A Theory of Modular Production Networks Ari Van Assche

1. 1 A Theory of Modular Production NetworksAri Van Assche

2. 2 Stylized Facts Literature Review Model Setup Equilibrium Determination Results Agenda for Future Research

3. 3 Vertically Integrated Electronics Industry (ca. 1970)

4. 4 Vertically Segmented Industry (present)

5. 5 Market Value of the Computer Industry in constant 1996 U.S. Dollars.  CompustatCompustat

6. 6 Industry transformation through two co-evolving trends Co-evolution of vertical outsourcing between vertical layers and horizontal consolidation within vertical layers. Leading electronics companies focus on one or few production stages and outsource other production stages to external firms. Within production stages, specialized firms consolidate their market share.

7. 7 Example: Rise of the contract manufacturing (CM) industry Brand-name electronics firms have en masse outsourced manufacturing capacity to CMs. Between 1990 and 2000, the share of CM in electronics manufacturing has risen from 0% to 13%. Market share of five largest CM firms has increased from 38% in 1999 to 65% in 2003 through M&As. Solectron, Flextronics, Sanmina/SCI, Celestica, Jabil Circuits. IBM, Nortel, Apple, 3Com, HP, Maxtor, Lucent, Ericsson, Alcatel outsourced circuit-board and product-level assembly by selling off production facilities to contract manufacturers (CMs). Sun Microsystems, Cisco Systems from the offset outsourced to CMs. While in 1990, the CM industry was virtually nonexistent, its share in the total available market for circuit board and product-level electronics manufacturing reached 13% in 2000. IBM, Nortel, Apple, 3Com, HP, Maxtor, Lucent, Ericsson, Alcatel outsourced circuit-board and product-level assembly by selling off production facilities to contract manufacturers (CMs). Sun Microsystems, Cisco Systems from the offset outsourced to CMs. While in 1990, the CM industry was virtually nonexistent, its share in the total available market for circuit board and product-level electronics manufacturing reached 13% in 2000.

8. 8 Other Industries Similar trends described in other industries: Semiconductors (Langlois & Steinmueller, 1999) Telecommunications (Li & Whalley, 2002) Automobiles (Sturgeon & Florida, 2000) Chemicals (Arora, Fosfuri & Gambardella, 2001) Which industry or product characteristics can explain co-evolution?

9. 9 Stylized Facts Literature Review Model Setup Equilibrium Determination Results Agenda for Future Research

10. 10 International Trade Literature on Outsourcing Outsourcing literature analyzes make-or-buy decision of final good firms by incorporating elements of transaction cost theory into industry-equilibrium trade models. McLaren (2000) Grossman and Helpman (2002) Antras and Helpman (2004) No explanation for the co-evolution of vertical outsourcing and horizontal consolidation.

11. 11 Management Literature on Modularity Modularization of electronic products has induced modularization of production Baldwin and Clark (2000) Sturgeon (2002): Modular Production Networks No formal model that explains how product modularization has led to co-evolution

12. 12 What is Modularity? Modularity is a characteristic of a product It defines how components interact with another to constitute a final product Non-modular Modular

13. 13 Non-Modular Product

14. 14 Modular product

15. 15 Example of modular product A computer is a limited number of standards parts (e.g., resistors, capacitors and memory chips) which get mounted onto printed circuit boards in different combinations. Dell example

16. 16 Stylized Facts Literature Review Model Setup Equilibrium Determination Results Agenda for Future Research

17. 17 Outline of the model Set up of industry-equilibrium model in which firm boundaries are endogenized in both horizontal and vertical dimensions of international production. Formalization of “modularity” and analysis of its impact on the organization of international production.

18. 18 Model Setup Industry-equilibrium model Consumers have Dixit-Stiglitz preferences Two vertical layers of production Intermediate good layer z – contestable markets Final good layer x – Dixit-Stiglitz monopolistic competition Two-country model Final goods produced in North Intermediate goods produced in South Model characterized by three trade-offs Vertical trade-off Horizontal trade-off Burden of customization

19. 19 Vertical boundaries of the firm: double marginalization Two successive vertical layers of production with increasing returns to scale Final good firms need to spend fixed cost F to start production. Intermediate good firms need to spend fixed cost Gz or Gx. Vertical integration: high fixed cost – low marginal cost. Outsourcing: low fixed cost – high marginal cost.

20. 20 Vertical Trade-Off Vertical Integration: Outsourcing: In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.

21. 21 Horizontal boundaries of the firm: Input specificity

22. 22

23. 23 Horizontal Trade-Off In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.

24. 24 Burden of Customization If intermediate good firms provide standardized components to multiple final good firms If intermediate good firms use standardized production processes to produce customized components to multiple final good firms

25. 25 Burden of Customization In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.In stage two, we assume that we already have determined the equilibrium production structure and search for the profit maximizing conditions given the production structure. We first start with vertical integration. The profit function has the following form: Marginal cost: s is the labor cost in the North, w* is the labor cost in the south and tau is transportation cost. Fixed cost: F is fixed cost of setting up firm, Gx is the fixed cost of setting up a subsidiary. Note that under outsourcing, the final goods producer will not face Gx. FOC: each firm’s decision yields a constant markup on marginal cost. Notice that output is increasing in fixed cost and elasticity of substitution and decreasing in marginal cost. As we shall see below the interrelation between fixed and marginal cost is crucial for the results.

26. 26

27. 27 Modularity and Degree of Input Specificity

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29. 29 Stylized Facts Literature Review Model Setup Equilibrium Determination Results Agenda for Future Research

30. 30 Two-Step Equilibrium Determination Solve for profit-maximizing price and quantities for each production structure Determine equilibrium production structure by using following rule: Production structure i is the equilibrium production structure iff it is not profitable for firms with another production structure to enter the market

31. 31 Stylized Facts Literature Review Model Setup Results Agenda for Future Research

32. 32 Vertical Integration if:

33. 33 Ideal Outsourcing if: 100 * customization cost under SO ¸ percentage difference in the markup between IO and SO 100 * customization cost under CO ¸ percentage difference in the markup between IO and CO Modularity induces horizontal consolidation

34. 34 Customized outsourcing if: Percentage difference between customization cost under SO and CO ¸ minus the percentage difference between the markup under SO and CO. Not necessarily the case that firm with lowest customization cost carries burden of customization!!!

35. 35 Results Co-evolution driven by modularity and by economies of scale in intermediate good sector. Co-evolution linked to emergence of de facto standardization of inputs (SO) and production processes (CO). Model provides insights into which firm faces burden of customization. By distinguishing three types of outsourcing, the model provides novel insights into the variety of outsourcing strategies available to MNE’s.

36. 36 Stylized Facts Literature Review Model Setup Results Agenda for Future Research

37. 37 Agenda for Future Research: Endogenizing Degree of Modularity To modularize a product, a manager faces both costs and benefits. Modularizing a product at least partially is a managerial decision by the firm. A model is needed that endogenizes both the degree of modularity and the organization of international production.

38. 38 Agenda for Future Research: Contract Incompleteness Modularization reduces knowledge tacitness in arm’s length relations. As a result, it can reduce degree of contract incompleteness. Modularization can improve a component producer’s outside options, thus reducing the hold-up problem. By improving the component producer’s outside options, modularization raises the component producer’s ex post bargaining power.