analyze two articles

Innovation, Production, and Sustainable Job Creation: Reviving U.S. Prosperity

The Impact of Manufacturing Offshore on Technology Competitiveness: Implications for U.S. Policy

Erica R.H. Fuchs

From the Department of Engineering and Public Policy, Carnegie Mellon University

February 2012

Manufacturing Offshore on Technology Competitiveness: Implications for U.S. Policy

Erica R.H. Fuchs

From the Department of Engineering and Public Policy, Carnegie Mellon University

Development of the recommendations was funded by

CONNECT Innovation Institute 8950 Villa La Jolla Drive, Suite A-124 La Jolla, CA 92037 Phone: 858.964.1300 connect.org

© by CONNECT. All rights reserved.

The Impact of Manufacturing Offshore on Technology Competitiveness: Implications for U.S. Policy

Erica R.H. Fuchs Department of Engineering and Public Policy, Carnegie Mellon University

Abstract:

This paper demonstrates the relationship between manufacturing location and innovation trajectories and why national policy should not expect the same relationship for all technologies and industries. I focus on emerging technologies in two polar-opposite industries—automobiles and photonic semiconductors (the latter for telecom, computing, and military applications). In both cases, my results show that when U.S. firms shift production from the U.S. to countries like China, the most advanced technologies that were developed in the U.S. are no longer profitable. Production characteristics are different abroad and earlier technologies can be more cost-effective in countries like China. While in both cases, these economics lead firms to abandon producing the most advanced technologies, in only one of the two cases is there a barrier to pursuing innovation in the most advanced technologies back the U.S. I conclude by introducing a classification system to explain how the relationship between manufacturing and innovation may differ by technology. Within this framework, particularly important may be policies to support manufacturing, technology development, and commercialization activities by early-stage, high-technology, small- and medium-sized enterprises.

Summary

This paper leverages data from two industries to unpack the relationship between moving manufacturing to developing nations and the innovation trajectories of firms.

• I find, in both cases, moving manufacturing overseas to developing countries reduces the incentives for firms to develop the most advanced technologies.

• I find that, in both cases, firms follow these economics moving manufacturing overseas to developing countries and producing less advanced technologies there.

• However, in only one case does moving core manufacturing overseas to developing countries reduce the capability of firms to develop the most advanced technologies back in the U.S. and change the innovation trajectory of the firms that move overseas.

• Drawing on these two cases, I present a framework to predict how the relationship between manufacturing and innovation might be expected to differ across technologies and industries.

The above findings run counter to classical economic arguments in two areas: First, contrary to most models derived from neoclassical trade theories, these results show that moving manufacturing overseas may not only

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lead firms to exchange capital for labor or use lower-cost factor inputs to produce the same technology, but can in certain cases change the technology trajectories of firms. Second, these results show that in certain cases— representative of early-stage, process-based technologies—moving manufacturing to developing countries, rather than leading firms to invest more in higher-value added activities, can lead to firms reducing innovation back in the home country. At the national level, it is unclear if innovative activities in the most advanced technology are continued in new institutions beyond the offshoring firm, and at what level. Within the industry, only private, venture- or government-backed firms remain manufacturing in the U.S. and innovating in the new technology.

In 1995, future Nobel Prize winner Paul Krugman described economics as occurring in a “wonderland of no spatial dimensions”(Krugman 1995). Today, a similar criticism could be made of engineering design and technology management. Current schools of thought on design, product development, paths of innovation, and the management of these processes see geographic location as secondary to other considerations or as having impact on only a singular aspect of the process, such as cost of labor or knowledge transfer. However, location—in the form of institutions, resources, and regulations—has a system-wide impact on the development, manufacturing, and market environment facing technology. Further, the geographic properties of a location cannot be isolated from one another; it is not feasible to choose one nation’s institutions and another’s resources, at least not without incurring additional transaction costs (Williamson 1985; Grossman and Hart 1986; Antras 2004) and costs of knowledge transfer (Polanyi 1958; Arrow 1969; Rosenberg 1976; Teece 1977; VonHippel 1994). Thus, in the same way that it is impossible to design a part without taking into consideration the properties of the part’s materials, it is impossible to separate technology decision-making and manufacturing from the nation in which they occur.1

My research has shown that manufacturing location can have dramatic implications for the economic viability of emerging technologies. To-date, I have conducted in-depth studies of two industries with emerging technologies developed in the U. S., but whose production was later shifted to developing East Asia. Both technologies, described below, typify the breakthroughs that analysts point to as critical to U.S. economic progress and competitiveness. In both cases, when firms shift production from a developed nation (here, the United States) to a developing country (here, developing East Asia), the most advanced technologies that were developed in the United States are no longer the most profitable. Production characteristics abroad differ, and earlier stage technologies can be more cost-effective than new technologies in the production environments of developing countries. This leaves the most advanced technologies abandoned, and, in one case, creates a barrier to pursuing these technologies in the developed world.

