Global Supply Chain Management

Global Supply Chain Management (GSCM)

Class 2: The Benefits of Specialization & Offshoring: Three Theories of Trade

Today's Focus

• GSC activities are ideally located in nations where they can be undertaken most efficiently, considering the quality of work.

  • This means locating activities where a competitive advantage exists.

  • International trade connects these globally spread activities.

• Objective: Illustrate the gains from specialization & trade using 3 different theories:

  • Factor Proportions Theory (Heckscher & Ohlin)

    • Factor abundance drives GSC-activity location decisions.

  • Diamond Theory (Porter)

    • Clusters & sources of factor quality influence GSC-activity location decisions.

  • New Trade Theory (Paul Krugman & others)

    • Scale economies drive GSC-activity location decisions.

Heckscher-Ohlin’s Factor Proportions Theory

• Factor abundance underlies GSC-activity location decisions.

• Competitive advantages for locations primarily derive from the quantity of local factors (e.g., land, labor & capital).

• Main Argument: Competitive advantages stem from differences in national/local factor endowments.

• Essence of the Argument:

  • The more abundant a factor of production, the lower its cost.

  • Therefore, a location is more likely to offer a competitive advantage for a GSC activity if the factors used intensively in that activity are locally abundant factors of production.

Logical ‘Wider’ Implications

• Countries export products that make intensive use of factors that are locally abundant.

• Countries import products that make intensive use of factors that are locally scarce.

• Pattern of World Trade is Determined by Differences in Factor Endowments

  • Capital-rich nations should export Capital-intensive products to Capital-poor nations.

  • Labor-rich nations should export Labor-intensive products to Labor-poor nations.

  • Example: China has generally excelled in exporting goods produced in labor-intensive manufacturing industries due to its relative abundance of low-cost labor.

  • The US lacks abundant low-cost labor and has been a big importer of these goods.

Background Definitions

• Factors of production: Create products and earn incomes for their owners

  • Broadest categories: land, labor (L), and capital (K)

  • These categories get broken down into sub-categories

  • Limited mobility across countries (in most cases)

  • Not incorporated into the products they make; a single factor makes a stream of products

• Factor Intensity: The relative importance of one factor versus others in production in an industry, usually compared across industries

  • Measured as share of value-added going to a particular factor

• Value Added: The difference between the total revenue of an industry and the total cost of inputs purchased from other industries

Examples of different ‘factor intensities’

• Pharmaceuticals uses high-skilled labor (measured as “administrative employees”) intensively (21% of value added)

  • E.G., Teva’s €3.6 bln. acquisition of Ratiopharm in 2010

• Footwear & furniture use low-skilled labor intensively (almost 40% of value added)

• Petroleum refining uses other factors (mainly physical capital) intensively

Factor Advantages

• Factor Advantages (competitive advantages derived from local factors) depend on relative – not absolute – abundance!

• A country may have larger absolute endowments of Capital (K) & Labor (L) compared to another but is relatively abundant in only 1 factor.

• Ratios test (2 countries, 2 factors):

  • A nation is capital abundant when nation’s \frac{K}{L} ratio is larger than the \frac{K}{L} ratio in the foreign country

  • Relativity: K-abundance implies L-scarcity

• Shares test:

  • Resolves many-countries/many-factors issue

  • A nation is abundant in factor F when its share of the world supply of factor F exceeds its share of world income (GDP)

Example: China & Vietnam 2019

Example: High & Low Skilled Workers

• China has “absolute” abundance compared to Vietnam in both:

  • 165 mln high-skilled in China > 7 mln in Vietnam

  • 611 mln low-skilled in China > 50.5 mln in Vietnam

  • But remember, “relative” abundance matters!!

• Applying Ratios Test with these 2 factors of prod:

  • Vietnam is ‘relatively’ low-skilled-labor abundant

  • China is ‘relatively’ high-skilled-labor abundant

    • \frac{Viet-High-Skilled}{Viet-Low-Skilled} < \frac{Chin-High-Skilled}{Chin-Low-Skilled}

    • \frac{7}{50.5} (=0.14 \text{ high-skilled for every low-skilled}) < \frac{165}{611} (=0.27 \text{ high-skilled for every low-skilled})

Example: High & Low Skilled Workers cont.

• Applying the shares test, Vietnam is also low-skilled-labor abundant vs. the world because its share of world’s low-skilled labor, 2.1% [\frac{50.5 \text{ mln}}{2400 \text{ mln}}], exceeds its share of world GDP, 0.3% [\frac{\$262 \text{ bln}}{\$86,599 \text{ bln}}]

• Thus, Vietnam is low-skilled-worker abundant (per the ratios & the shares test) suggesting that the wages for low-skilled-workers are relatively low/inexpensive there

  • Accordingly, GSCs will tend to locate production activities to Vietnam that intensively use low-skilled labor

  • You hear this from Chinese executives

  • Despite small size, Vietnam = 10% of worlds footwear exports!

