From Partial to Systemic Globalization:
International Production Networks in the Electronics Industry

Dieter Ernst

April 1997

Copyright 1997, by Graduate School of International Relations and Pacific Studies, University of California at San Diego and Berkeley Roundtable on the International Economy

This is a joint publication of The Data Storage Industry Globalization Project Report 97-02, Graduate School of International Relations and Pacific Studies, University of California at San Diego, and BRIE Working Paper #98, Berkeley Roundtable on the International Economy, University of California at Berkeley, 1997.

Dieter Ernst, Ph.D., is a Senior Research Fellow at BRIE. He is currently a professor of International Management at Copenhagen Business School, Denmark. Before joining BRIE, Dr. Ernst had been a senior advisor at the OECD Development Centre (Paris). For over two decades, Dr. Ernst has written about technology and international competition in various industries and implications for firms' strategies and government policies.

Generous support for this work was provided by the Alfred P. Sloan Foundation.

Table of Contents

Chapter I: The Dynamics of Global Competition in the Electronics Industry

1. 1. Strategic Games and Entry Barriers
   2. Changing Competitive Requirements
   3. Competitive Challenges in the Hard Disk Drive Industry
   1. 3.1. Scale Economies
      3.2. Complex Capability Requirements
      3.3. Volatility
      3.4. Implications for Entry Barriers and Industry Structure

Chapter II: A Shift from Partial to Systemic Globalization: Key Features of International Production Networks

1. 1. A Puzzle
   2. Conflicting Determinants of International Production
   3. The Limits to Partial Globalization
   4. Systemic Globalization: The Concept of the International Production Network
   1. 4.1. Levels of Analysis
      4.2. Basic Definitions
      4.3. Intra-Firm Versus Inter-Firm Production Networks
      4.4. Governance Structures
      4.5. Indicators

Chapter III: Geographic Dispersion

1. 1. The Concept of Geographic Dispersion
   2. American Firms as Pace-Setters
   3. A Sophisticated Asian Production Network: The Case of Seagate
   4. Divergent Approaches to Geographic Dispersion
   1. 4.1. A Heavy Reliance on Outsourcing: The Case of Apple Computer
      4.2. A Late Shift to Asia: Geographic Dispersion at IBM's Storage System Division

   
   5. The Ascent of Japanese International Production Networks

   1. 5.1. The Move to East Asia
      5.2. Changes in the Locational Patterns-Towards a Regional Specialization
      5.3. The Vintage Factor: Learning How to Manage International Production Networks
      5.4. Current Developments: Competing for Asia's Supply Base and Markets

Chapter IV: Increasing Complexity

1. 1. Product Mix
   2. Scope of Activities
   3. The Migration of Key Support Functions: A Misplaced Focus on R&D
   4. Capability Transfer Through Subcontracting: The Experience of American Semiconductor Firms
   5. Capability Transfer by Japanese Electronics Firms
   1. 5.1. Procurement
      5.2. Transferring Some Elements of R&D

   
   6. Outsourcing in the Computer Industry

   1. 6.1. The Increasing Importance of Outsourcing
      6.2. Motivations for Outsourcing
      6.3. Implications for Local Capabilities-The Example of OEM Arrangements

   
   7. The Joint Migration of Key Support Functions

   1. 7.1. Systemic Rationalization
      7.2. The Example of Hewlett Packard
      7.3. The Role of Proximity: New Options for Co-Location Abroad

Conclusions
Bibliography
Endnotes

THE ISSUE: OPENING THE BLACKBOX OF "GLOBALIZATION"

Far-reaching changes are currently occurring in the organization and location of the production of industrial goods and services, changes which are bound to have important implications for the welfare, the development potential, and the competitive position of different countries and regions. As competition cuts across national and sectoral boundaries and becomes increasingly global, firms everywhere are forced to shift from exports to international production. Today, dominance in a domestic market--even one as large as the U.S.--is no longer enough. Mutual raiding of established customer and supply bases has become an established business practice, with the result that firms are now forced to compete simultaneously in all major markets, notably in Europe, North America and Asia.

This has led to a rapid expansion of international production: new production sites have been added at a breath-taking speed outside the industrial heartlands of Europe, North America and Japan. Since the mid-1980's, international production has grown considerably faster than international trade. Today, the sales of foreign affiliates of TNCs far outpace exports as the principal vehicle to deliver goods and services to foreign markets. The expansion of international production is likely to continue.⁽¹⁾

Yet, quantitative expansion is only part of the story. Of equal importance are qualitative changes: a shift from partial to systemic forms of globalization. In order to cope with the increasingly demanding requirements of global competition, companies are forced to integrate their erstwhile stand-alone operations in individual host countries into increasingly complex international production networks. Companies break down the value chain into discrete functions, and locate them wherever they can be carried out most effectively and where they are needed to facilitate the penetration of important growth markets.

Reduction of transaction costs is one important motivation. Of equal importance are access to clusters of specialized capabilities and contested growth markets, and the need to speed up response time to technological change and to changing market requirements.