The first of these emerging technology cases is fiberglass composites for lighter-weight, more efficient automobile bodies. Composite bodies may reduce automobile fuel consumption by more than ten percent, with an equivalent reduction in per-vehicle carbon emissions and dependency on oil. Composite automobile bodies, if produced in the United States, would be significantly more competitive with today’s steel alternatives than previously demonstrated (Fuchs et al. 2008). Indeed, 68% of car models produced in the U.S. for the U.S. market in 2006 would have been cheaper if they had instead been produced out of composites. However, contrary to the mainstream belief that composites should be even more cost-competitive in a developing country environment, the composite-bodied vehicle design was cost-competitive for a lower percentage of the car

1 Note: An analogous first paragraph can be found in the report, Fuchs, E. 2009. Remembering Comparative Advantage: Leveraging National Differences in Technology Competitiveness. Invited Contribution. Report by CMU

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models produced in 2006 in China than found for the car models produced in the U.S. (Fuchs et al. 2011). These results are particularly significant in an era when the energy-efficiency of transportation is under increased scrutiny. With demand for and production of automobiles now being greater in China than in the U.S. and still rapidly rising (Liu et al. 2010 ), these economics may change not only the vehicles produced in the developing world, but, due to the economics of production platforms, the global viability of certain energy-saving technologies.

The two automotive firms that have, historically, attempted to produce composite bodied vehicles in China for the Chinese market follow the above economics, pulling out of China with composite vehicles. In both cases (and again, more recently, in the case of the Tata Nano in India (Dhume 2011)), the companies’ main focus was to produce a low-cost “car for the people” accessible to the population that do yet own a car. The companies pull out, not because they learn that composites’ production economics are not as competitive as they thought, rather because they mis-judge the mass market’s willingness to pay for a “cheap vehicle” (Dhume 2011; Fuchs et al. 2011). In all three cases the rising middle class doesn’t want to be perceived as having something “cheap”, especially when they may have the money to buy a “real” automobile in just a few years. Thus, the technology is abandoned when marketing is really at fault. Most importantly, our analysis shows that 44% of car models produced today in China would have been cheaper if they had been produced instead out of composites. While this percentage is lower than the percentage of car models produced in the U.S. that would have been cheaper if produced out of composites, given the potentially more forgiving regulatory environment in China, the automakers may have lost a key opportunity to experiment with a new energy-savings technology. More environmentally stringent regulation, such as higher gas prices, in either of the top two automotive markets (and producers) globally (the U.S. and China) may give automotive companies more cause to find the true culprit behind low sales and not abandon such fuel-savings technologies, both in these countries, and globally.

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Figure 1: In automobile bodies, existing energy-savings composite body designs are cheaper for a greater proportion of cars if they are produced in the U.S. for the U.S. market, than if they are produced in China for the Chinese market. Source: (Fuchs et al. 2011)

The second emerging technology, integrated photonics, today is perhaps best known for its role in increasing bandwidth and reducing power consumption in tele- and data-communication networks such as fi ber optic communications, fi ber-to-the-home, Ethernet, and data centers. Photonic integration may be essential to future advances in sensor, medical, and solar applications, and to meeting the performance targets associated with Moore’s Law. The economic (not to mention the social) ramifi cations of such advances are not small. Alone, advances in information technology (IT) associated with Moore’s Law are estimated to have contributed to half of total factor productivity growth in the U.S. in the 1990s, and to growth in per-capita output worldwide (Jorgenson et al. 2005; Jorgenson and Vu 2005). While industry experts expected that the high capital costs and low production yields of integrated designs would render them uncompetitive, particularly at low volumes, our results fi nd that these expectations were incorrect: The new, integrated designs cost less than the prevailing technology at all production volumes when manufactured in the United States (Fuchs et al. 2006). Even more surprising to industry representatives (who thought manufacturing location irrelevant to their technical decisions), however, was that the opposite was true if fi rms produced in developing East Asia. Indeed, whereas the emerging integrated design was cheapest to produce in the U.S., the prevailing discrete design was cheapest to produce in developing East Asia. The cheapest option globally was to produce the old, discrete technology in developing East Asia and to locate no production in the United States (Fuchs and Kirchain 2010).

