies that create a monopoly in particular technologies, and ''temporary'' protection. As appealing as these policies may seem in the short run, they will only make further loss of competitive advantage more likely.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: DYNAMIC DIAMOND The elements of competitive advantage reinforce each other: Japan's demanding consumers spur its many manufacturers and suppliers. Labor is costly but efficient.

CHART: NOT AVAILABLE CREDIT: SOURCE: INTERNATIONAL MONETARY FUND CAPTION: EXPORTS AS A PERCENTAGE OF WORLD TOTAL The U.S. share of world exports, commanding in 1950, now trails West Germany's -- and Japan runs a close third. Rising: South Korea.