Outsourcing Isn’t a Problem for Silicon Valley But Is for Detroit

Outsourcing manufacturing and product design to Asia has had an undeniably negative impact on the number of manufacturing jobs in the United States. But at least in the information technology industry, there is little evidence that outsourcing has slowed the rate of U.S. innovation or made the country less competitive. However, applying the lessons of IT to emerging industries where the U.S. has a weaker starting position — like electric vehicles — is another story.

There is a simple explanation: The inevitable march of value downstream toward customers and applications means that component technologies and processes become relatively plentiful, while the vision of how to combine and exploit increasingly capable, complex, and cheap building blocks becomes scarce. Thus, in IT, controlling demand for key technologies has proven far more valuable than attempting to control their supply.

DRAMs are a case in point. Since calls in the late 1980s to prop up the failing U.S. memory business through subsidies and tariffs were rightly turned back, the American IT industry has created many times more economic value by exploiting cheap and plentiful memories than U.S. chip makers lost by ceding the market to Japan, Korea, and Taiwan. And there is no evidence that companies mastering and controlling memory technology have gained any ability to move downstream — at the very least, their margins are too thin to fund anything other than the skills they need to stay where they are.

That the U.S. IT industry has been able to innovate over the past 20 years even while ceding leadership of component technologies and basic processes to industrial commons in other countries is a testament to the basic power free markets. Apple enjoys predictable and unfettered supply of leading edge technology because its software, design, marketing, and now retail prowess give it ultimate control over customer spending. Amazon, Google, Hewlett-Packard, IBM, AT&T, and Qualcomm have successfully used their investments in software, services, infrastructure, and intellectual property to do the same. All use their market power to force upstream vendors to invest for them to make the inputs to downstream innovations and transformations cheaper and more plentiful. As long as they innovate sufficiently to follow the flow of market value downstream, all are able to limit the eventual return and market power accruing to these upstream innovations.

While these upstream suppliers might control the knowledge of how to transfer new innovations from R&D to high volume manufacturing, they have every incentive to collaborate with innovators that lack such knowledge when doing so increases their share of or profitability in the markets where they compete. Witness the ability of the MIT One Laptop Per Child program to get Taiwanese LCD plants to produce its innovative LCD displays or the ability of flash-memory innovator SanDisk, which lacked its own fabs, to gain access to state-of-the-art process and manufacturing expertise through a partnership with Toshiba.

It’s tempting to see IT as a special case, and to be more fearful of outsourcing in other areas. But the reality is not so simple. For example, it’s likely that the U.S. will gain far more from low-cost manufacturing of solar modules in China than it will lose. The math is simple: Emerging photovoltaic technologies will reduce the manufacturing value added of a solar panel (i.e., transformation net of materials and capital costs) to less than 10 cents per watt of rated output power, or roughly the value of the energy it will produce in 600 hours of use.

But, installed in, say, California, a solar module will see 60,000 sun hours over its 20-year life, making its use 100 times more valuable than its production. There is still plenty of room to improve efficiency and lower solar-panel cost, and U.S. companies can and will gain market power by investing in the intellectual property needed to drive these improvements. But as the absolute cost of photovoltaic conversion falls over the next several years, economic opportunities around applications will swamp the payback on marginal innovation in the panels themselves, and ownership of manufacturing assets will not be required for the most valuable innovations.

Where this model breaks down is where U.S. companies and innovators do not naturally control downstream demand. Take batteries for electric vehicles. The U.S. has ceded both innovation in the critical building block (the battery) as well as leadership in the integration of these blocks into downstream value (competitive automobiles).

By investing early in alternative drive trains and capitalizing on decades of investment in related technologies for low-cost, high-quality automotive integration — indeed by anticipating innovation in batteries — Toyota and Honda have better positioned themselves to benefit from new technology, whether or not they develop it themselves, than any U.S. car company could, even if it instantly had access to some magic and unique U.S.-made battery.

It is not too late for the U.S. to invest in creating an infrastructure, or commons, for developing and manufacturing high-power batteries. But without the much greater investment in innovation of the downstream pieces, it’s not at all clear that the U.S. will share in the greatest slice of the economic pie.

Andy Rappaport
Partner
August Capital