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Figure 2: In optoelectronic components, the cheapest option was for fi rms to move manufacturing overseas and produce the prevailing technology in developing East Asia. Source: (Fuchs and Kirchain 2010)

Before trying to understand the implications of the above-described economics for innovation, it is important to fi rst observe the subsequent manufacturing location decisions of the optoelectronic component manufacturers, and what products subsequently they chose to produce in those manufacturing locations. Of the U.S.-based manufacturers in the original study, seven of the eight manufacturers moved some portion of their manufacturing offshore to developing East Asia and currently produce there the discrete technology (Fuchs et al. 2011). Some fi rms moved just assembly overseas, while others moved both assembly and chip fabrication. Meanwhile, two new fi rms emerged in the U.S. with only U.S.-based manufacturing, and efforts to manufacture in the U.S. the integrated technology. No fi rms produce the integrated technology overseas in developing East Asia.

While a fi rm may not at a given moment be manufacturing integrated technologies, the fi rm may still be pursuing innovation in the integrated technologies. Indeed, classical economics would suggest that fi rms would be likely to invest the cost-savings from moving manufacturing overseas into performing additional higher- value activities, such as innovation, back in the U.S. (Baily and Farrell 2004). To explore this relationship, we collected patent and archival fi nancial data on all 28 public and private fi rms engaged in optoelectronic component manufacturing with either signifi cant market shares or signifi cant innovation activities in integration between 1992 and 2008 (Yang et al. 2011). We fi nd that each additional year a fi rm has assembly manufacturing activities offshore (but not their fabrication activities) is associated with an increase in patenting activities in

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non-integration technologies, although notably no statistically significant change in the patenting in integration (Yang et al. 2011). In contrast, each additional year a firm has both their assembly and fabrication facilities overseas is associated with a decline in integration patenting activity, and no statistically significant change in non-integration patenting (Yang et al. 2011). Thus, it is the offshoring of fabrication manufacturing activities – the activity that is necessary to create the monolithic technology – and not alone the offshoring of assembly that is associated with a decline in firms’ innovation activities in the most advanced technology. These results are consistent with the economics found in Fuchs and Kirchain (2010), which show that manufacturing overseas reduces the economic viability of producing monolithically integrated technologies. In Yang et al (2011), however, we then take those results a step farther, showing that the firms not only lose incentives for producing the emerging technology – they also reduce their innovation activities back home in that same technology. It is particularly interesting that the statistically significant relationship between offshoring and reducing innovation activities in monolithic integration is only found once the firms move fabrication capabilities offshore – as this is the section of manufacturing that Fuchs and Kirchain (2010) report to have very low yields and require regular attention by the R&D engineer on the manufacturing line. Fabrication is also the specific manufacturing capabilities key to producing the monolithically integrated technology. The increase in non-integrated patenting is difficult to interpret without future work into the details of the exact non-integrated technologies being patented. If these technologies are advanced technologies in other areas or directions, this result could be seen as supporting past work by economists that suggests offshoring enables a firm to save costs and thereby direct more resources toward higher- value-added activities (e.g. Farrell), (even if not to the emerging technology of monolithic integration). On the other hand, if these are more incremental patents, or manufacturing patents supporting activities, for example, in assembly, the decline in monolithic patenting may remain the most significant result.

