Gains from Trade

James Fallows on who benefits most from China's manufacturing boom:

China Makes, The World Takes: Has the move to China been good for American companies? The answer would seemingly have to be yes—otherwise, why would they go there? It is conceivable that bad partnerships, stolen intellectual property, dilution of brand name, logistics nightmares, or other difficulties have given many companies a sour view of outsourcing; I have heard examples in each category from foreign executives. But the more interesting theme I have heard from them, which explains why they are willing to surmount the inconveniences, involves something called the “smiley curve.”

The curve is named for the U-shaped arc of the 1970s-era smiley-face icon, and it runs from the beginning to the end of a product’s creation and sale. At the beginning is the company’s brand: HP, Siemens, Dell, Nokia, Apple. Next comes the idea for the product: an iPod, a new computer, a camera phone. After that is high-level industrial design—the conceiving of how the product will look and work. Then the detailed engineering design for how it will be made. Then the necessary components. Then the actual manufacture and assembly. Then the shipping and distribution. Then retail sales. And, finally, service contracts and sales of parts and accessories.

The significance is that China’s activity is in the middle stages—manufacturing, plus some component supply and engineering design—but America’s is at the two ends, and those are where the money is. The smiley curve, which shows the profitability or value added at each stage, starts high for branding and product concept, swoops down for manufacturing, and rises again in the retail and servicing stages. The simple way to put this—that the real money is in brand name, plus retail—may sound obvious, but its implications are illuminating.

At each factory I visited, I asked managers to estimate how much of a product’s sales price ended up in whose hands. The strength of the brand name was the most important variable. If a product is unusual enough and its brand name attractive enough, it could command so high a price that the retailer might keep half the revenue. (Think: an Armani suit, a Starbucks latte.) Most electronics products are now subject to much fiercer price competition, since it is so easy for shoppers to find bargains on the Internet. Therefore the generic Windows-style laptops I saw in one modern factory might go for around $1,000 in the United States, with the retailer keeping less than $50.

Where does the rest of the money go? The manager of that factory guessed that Intel and Microsoft together would collect about $300, and that the makers of the display screen, the disk-storage devices, and other electronic components [in Malaysia, Korea, and elsewhere outside China] might get $150 or so apiece. The keyboard makers would get $15 or $20; FedEx or UPS would get slightly less. When all other costs were accounted for, perhaps $30 to $40—3 to 4 percent of the total—would stay in China with the factory owners and the young women on the assembly lines.

Other examples: A carrying case for an audio device from a big-name Western company retails for just under $30. That company pays the Chinese supplier $6 per case, of which about half goes for materials. The other $24 stays with the big-name company. An earphone-like accessory for another U.S.-brand audio device also retails for about $30. Of this, I was told, $3 stayed in China. I saw a set of high-end Ethernet connecting cables. The cables are sold, with identical specifications but in three different kinds of packaging, in three forms in the United States: as a specialty product, as a house brand in a nationwide office-supply store, and with no brand over eBay. The retail prices are $29.95 for the specialty brand, $19.95 in the chain store, and $15.95 on eBay. The Shenzhen-area company that makes them gets $2 apiece.

In case the point isn’t clear: Chinese workers making $1,000 a year have been helping American designers, marketers, engineers, and retailers making $1,000 a week (and up) earn even more. Plus, they have helped shareholders of U.S.-based companies.

Comments

[Kaleberg]

This gives us an interesting glimpse at the future of the world economy. The number of workers involved in manufacturing has been falling, as a percentage of the population, for over a century now, even as manufactured goods have grown more abundant. If we look at the middle of the smile, we might see a world population of 8 billion, and a manufacturing labor force in the hundreds of millions. What are the numbers if we look at the branding and design end of the smile? I can imagine tens of millions, but not hundreds of millions. What do we see in retail? I can imagine hundreds of millions here, but, unless retail changes structure, I can see a much lower number. What if everyone buys everything from some future Amazon? Clearly, retail has to be even more about the shopping and buying experience as opposed to a simple matter of acquisition.

[save_the_rustbelt]

The patients who died from poisoned heparin would not have such an optimistic view of trade with China.

Baxter shareholders did quite well though - even after the trial lawyers are finished.

[Matt]

We need thew Chinese to market and distribute on their own in the US .

If they get a greater share from assembly, then they will devote more resources to better products.

You and I can debate government health insurance all we want, but when the rubber hits the road it will be Chinese lightweight vehicle systems that will save our ass.

[Maynard Handley]

"The smiley curve, which shows the profitability or value added at each stage, starts high for branding and product concept, swoops down for manufacturing, and rises again in the retail and servicing stages."

This strikes me simple-minded, the kind of thing that is "obvious" but not necessarily true.
There are plenty of retailers that are struggling, plenty of brands that are worthless.

At the macro level, a better framework would be to focus on the extent of competition and commoditization at each stage. As anyone who has studied more than just Econ 101 knows, large parts (certainly all the consumer parts) of modern western economies do not operate on anything like perfect competition for the simple reason that such a system (a) provides only commodities and (b) provides no profits. Instead the name of the game in the west is to differentiate what you are doing in some fashion (which may be very real, if you are selling a mac computer) or may be basically the imaginary product of advertising (if you are selling gasoline).

What this means for China is that the parts of China that offer nothing but commodity labor will, like all (non-limited) commodities at all times, basically make nothing. Sure the government can provide a little value-add with decent utilities and some rule of law, but those workers are in competition with India, Vietnam, Indonesia and so on. On the other hand, the parts of China that can differentiate what they do by doing it substantially better (presumably this means investing in both R&D and in fancy plants and the labor to run them) can make profits just as aggressively as anywhere else in the world. (Presumably China organizations could also try to differentiate themselves to those who contract them on the basis of advertising, but this seems unlikely to work well.)

In other words, to describe this as an issue of manufacturing misses the point. If China got into the business of manufacturing difficult items (jet turbines, quantum cascade lasers, ultra-high-efficiency photo-voltaics, etc) there is no reason those industries could not reap the bulk of the profits, with branding and retail in the US making very little. Heck, if the problem is one (as many are) where the manufacturing is more difficult than the design, there is no reason why the design end of the spectrum should also not be impoverished.

[PeeDee]

China is indeed moving from the middle towards both ends - doing more and more original design and intermediating directly with end-consumers via eBay and alibaba. The remaining rents are largely due to information inefficiencies - what is a good value product and where can I get it. I wouldn't want my living to be dependent on this information arbitrage enduring. It is only a matter of time before the expensive and wasteful is eliminated.

[Joe S.]

There is real value in engineering and design. But is there value in marketing--or at least that part of marketing that consists of deception and the manipulation of preferences?

To the extent that Americans are "adding value" by deceiving other Americans, all they are doing is taking in each others' laundry. And returning it just as dirty as they took it in.

[vtcodger]

***In case the point isn’t clear: Chinese workers making $1,000 a year have been helping American designers, marketers, engineers, and retailers making $1,000 a week (and up) earn even more.*** And why, exactly, would anyone believe that situation to be sustainable?