A Theory of Modular Production

Networks

Ari Van Assche

1
Presentation Overview
Stylized Facts
Literature Review
Model Setup
Equilibrium Determination
Results
Agenda for Future Research

2
Vertically Integrated Electronics
Industry (ca. 1970)

3
Vertically Segmented Industry
(present)

4
Market Value of the Computer Industry
in constant 1996 U.S. Dollars.
IBM

Intel

Microsoft 5
Industry transformation through two co-
evolving trends
Co-evolution of vertical outsourcing between vertical
layers and horizontal consolidation within vertical
layers.
 Leading electronics companies focus on one or few

production stages and outsource other production

stages to external firms.
 Within production stages, specialized firms

consolidate their market share.

6
Example: Rise of the contract
manufacturing (CM) industry
 Brand-name electronics firms have en masse
outsourced manufacturing capacity to CMs.
 Between 1990 and 2000, the share of CM in electronics
manufacturing has risen from 0% to 13%.

 Market share of five largest CM firms has

increased from 38% in 1999 to 65% in 2003
through M&As.
 Solectron, Flextronics, Sanmina/SCI, Celestica, Jabil
Circuits.
7
Other Industries

Similar trends described in other industries:

 Semiconductors (Langlois & Steinmueller, 1999)

 Telecommunications (Li & Whalley, 2002)

 Automobiles (Sturgeon & Florida, 2000)

 Chemicals (Arora, Fosfuri & Gambardella, 2001)

Which industry or product characteristics can

explain co-evolution?

8
 Stylized Facts
Literature Review
Model Setup
Equilibrium Determination
Results
Agenda for Future Research

9
International Trade Literature on
Outsourcing
 Outsourcing literature analyzes make-or-buy
decision of final good firms by incorporating
elements of transaction cost theory into industry-
equilibrium trade models.
 McLaren (2000)
 Grossman and Helpman (2002)
 Antras and Helpman (2004)

No explanation for the co-evolution of vertical

outsourcing and horizontal consolidation.
10
Management Literature on
Modularity
 Modularization of electronic products has induced

modularization of production
 Baldwin and Clark (2000)
 Sturgeon (2002):
Modular Production Networks

No formal model that explains how product

modularization has led to co-evolution

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What is Modularity?

 Modularity is a characteristic of a product

 It defines how components interact with
another to constitute a final product
 Non-modular
 Modular

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Non-Modular Product
A

D B

C
•Components specifically adjusted to each other
•Low input substitutability
13
Modular product

Global Design Rules

A B C D

•Components interact through standardized interfaces

•High component substitutability

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Example of modular product

 A computer is a limited number of standards parts

(e.g., resistors, capacitors and memory chips)
which get mounted onto printed circuit boards in
different combinations.
 Dell example

15
 Stylized Facts
Literature Review
Model Setup
Equilibrium Determination
Results
Agenda for Future Research

16
Outline of the model
 Set up of industry-equilibrium model in which
firm boundaries are endogenized in both
horizontal and vertical dimensions of international
production.
 Formalization of “modularity” and analysis of its
impact on the organization of international
production.

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Model Setup
 Industry-equilibrium model
 Consumers have Dixit-Stiglitz preferences
 Two vertical layers of production
 Intermediate good layer z – contestable markets
 Final good layer x – Dixit-Stiglitz monopolistic competition
 Two-country model
 Final goods produced in North
 Intermediate goods produced in South
 Model characterized by three trade-offs
 Vertical trade-off
 Horizontal trade-off
 Burden of customization

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Vertical boundaries of the firm:
double marginalization
Two successive vertical layers of production with
increasing returns to scale
 Final good firms need to spend fixed cost F to start
production.
 Intermediate good firms need to spend fixed cost Gz or
Gx.
Vertical integration: high fixed cost – low
marginal cost.
Outsourcing: low fixed cost – high marginal cost.
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Vertical Trade-Off
Vertical Integration:

Outsourcing:

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Horizontal boundaries of the firm:
Input specificity
 Each final good has ideal component
 If component non-ideal customization costs
 Ideal Outsourcing: each intermediate good firm
produces ideal intermediate good for one final good
firm
 Other Types of Outsourcing: each intermediate
good firm uses standardized production processes or
produces standardized components for multiple final
good firms. Horizontal consolidation

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 X1

z1 
z3

X4 z2 X2

X3

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Horizontal Trade-Off

zSO<zIO
zCO<zIO

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Burden of Customization

 If intermediate good firms provide standardized

components to multiple final good firms
standardized outsourcing
 If intermediate good firms use standardized
production processes to produce customized
components to multiple final good firms
customized outsourcing

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Burden of Customization

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Modularity and Degree of Input
Specificity
 Modularity indicates how components interact with

each other
 Non-modular product: components specifically

adjusted to each other.

High input specificity
 Modular product: components interact through
codified standards
Low input specificity
 By linking modularity to degree input specificity,
modularity incorporated in model

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 X1 Increase in
modularity

z1 
1 z3 >1
1 
X4 X2
z2

X3
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 Stylized Facts
Literature Review
Model Setup
Equilibrium Determination
Results
Agenda for Future Research

29
Two-Step Equilibrium Determination
 Solve for profit-maximizing price and quantities for
each production structure
 Determine equilibrium production structure by using
following rule:

Production structure i is the equilibrium production

structure

iff

it is not profitable for firms with another production

structure to enter the market
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 Stylized Facts
Literature Review
Model Setup
Results
Agenda for Future Research

31
Vertical Integration if:

Modularity reduces 

Modularity increases the relative marginal cost of

vertical integration.

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Ideal Outsourcing if:

 100 * customization cost under SO ¸ percentage

difference in the markup between IO and SO

 100 * customization cost under CO ¸ percentage

difference in the markup between IO and CO
 Modularity induces horizontal consolidation

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Customized outsourcing if:

 Percentage difference between customization cost

under SO and CO ¸ minus the percentage
difference between the markup under SO and CO.
 Not necessarily the case that firm with lowest
customization cost carries burden of
customization!!!

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Results
 Co-evolution driven by modularity and by
economies of scale in intermediate good sector.
 Co-evolution linked to emergence of de facto
standardization of inputs (SO) and production
processes (CO).
 Model provides insights into which firm faces
burden of customization.
 By distinguishing three types of outsourcing, the
model provides novel insights into the variety of
outsourcing strategies available to MNE’s.
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 Stylized Facts
Literature Review
Model Setup
Results
Agenda for Future Research

36
Agenda for Future Research:
Endogenizing Degree of Modularity
 To modularize a product, a manager faces both
costs and benefits.
 Modularizing a product at least partially is a
managerial decision by the firm.
 A model is needed that endogenizes both the
degree of modularity and the organization of
international production.

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Agenda for Future Research:
Contract Incompleteness
 Modularization reduces knowledge tacitness in
arm’s length relations. As a result, it can reduce
degree of contract incompleteness.
 Modularization can improve a component
producer’s outside options, thus reducing the
hold-up problem.
 By improving the component producer’s outside
options, modularization raises the component
producer’s ex post bargaining power.
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