Several important differences exist between the firms who choose to move manufacturing overseas and those that stay in the U.S. First, we find that more innovative firms (specifically those with higher total non-integrated patents as well as those with higher non-integrated patenting rates pre-offshoring) are more likely to offshore. We find no relationship between (monolithic) integrated patenting and the probability of going offshore2. These findings dispel the possibility that firms “already weak” in innovation were those that chose to move offshore, and that this tendency might be a partial explanation for why integration patenting decreased in firms that moved (Yang et al. 2011)3. Second, and potentially even more interesting from a policy perspective, all of the major public, revenue- earning firms move overseas and produce there the discrete technology. In contrast, the single firm that stays in the U.S. is at that time private and venture backed. The two new firms that emerge in the U.S. pursuing integration are supported by a combination of government funds (including funding from Small Business Innovation Research (SBIR) – in particular SBIR funds from the Department of Defense, the Advanced Technology Program, and Defense Advanced Research Projects Agency), and private (venture) funding. In addition to matching cross- industry trends in the U.S. innovation ecosystem over the past four decades, these findings support recent research suggesting that public firms may make decisions leading them to be less innovative (Bernstein 2011). Most importantly, they suggest that private venture- and government-backed small and medium sized firms may be playing a critical and tenuous role in supporting longer-term innovations.

2 There are significantly fewer monolithically integrated patents than overall (non-integrated) optoelectronic patents. As such, we may have lacked the necessary data to find statistical significance for the relationship between the probability of offshoring and the firms’ total (or rate of) monolithically integrated patents. We find, however, that within a firm, the non-integrated and monolithically integrated patenting rates are positively correlated, suggesting that firms with more non-integrated patents were more likely to also have more monolithically integrated patents. (Yang et al 2011) 3 Here, non-integrated patenting rates may be representative of firm’s capabilities in areas other than integration, including manufacturing

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Table 1: Optoelectronic component fi rms manufacturing location and associated product decisions. Firms that stay in the U.S. and pursue manufacturing the new, integrated technology are all private (pre-sales) and backed by either private or government funding.

Tracking the post-offshoring mobility of inventors originally at the offshoring fi rms provides the opportunity to explore the impact of offshoring on innovation beyond the individual offshoring fi rms, and shed some insights into the potential impact on integration activities in the broader industry and, in some small part, the nation. Twenty- four percent of inventors at offshoring fi rms who have prior experience in integration leave (Yang et al. 2011)4. Interestingly, these leave rates are no higher than those of integration inventors at non-offshoring fi rms, although signifi cantly higher than those of inventors without integration patents. Nine percent of the integration inventors who leave go to the venture-backed fi rm (Infi nera) that stayed onshore and patent there in integration (Yang et al. 2011).5 Ninety-one percent of them leave the optoelectronic component manufacturing industry all together, and of these only 12% (7 inventors) continue patenting in monolithic integration (Yang et al. 2011)6. Of the inventors that leave and go to the onshore fi rm pursuing integration (Infi nera), all of them leave for the onshore fi rm 1-3 years after their fi rms go offshore (Yang et al. 2011). This fi rm dominates patenting in integration, with more than twice the integration patents of any other optoelectronic component manufacturer and 32% of the total integration patents in the industry by 2009 (Yang et al. 2011). Interestingly, in addition to drawing integration inventors from the offshoring fi rms, Infi nera also draws many top non-integration inventors from the same fi rms, and once at Infi nera, they switch to patenting in monolithic integration (Yang et al. 2011). (See Table 2.) Again, the fi nding that only fi rms who were not yet under public market pressures choose to pursue the new technology in the United States, and that, in the case of Infi nera, this fi rm becomes a place for inventors originally at offshoring fi rms to push forward integration innovation underscores both the centrality of small start-ups within the current innovation ecosystem and the central role government and private funding can play in these high-tech small and medium sized business existence, early survival, and decision-making.

4 Eighteen percent of inventors at offshoring fi rms with one or two integration patents and 45% of inventors with more than two patents in integration eventually leave. 5 Three percent of inventors (1 inventor) at offshoring fi rms with one or two integration patents and 18% of inventors (5 inventors) with more than two integration patents go to the venture-backed fi rm that stayed onshore (Infi nera) and patent there in integration. 6 Ninety-seven percent of inventors at offshoring fi rms with one or two integration patents and 82% of inventors with more than two integration patents leave the optoelectroinc component manufacturing industry all together.

