International Subcontracting

by V S Rama Rao on August 28, 2008 The classic explanation of why trade takes place among the countries runs in terms of what is known as comparative cost advantage theory in economic literature. The basic argument developed in the theory is that if a country is relatively more endowed with a factor of production, it will have comparatively more advantage in the production of a product which is relatively more intensive in that factor. Developing countries, by and large tend to be overpopulated, especially in the context of relative capital scarcity. It follows, therefore, that the developing the developing countries should have an edge in the production of labor-intensive items, if the production differential between a worker of a developing country and one in a developed country is not such as to more than counterbalance the advantage accruing from the relative cheapness of labor in the developing countries. The relatively stable level of population on the developed countries along with the high tempo of industrialization is exerting a strong upward pressure on the wage level in these countries. As a result, the initial comparative advantage of a developing country in the production and export of labor intensive products is becoming more substantial. Some data presented below will testify to the above observation. While in the manufacture of consumers electronic products, the average hourly earnings of a worker in Hong Kong is about $0.27, in Mexico $0.53 and in Taiwan $0.14 the US average hourly earnings ranges from $2.31 to $3.13, Similarly in the manufacture of semiconductors workers hourly average earnings ranges from $0.28 to $ 0.61 in the developing region and the average US earnings is in the range of $ 2.23 to $ 2.30. Such high magnitude of wage differential has motivated the manufacturers in the developed countries to seek partners in the developing countries who can supply labor intensive parts and components and/or do assembly operations on a long term basis This arrangement has come to be known as International Subcontracting. International Subcontracting as Extension of Domestic Subcontracting:

International subcontracting is, thus, a logical extension of domestic subcontracting which has flourished in a number of highly industrialized countries, notably the United States and Japan. The basic reason behind the dependence of the large manufacturing firms on units in the small scale sector of the supply of parts, and components of their assembly is that the wage rate the unorganized sector is much below the rate prevailing in the organized sector. The low level of overhead cost in the small scale units also makes their cost of production much lower. The relationship between the contractee and the subcontract may be very close as it is in Japan where the subcontractor depends on the contractee for almost everything from the supply of finance to technical expertise. The case of the automobile industry in Japan will exemplify this statement. While there are only 9 major manufacturers of automobiles in Japan, there are about 6,000 ancillary manufacturers. Automobile manufacturers depend upon the subcontractors (ancillary manufacturers) for the supply of parts while the latter rely upon the former for technical assistance, designs, specifications and finance. In fact, the two major auto firms namely, Toyota and Nissan are not selfsufficient in the production of major parts. Similarly a characteristic feature of Japans electronic industry is that the production of parts and components that of the finished goods is separated. Big electronic companies like Hitachi, Toshiba, Mitsubishi Electric or Sanyo Electric do not manufacturer every component that goes into their finished product. They depend on a large percentage of their requirements of components on outside suppliers. There are a large number of companies which specialize in the manufacture of parts. Such enterprises include Mitsumi Electric, Toyo Electric and Sankei Electric.