This raises an intriguing question: As the pace of globalization accelerates and as this deepens the functional integration between previously separate national production systems, how will this affect firm strategies? And, more specifically, will globalization increase rather than decrease the choices that companies have in organizing their worldwide production activities? In order to answer this question, we need to open the blackbox of "globalization." In other words, we need to inquire why firms are forced to shift from exports to international production, what factors shape the location and organization of such activities, and why firms differ in how they approach international production.

This study is an attempt to provide a conceptual framework for addressing this research agenda. The focus is on the electronics industry which has been at the forefront of globalization; indeed, the electronics industry's reliance on international markets and production is unrivaled by any other industry, as is its exposure to international production networks. The industry also reflects quite well the increasingly complex requirements of global competition. As this study is part of the Sloan Foundation project on "The Globalization of the Data Storage Industry," I will try to include, wherever possible, illustrative examples from this particular sector of the electronics industry.

The analysis proceeds in four steps. In chapter I, I analyze how the increasingly demanding requirements of global competition are reshaping the entry barriers and the structure of the electronics industry. I also identify some distinctive competitive challenges that set the hard disk drive industry apart from the rest of the electronics industry.

In chapter II, I analyze how this has led to a shift from partial to systemic forms of globalization and the spread of international production networks. I show that international production networks are more than "governance structures for economizing on transaction costs."⁽²⁾ Of equal importance are the search for clusters of specialized capabilities and access to contested growth markets. The focus on capabilities is consistent with the evolutionary theory of the firm which argues that competition today centers around a firm's ability to build capabilities quicker and at less cost than its competitors.⁽³⁾ The focus on market penetration is consistent with Dunning's eclectic FDI theory, which considers spatial variations in the size and composition of markets as a critical location-specific factor.⁽⁴⁾

In the remaining two chapters, I analyze two main features of systemic globalization: geographic dispersion and concentration, and the increasing complexity of value chain activities that move abroad.

Chapter III deals with the first of these issues. It shows that electronics firms have pursued a variety of geographic dispersion strategies, and documents the new patterns of specialization that are emerging in various sectors of the electronics industry.

Finally, Chapter IV analyzes some important aspects of the increasing complexity of international production: (1) new products are produced overseas much earlier than predicted by the product life cycle (PLC) theory; (2) the scope of international production has been substantially broadened and now covers all stages of the value chain, including some high value-added support functions; (3) outsourcing has increased in importance, and now covers a variety of high value-added support functions; and (4) systemic rationalization now cuts across national borders and covers a variety of cross-border linkages. To the degree that proximity advantages can be replicated abroad, these factors have further expanded the internationalization of the value chain. In other words, once manufacturing moves abroad, there is a strong tendency for a concomitant migration of key support functions.

Chapter I: The Dynamics of Global Competition in the Electronics Industry

1. Strategic Games and Entry Barriers

More than in any other industry, competition in the electronics industry today cuts across national and sectoral boundaries. In order to compete in this industry, a firm must be able to internalize, on a global scale, specialized assets and capabilities, including technological knowledge, organizational competence, finance, production experience, supplier and customer networks and market intelligence. These capabilities are important because they can lead to the timely development and effective commercialization of a wide variety of electronics goods and services. Of critical importance is that the firm can build these capabilities quicker and at less cost than its competitors.⁽⁵⁾

Due to pervasive globalization pressures, fundamental changes have occurred in competitive behavior and how firms create or acquire these capabilities. No firm, not even a dominant market leader, can generate all these different capabilities internally, let alone deploy them on a global scale. This necessitates a shift from individual to increasingly collective forms of competition, "... from the legal entity known as the firm to the contractual network of firms tied together by mutual long-term interest."⁽⁶⁾ Competition is thus primarily shaped by "strategic games" among the leading companies or coalitions of firms which position themselves so as to discourage or dictate the actions and responses of their current and potential competitors.⁽⁷⁾

Such games are played on different levels, with cooperation often going hand in hand with intense competition. For instance, competitors can cooperate on basic support services (such as R&D and standards) and intermediate inputs (such as materials and components), while maintaining keen competition at the final product stage. Or they may join forces to create a variety of entry deterrence strategies against possible new entrants. Of equal importance are joint attempts to restrict technology leakages and to control the range of products and services that could act as superior substitutes.

Governments also play an important role in such games. In most sectors of the electronics industry, a variety of regulatory barriers restrict access to new technologies, product standards and markets. This reflects the growing "politicization"⁽⁸⁾ of competition in an industry which is widely claimed to be of strategic importance.⁽⁹⁾

An impressive arsenal of regulatory barriers exists today in the electronics industry.⁽¹⁰⁾ These barriers include: (1) restrictions on market access, whether through discriminatory access to government procurement markets or through market share quotas and "market reservation" schemes; (2) restrictions on the establishment of firms in a particular activity through, for instance, statutory monopolies, investment licensing, or restrictions on FDI; (3) regulations concerning standards for product design, quality, and reliability, and interface and connectivity requirements; (4) restrictions on access to scientific and technological knowledge and particular types of human resources, including restrictive intellectual property rights, technology export controls, and restrictions on the mobility of engineers and scientists; (5) limitations on access to key components; (6) restrictions on pricing behavior and the establishment of distribution channels; and (7) restrictions concerning the financial behavior of firms, especially with regard to discriminatory fiscal treatment and restrictions on profit repatriation.