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Table 2: More than half of Infi nera’s integration inventors (shown below) are originally from offs horing fi rms in the same industry. The remaining 48% come from a variety of locations with no clear trend. Source: (Yang et al. 2011)

The cross-case fi ndings that moving manufacturing overseas reduces economic incentives for developing the most advanced technologies may tempt some to hearken to protectionist policies. And yet, upon close refl ection, these fi ndings do not indicate that all high-tech manufacturing needs to take place in the developed world to ensure that economic incentives continue to exist for new technologies. Indeed, in the case of optoelectronics manufacturing, moving only assembly facilities overseas may increase innovation back in the U.S. in areas outside integration. Likewise, in the automotive industry case, we argue that fi rms could use multiple manufacturing locations across developed and developing nations to diversify their product development portfolio, and thus increase innovativeness. Thus, one of the most important lessons from these two cases is that different stages of manufacturing, different technologies and different industries cannot be treated equivalently. To begin to understand the link between production location and innovation, and what manufacturing a nation should to try to keep within its borders, policy-makers must develop 1) an understanding of in what

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manufacturing, technical, and industrial areas the U.S. has the potential to have comparative advantage, and 2) a classifi cation system by which to understand why technologies and industries may behave differently, both in terms of the relationship between manufacturing and innovation and in terms of their response to policy.

In beginning to develop such a classifi cation system as suggested by 2), alone in these two industry case studies several variables stand out as being key: global market heterogeneity, the plant-to-market ratio, transportation costs, fi rm size, and the ability to separate R&D from manufacturing.

The plant-to-market ratio – or the ratio of the size of the global market to the manufacturer’s minimum effi cient plant size – along with transportation costs determines how many manufacturing facilities can operate globally. For example, for automobile bodies, the minimum effi cient plant size is approximately equal to the size of regional markets, and transportation costs are high. Thus, a body manufacturer can afford to own multiple facilities, each producing a different technology suited for a regional market. Under these circumstances, a global automotive manufacturer has the opportunity to leverage national differences to diversify their product development portfolio and increase innovation. In contrast, in the case of optoelectronic components, the minimum effi cient plant size is on the same order of magnitude to the global market and transportation costs are low. Thus, an optoelectronic component manufacturer must choose to produce in one location for the global market, and must choose a technology suited to that location’s production environment. While a larger fi rm, with more diversifi ed products, may have had the option to have multiple manufacturing facilities by leveraging other products towards economies of scale or by pricing under cost, the small and medium sized optoelectronic component manufacturers lacked this option. (Fuchs and Kirchain 2010; Fuchs et al. 2011)

Figure 3: Relationship between market size, minimum effi cient plant size, and transportation costs and the relationship between manufacturing location and the technology decisions of fi rms. Source: (Fuchs et al. 2011)

Equally or more important to the plant-to-market ratio and transportation costs is the ability to separate R&D from manufacturing. In the case of optoelectronic components, the manufacturers were unable to manufacture the emerging, integrated technology offshore (Fuchs and Kirchain 2010). Due to low yields – historically common in early-stage process-based industries – R&D workers were on the production (and in particular the fabrication) line at regular intervals trying to fi gure out why products were not coming off the line (Fuchs and Kirchain 2010). These R&D workers were not willing to move their families from, for example, California, to

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developing East Asia. Nor is the science behind photonics production sufficiently well-understood that CAD technologies yet exist to enable design in one location to happen, that is subsequently sent electronically and fabricated in another (Fuchs and Kirchain 2010). At the same time, the engineers and technologists do not yet exist in Asia to produce these emerging, integrated products overseas (Fuchs and Kirchain 2010). History tells us that these challenges in low yield and separating R&D from manufacturing were common in the electronic semiconductor industry thirty years ago, and that parallels can be found in immature products in other process- based industries, such as chemicals and pharmaceuticals (Fuchs and Kirchain 2010). Other reasons also exist for early-stage start-up firms to want to produce close to the source of R&D. Company founders, who are frequently also the inventors themselves, are frequently in the early years involved in day-to-day company operation as well as the development and introduction of improvements on the current product and of new products. Preliminary surveys at Carnegie Mellon University suggest that these founder-inventors may prefer to remain in the same location, close to the university if professors, or simply close to their existing house and without moving their family (Alizadeh et al. 2011; Galvan et al. 2011; Kaushik et al. 2011).

