The Mechanics of International Production Networks and the Importance of SMEs

Although international production and distribution networks in East Asia began to form since the beginning of the 1990s, Jones and Kierzkowski (1990) began developing the theory of fragmentation around the same time. The theory pointed out fundamental differences between the division of labor for industry and production-processes, or rather between finished products trade and intermediate goods trade, particularly within the context of the firm's decision making in cutting out production blocks and service link costs.

Figure 5 [ PDF 18.7KB | 1 page ] illustrates the original idea of fragmentation. Suppose that a large factory in the machinery industry takes care of all production processes from upstream to downstream. Such a factory is both capital and human-capital intensive and as such is likely to be located in a developed country. However, if we look at the factory in detail, we may find various production processes. Some processes are human-capital intensive and require a pool of researchers and technicians. On the other hand, some processes are highly labor-intensive and a pool of unskilled labor may suffice. Other processes may need to operate 24-hours per day in order to accelerate capital depreciation. Hence, if we can fragment production processes into several production blocks and locate them in appropriate places that possess different location advantages, we may save on the total production cost. This is fragmentation.

Fragmentation of production processes makes sense when the savings of production costs in production blocks is large and incurred service link costs for connecting remotely located production blocks are small. Firms can cut out production blocks so as to exploit differences in location advantages in remote areas. However, service link costs, including transport costs and various coordination costs, should not be too large. Transactions between production blocks tend to be relation-specific in a production process.

The international production and distribution networks in East Asia have reached a high level of sophistication in that fragmentation and agglomeration occur at the same time, developing the complicated combination of intra-firm and inter-firm transactions. To analyze the sophistication of production and distribution networks in East Asia, Kimura and Ando (2005) introduced fragmentation in terms of the firm's disintegration. They also included a dimension of fragmentation in terms of geographical distance, where a firm decides whether to keep some economic activities inside the firm or to outsource them to unrelated firms (see Figure 6 [ PDF 18.1KB | 1 page ]). This two-dimensional framework explains the sophisticated nature of fragmentation in East Asia, where fragmentation of both intra-firm and inter-firm production processes is developed.

By introducing the idea of intimacy between geographical proximity and inter-firm transactions, the framework can explain the simultaneous development of the firm-level fragmentation of production processes and the industry-level formation of agglomeration. Inter-firm transactions are accompanied by extra transaction costs as compared to intra-firm transactions, which here are interpreted as service link costs in disintegration-type fragmentation. Such costs may be particularly high when a firm does not perfectly trust its counterpart. Short distances help such transactions by cutting down the cost of identifying and monitoring business partners as well as the cost of trouble-shooting. Such forces in turn formulate industrial agglomeration in East Asia. At such a sophisticated stage of development of the formation of production networks, SMEs play a crucial role. SMEs are essential components of production networks, involved in inter-firm fragmentation in various forms such as subcontracting arrangements and original equipment manufacturer (OEM) contracts. SMEs are also essential components for industrial agglomeration. In this context, local SMEs as well as multinational SMEs can be important participants in the vertical inter-firm division of labor.

In ASEAN and East Asia, international trade in parts and components has expanded explosively, and the international division of labor in terms of production processes has developed to an unprecedented degree. At the same time, economic agglomeration or industrial clusters have grown in several notable places where dense vertical supply chains have formed. The fragmentation of production processes and the formation of economic agglomeration, however, are rather new phenomena starting from the late 1980s or the early 1990s. The new economic geography and fragmentation theory are extremely useful in understanding the mechanisms of agglomeration and fragmentation.

The new economic geography explains the formation of economic agglomeration in geographical space. The spatial structure of economic activities is considered to be the outcome of a process involving two opposing types of forces—agglomeration forces and dispersion forces. The geographical theory analyzes the balance of these two opposing forces that generate a variety of location patterns of economic activities.

A key property of agglomeration forces is the circular causality of economic activities. For example, an automobile assembler would attract a number of upstream suppliers, and the resulting productivity enhancement and market expansion might lead to the entry of another assembler. Such circular causality would generate a sort of economies of scale through geographical proximity.

At the same time, the growth of economic agglomeration would enhance dispersion forces. Concentration of economic activities would increase land prices and wage rates, bring severe price competition among firms, cause traffic congestion, complicate telecommunication, and generate air pollution. Due to such congestion effects, dispersion forces would be intensified.

One of the important factors that affect the balance between agglomeration forces and dispersion forces is transport cost, which includes freight costs, tariffs, non-tariff barriers, and risk for exchange-rate variation. As transport costs decrease, agglomeration may grow. With a substantial decrease in transport cost, production activity may disperse instead.

There are three elements that make fragmentation possible. First, there must be production cost saving in fragmented production blocks—the firm must take advantage of differences in location advantages between the original location and a new location. Second, the cost of service links that connect remotely located production blocks, like the costs of transportation, must not be too high. Third, the cost of network set-ups must be small. When the additional cost for setting up a new plant is relatively small, the production process fragments easily. The feasibility of fragmentation, therefore, depends heavily on the nature of technologies in the industry and economic environment. New economic geography and the fragmentation theory provide insights to important factors that determine the location of economic activities in the globalizing era.

International production and distribution networks in ASEAN and East Asia are, relatively speaking, the most advanced and sophisticated in the world. East Asia has no doubt developed a favorable policy environment that is suitable for globalizing corporate activities. However, such a policy environment has been realized through accumulated profit-motivation actions by the private sector rather than being developed with well-designed strategic moves.

New economic geography and the fragmentation theory provide rich implications for policy environments in the globalizing era. New economic geography suggests a promulgation of policies that affect agglomeration forces and dispersion forces. The fragmentation theory suggests policies affecting production cost saving, service link cost, and network-set-up cost. Combined with careful consideration of policy needs that differ by development stages, it is possible to develop desirable policy packages in order to utilize globalizing forces.

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