What does evidence tell us about fragmentation and outsourcing?

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Abstract

International production networks have emerged in a manifold of industries and products: sports footwear, mobile phones, cars, clothing, computers, and furniture to name only a few. While there obviously are agglomeration forces operating in some areas, dispersion of economic activities is also a fact of life. One of the consequences of disagglomeration manifests itself in a rapid expansion of international trade in parts and components. We look at the empirical evidence demonstrating trends regarding disagglomeration of production on a regional or global basis.

We also test two hypotheses stemming from our joint work on fragmentation of production:

  • Growth of the world economy increases the degree of fragmentation.

  • As services become cheaper and more readily available, international trade in parts and components expands.

Introduction

About 30 years ago international trade economists uncovered a phenomenon that had increasingly been permeating the international exchange of goods. Thanks to the outstanding work of Herbert Grubel and Peter Lloyd, overwhelming empirical evidence has been produced to demonstrate that a large part of international trade consists of flows of goods within the same industries.1 Two other stylized facts have emerged as well: First, the importance of intra-industry trade, as the new phenomenon came to be known, increased over time. Second, intra-industry exchanges have been particularly intensive between developed countries with similar per capita incomes and comparable factor endowments.

New facts demanded new theory. Although Grubel and Lloyd offered some penetrating suggestions as to what could account for this novel type of trade, more detailed theory emerged. A fresh chapter in the theory of international trade opened, with increasing returns to scale and monopolistic competition gaining a permanent place.

New problems have now come to the attention of policy makers and fresh events have captured the imagination of theorists. During the last decade or so, yet another form of international exchange has gained in importance—international outsourcing. Trade in parts and components, in middle products or in fragments of final goods (many names have been coined in this respect) has exhibited a dynamism exceeding that of trade in final goods. This paper focuses on trade in parts and components that result from the international fragmentation of production, a type of trade increasingly paramount in advanced stages of globalization. It occurs with the death of distance, to borrow the title of a remarkable book dealing with many aspects of globalization,2 such trade expanded as the world economy achieved its most liberal state since WWII, and has grown impressively with recent enormous improvements in telecommunications, globalization of finances and reductions of entry costs in many sectors worldwide.

Section 2 of the paper reviews the existing evidence supporting the claim that trade in fragments and in middle products is today what intra-industry trade was in the last several decades of the 20th century, with an important difference: Trade in middle products opens up an important role for developing countries.

After presenting the basic facts regarding international outsourcing, we propose, in Section 3, to review a theory of fragmentation in production that is capable of explaining the reasons for the new phenomenon. This analytical framework, developed over the period of the last decade and a half, stresses the fact that the process of production need not be confined by the boundaries of a region within a country or, indeed, by national boundaries. The framework stresses the essential role of a wide range of services required to support and sustain fragmented production technologies. Technological progress, domestic liberalization and international negotiations all result in lowered prices of service links that encourage increased international fragmentation of production.

The theory of international fragmentation of production and outsourcing offers a number of testable hypotheses: It predicts that income growth will lead to more fragmentation and more trade in parts and components. Equally important, it asserts that lower prices of service links will work in the same direction. We put these predictions to a series of tests in Section 4. The empirical results allow a comparison with a prediction commonly made by the new economic geography to the effect that economic growth leads to agglomeration. We find this conclusion to be inconsistent at the international level with the data. The paper ends with concluding remarks.

Section snippets

The emergence and growth of trade in parts and components

International fragmentation of production and the resulting trade in parts and components were already present in the early 1960s. The main driver of this process was the US economy adjusting to structural changes and attempting to remain competitive vis-à-vis Western Europe and Japan. Geography, costs and history all combined to select efficient sub-suppliers of US firms in Canada and Latin America. In analyzing the new phenomenon, the initial attention of trade theorists was concentrated on

The theory of fragmentation in production and outsourcing

Before turning to our empirical results it may prove useful to review several of the principal features underlying the rise in international outsourcing of production and services. As sketched out in Jones & Kierzkowski, 1990, Jones & Kierzkowski, 2001 and other work, the existence of increasing returns is crucial in the understanding of the outsourcing phenomenon. Adam Smith emphasized the division of labor, whereby as scale increases each worker can become more specialized in particular

Empirical results

The purpose of this section is to test the validity of the fragmentation-outsourcing framework against empirical data. Given the limited database there is no hope of estimating a full-scale model that would include behavioral relationships, identities, etc. And in fact, proceeding directly to reduced form equations may even be desirable. This is so because the fragmentation framework does not depend on a particular market structure. Its main massage carries through under perfect competition as

Conclusions

International outsourcing has become a symbol of globalization. The data clearly show the great increase in trade in parts and components. It surpasses the expansion of intra-industry trade which some observers have also seen as a key characteristic of the modern economy. The phenomenon merits a theoretical explanation and empirical testing, the subject of the present paper.

The theory of the fragmentation of vertically integrated production processes leading to international outsourcing can be

Acknowledgements

We thank Hartmut Egger for his comments.

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