As emphasized by the above results, a nation cannot adopt a one-size-fits-all approach to technology. The most economically viable technologies when produced in one country are not necessarily the most economically viable technologies when produced in another. To remain competitive in a global economy where the U.S. is no longer the dominant location of production or source of demand, such as for example, in automobiles, where demand and production in China now both supersede the U.S., we must understand how production location effects the economic viability of the products we innovate and that the U.S. cannot expect to unilaterally direct the development of these new technologies. Further, while some technologies, like optoelectronic components, will be most economically produced in one location for the global market, others, like automobiles, will be most economically produced in multiple locations and customized to regional markets. In these latter cases where products are produced in multiple locations, to prevent firms from manufacturing internationally could hurt not only firms’ competitiveness, but also U.S. competitiveness by reducing these firms opportunities to leverage national differences to globally increase their innovativeness. In cases where products are produced in one location for the global market, the opposite may be true. On the one hand, if the product is a commodity, and there is little new room for innovation, then from an innovation standpoint little may be lost by allowing that product to be manufactured offshore. On the other hand, if the product is an emerging technology, and moving manufacturing offshore to developing nations reduces both incentives and capability in the U.S. for innovation (continuing to advance the most advanced technology) then much is lost from the U.S. perspective – and perhaps even globally if other developed nations (whose manufacturing structures could be expected to incentivize production and innovation in the most advanced technologies) also move offshore or otherwise do not push forward innovations in the most advanced technology.

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Figure 5: Relationship between technology constraints and the relationship between manufacturing and innovation. To maximize innovation in the U.S., the U.S. wants to manufacture in the U.S. the technologies in the “most constrained” category and support technologies in the “least constrained” category being manufactured overseas.

Finally, our study of integrated photonic semiconductors – which represents our most constrained scenario in Figure 5 – holds important lessons for the future advancement of high-technology manufacturing-based industries in United States. With the decline of corporate R&D laboratories, and the increased reliance by large fi rm on leveraging the innovations of small and medium sized enterprises through technology alliances and acquisitions, new challenges have arisen for the alignment of incentives across these vertically disintegrated supply chains, and in particular for long-term research. Central within this model is the incentive structures and funding of the small and medium sized fi rms themselves. The manufacturers of optoelectronic components can only effi ciently afford one manufacturing facility given the small size of the market and diffi culty of separating R&D from manufacturing. This experience is likely to generalize to many small fi rms with emerging, immature process-based technologies. Such immature, high-tech process-based manufacturing fi rms could range as widely as pharmaceuticals and chemicals, to solar, sensor, and battery technologies. If government and private funding are the only thing keeping these small and medium sized business alive in the years between conception and the time the product’s costs are down to meet demand on the market, then the sources of funding for these small and medium sized start-ups needs far greater attention, and the U.S. system is frail indeed.

Implications of manufacturing offshore on firm technology strategy

Manufacturing offshore requires change in technology

Manufacturing offshore enables diversification of product development portfolio

Implications of manufacturing offshore on firm path of technology development

Manufacturing offshore changes firm path of technology development

Manufacturing offshore doesn’t changes firm path of technology development

Most Least Constrained Constrained

3. Low market-to-plant ratio (one plant)

4. Difficulty separating R&D from manufacturing

Technology Scenario

1. High market-to-plant ratio (many plants)

2. Ease separating R&D from manufacturing

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The CONNECT Innovation Institute was founded in July 2010 as a think tank to focus exclusively on innovation policy and competitiveness in the global economy. The CONNECT Innovation Institute publishes timely thought papers from San Diego leaders for use in addressing federal policy issues, and it raises funds for larger scale policy projects involving leading scholars of innovation.

CONNECT is a non-profit that has assisted in the formation and development of more than 3,000 companies in the San Diego region and is widely regarded as one of the world’s most successful organizations linking inventors and entrepreneurs with the resources they need for commercialization of innovative products in high tech and life sciences. The program has been modeled in more than 50 regions around the world. CONNECT has been recognized by Time, Inc. and Entrepreneur magazines and in 2011 won the national State Science and Technology Institute’s 2011 Excellence in Tech Based Economic Development Award for Building Entrepreneurial Capacity. In 2010, CONNECT was the recipient of the Innovation in Economic Development Award from the U.S. Department of Commerce for creation of Regional Innovation Clusters. CONNECT manages the San Diego, Imperial Valley, Inland SoCal Innovation Hub (iHub) designated by the state of California Governor’s Office of Business & Economic Development in 2010. Key to our success has been the unique “culture of collaboration” between research organizations, capital sources, professional service providers and the established industries.

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