  • #2 Exporter after China {2.1% share of the world’s low-skilled-workers > 0.3% share of the world’s GDP}

Global-supply-chain Activities that Create a Laptop

1. Basic R&D for product design

   • Requires a pool of high-skilled/educated workers with backgrounds in micro-electronics (US & Japan)

2. Manufacturing of standard electronic components (e.g., memory chips)

   • Requires a capital-intensive process along with semi-skilled labor (Taiwan, S. Korea & Increasingly China)

3. Manufacturing of advanced components (e.g., microprocessors)

   • Requires a capital-intensive process along with skilled labor (traditionally US & Japan, but now more Taiwan & S. Korea)

4. Final Assembly of Laptop

   • Requires a labor-intensive process with low-skilled labor (China)

Factor Proportions Theory Not Everything!

• What explains export prowess in footwear of Germany & Italy?

  • Clearly not low-skilled-labor abundant in a relative sense!

• Accordingly, the Empirical Evidence has been somewhat shaky (i.e., some empirical irregularities)

• Partial Explanation: Factor Proportions assumes constant technology across countries—but Probably not the case! For example:

  • E.G., Japan’s ‘70s & ‘80s auto export success more than just relative abundance of capital, but also innovative manufacturing processes!

  • China’s export success over the last 15 years more than just relative abundance of low-cost labor, but arguably the most tech- sophisticated of the emerging nations

Michael Porter’s National Competitive Advantage (Diamond Theory)

• So why does a nation have a competitive advantage in some industries & not others?

  • Somewhat dissatisfied with existing theories, as they only got part of the story

  • Heckscher-Ohlin could not necessarily explain:

    • Japan: autos & electronics;

    • Swiss: precision instruments & pharmaceuticals;

    • US/Germany: advanced chemicals; etc..

  • Porter was struck by the manifestation of national clusters of excellence for specific activities

Porter Offers ‘The Diamond’

• 4 Broad – reinforcing – Attributes that shape environment in which local firms compete and are determinants of competitive advantage:

  • Factor endowments

  • Related and supporting industries

  • Demand Conditions

  • Firm Strategy, Structure & Rivalry

Factor Endowments

• Specificity to individual industries

• Origin of factor:

  • Basic (endowed)

    • General-use: e.g., Unskilled labor, Pasture Land

    • Industry-specific: e.g., Oil & Uranium Deposits

  • Advanced (man-made)

    • General-use: e.g., Skilled Labor, Masters & PhD degrees

    • Industry-specific: e.g., Research facilities, Tech Know-how (Boston & Hollywood)

Related & Supporting Industries

• Investments in advanced factors of production by related & supporting industries spill over into an industry and help it achieve a strong competitive position internationally

• E.G.,

  • Previous US success in semi-conductors → basis of US success in Smart-Phones and other technically advanced electronic products

  • Swiss success in pharma related to previous intl success in technically-related dye industry

• Clusters are important as valuable knowledge flows between firms within a geographic cluster (via interactions & employee mobility)

Demand Conditions

• Firms Most Sensitive to Needs of Closest Customers; i.e., domestic customers not international customers

• Source of Pressure for Innovation & Quality Upgrading

  • The more sophisticated & demanding the better

  • E.G.,

    • Japanese consumers pushed camera makers

    • Scandinavian consumers pushed Nokia & Ericsson

• Somewhat controversial part of diamond

  • Critics (not Porter) argue international consumers can be sufficient source of pressure

Firm Strategy, Structure & Rivalry

• Vigorous Domestic Rivalry → Persistent Competitive Advantage in an Industry

  • Pressure to innovate, improve quality, reduce costs, upgrade advanced factors, etc..

  • Japanese example with cut-throat competition for market-shares (not profits) and constant rate of new products and process development

  • All of which are motivational w.r.t. continuous investment & upgrading and ultimately creating a competitive advantage

  • So, national clusters lead to benchmarking, competition & rivalry → innovation & excellence

Porter’s ‘Diamond’

• The 4 reinforcing attributes that shape a national environment (a local cluster) in which firms compete

• Represent sources of factor quality

• Which are in turn determinants of competitive advantage

Italian Footwear Industry

• Shoes synonymous with quality & craftsmanship

• A true cluster of excellence:

  • 5,031 companies & 76,610 employees situated in 7 regions: Marche, Tuscany, Lombardy, Veneto, Campania, Puglia, & Emilia Romagna

Italian Footwear & The Diamond

• Advanced Factors of Production:

  • Local training schools produce skilled labor

• Related & Supporting Industries:

  • System of sub-supply of raw materials, tanneries, accessories, machine manufacturers, model makers, & stylists

• Intense Rivalry between strong brands:

  • Gucci, Prada, Salvatore Ferragamo, Tod’s, Fratelli Rossetti, Dolce & Gabbana, Giorgio Armani, Giuseppe Zanotti

• Local Demand Conditions:

  • Exacting—see related fashion industry

New Trade Theory (Krugman & others)

• The most recent trade theory is based on the ‘returns to scale’ concept

  • i.e., Scale Economies

  • Unit-cost reductions with large scale of output

  • E.g., Microsoft with \$10 \text{ bln} to develop new operating system that is spread over 2 bln PCs [\$5 \text{ per unit in Fixed Cost!}]

• Ability of firms/industries to attain scale-economies can have substantial implications with respect to optimal location of GSC activities

Scale Economies/Returns to Scale Sources

1. Indivisible inputs (fixed costs)

2. Geometric relationship btw cost & capacity

3. Learning by doing (experience)

4. Specialization of employees/equipment

Returns to Scale

• Returns to scale represent a means to obtain gains from trade

• Plant-level economies of scale (PLEoS) are important in many industries (e.g., Fixed Costs with Auto manufacturing)

  • Key Point: But not all industries (this varies)!

• You Need Those Sources!!

Scale-Economy gains (when present) are a bit different

• No such thing as specializing in the ‘wrong’ place:

  • i.e., the wrong nation for a cluster, or the wrong nation in terms of factor abundance

• Key is to avoid duplicative overhead and reap substantial scale economies

• Simply put—specialization in ‘one place’ (or ‘limited places’) is more important than specializing in the ‘right place’!

Example of Scale-Economies at Play in GSC activity location decisions

• Commercial Aircraft Assembly Involves Substantial Scale Economies

  • Founded on reduced duplication of fixed costs, specialization, & learning/experience effects

Consider the Commercial Aircraft Makers & Where They Assemble

• Boeing: Washington state, & some in South Carolina

• Airbus: Toulouse France, & Hamburg Germany

• Bombardier: Quebec Canada, & some in Alabama

• Embraer: near Sao Paulo Brazil, & now Florida

An Additional Point

• First Mover Advantages Can Result

  • Ability to capture scale-econ ahead of later entrants, and thus benefit from lower cost structure (important 1st mover advantage)

  • Later entrants simply cannot match scale-based cost advantage

• see firm A vs. firm B…

Additional Point cont.

• First Mover Advantage Can Result

  • Ability to capture scale-econ ahead of later entrants, and thus benefit from lower cost structure (important 1st mover advantage)

  • Later entrants simply cannot match scale-based cost advantage

• see firm A vs. firm B…

• So countries can dominate a particular GSC activity, as firms in this industry were first to capture scale economies

• Example…

E.G., Airbus & $25 bln to develop A-380

• Had to sell ‘at least’ 250 A-380s to recoup those costs & Break Even!

  • Represents \$100 \text{ mln} in Fixed Costs per super-jumbo

  • Line will be fairly profitable at 350 A-380s

  • In 2015 there were 318 delivered/ordered A-380s

• World Demand over 20 years considered to be Max of 400-600 units at that time!!

• Airbus thus dominated super-jumbo category, as Boeing was shut out as they lacked sufficient scale economies as a second-mover

  • Boeing instead took bet on super-efficient 787

• In the end a much-better move, as Airbus ends production in 2021 with a total of 251 A-380 deliveries (so barely broke even & with recent increased costs → profit-losing)

In sum, we have different theoretical foundations behind the specialization of GSC production in different nations

• ‘Factor Proportions’ … à la Heckscher-Ohlin

• ‘The Diamond’ … à la Porter

• ‘New Trade Theory’ … à la Krugman

• An aside—a few additional theories exist

  • e.g., Smith’s Absolute Advantage, Ricardo’s Comparative Advantage, & Vernon’s Lifecycle theories from the text

• Each rationale suggests that global businesses specialize specific production activities of the GSC in a particular location & then use trade to connect the activities

Implications/Prescriptions

• But the theories provide different prescriptions regarding ‘where’ managers might want to specialize the different GSC production activities

  • Heckscher-Ohlin: where there is a relative abundance of the intensively used factors of production for the specific activity

  • Porter: in a cluster where the four attributes of the diamond are present for the specific activity

  • Krugman: in a single – but potentially idiosyncratic – location to reap scale economies in producing the specific activity

• Managerial challenge is figuring out which ‘trade theory’ (or combination of theories!!) is applicable with your GSC—with that, appropriate location decisions for the different GSC activities can be made