In short, competition in the electronics industry is based on strategic interaction between firms and governments. It centers on market positions and on the definition of the rules of the game, where technological and organizational innovations, entry deterrence strategies, and regulatory barriers are used as important weapons. Creating and destroying entry barriers thus has become the essence of competition in this industry. What separates the electronics industry from other industries, however, is the intensity, spread, and variety of such entry barriers, their complex dynamics and their increasingly systemic nature. As R&D and capital intensity are high and rapidly increasing, entry barriers into the electronics industry in general are well above the industry average.⁽¹¹⁾

As usual, the average hides the essence of the story. Once we disaggregate by product groups and market segments, we find a complex picture. The electronics industry has a reputation for a historically unprecedented rate of technological progress.⁽¹²⁾ Rapid technical change, however, has acted as a "double-edged sword."⁽¹³⁾ In some sectors, trajectory-disrupting innovations have dismantled entrenched entry barriers and have acted as a powerful equalizer by eroding the competitive advantages of erstwhile market leaders. At the same time, however, rapid technical change has produced very steep entry barriers in sectors (for example, microprocessors) where its implementation requires huge and rising R&D and investment outlays and where economies of scale, scope, and learning are of critical importance.⁽¹⁴⁾

Let us take a closer look at the nature of entry barriers in the electronics industry.⁽¹⁵⁾ The analysis of barriers to entry has focused primarily on the impact of economies of scale in industrial manufacturing. As Bain has shown in his pioneering work,⁽¹⁶⁾ scale economies can constrain the entry of new firms if the minimum efficient scale of operation is high relative to the size and growth rate of the market, and if dynamic economies of scale or learning economies result in unit cost reduction with cumulative production experience.⁽¹⁷⁾ Under such conditions, temporary monopoly positions of firms can be quite persistent. The same applies to the "technology gap trade" to which monopoly leads.⁽¹⁸⁾ Case studies on the semiconductor and computer industries have shown that as long as initial innovators are able to generate a continuous flow of process and product innovations, the competitive efforts of would-be imitators can be repelled.⁽¹⁹⁾ It is widely assumed that this is largely due to the important role which threshold barriers and learning economies play in both industries.

Yet, scale economies are only part of the story. A much broader view is required in order to capture the great variety of entry barriers in the electronics industry and possible interactions between them. Such a broader concept is also necessary to understand how entry barriers vary over time and space and across different product groups and market segments. Four types of entry barriers⁽²⁰⁾ are essential for an understanding of the global dynamics of competition in the electronics industry: (1) production-related scale economies, including learning economies, threshold barriers and economies of scope; (2) barriers related to intangible investments required for developing the knowledge and competence base as much as complementary support services; (3) barriers to entry and exit of supplier networks, such as subcontracting and OEM (original equipment manufacturing) arrangements; and (4) barriers related to sales, marketing (especially with regard to distribution channels and the creation of global brand images), and after-sales services.

Elsewhere, I have provided a detailed analysis of the development of each of these different types of entry barriers in the electronics industry.⁽²¹⁾ The main findings can be summarized as follows. Technical change and changes in demand continuously create new products and markets and thereby create new entry possibilities. Thus, entry barriers have declined for a number of product groups and market segments. Simultaneously, however, entry barriers have increased for those stages of the value chain which are currently of critical importance for competitive success. Production-related scale economies continue to matter. But the epicenter of competition has shifted to R&D and other forms of intangible investment that are necessary to enhance a firm's speed of response to changes in technology, markets and regulations. In short, what really matters are the substantial investments required in the formation of a firm's technological and organizational capabilities.⁽²²⁾

2. Changing Competitive Requirements

These changes in the nature and the dynamics of entry barriers are due to quite fundamental changes in the competitive requirements. Traditionally, two types of competitive strategies could be distinguished in the electronics industry. For consumer electronics and electronic components, competition used to center primarily on cost reduction and judicious pricing. Non-price competition was largely restricted to a few high value-added market niches. In the computer industry, on the other hand, the focus of competition has been on product differentiation, based on proprietary computer designs and market segmentation. In short, it was possible to neatly separate patterns of competition in the electronics industry by sector, product group, and market segment.

Today, this is no longer the case. In almost every sector of the industry, firms have to cope with much more complex requirements, where price and non-price forms of competition are closely intertwined. In contrast to a widespread misconception that electronics products are all differentiated products, this industry covers an extremely broad variety of products that face very different patterns of demand. Some electronic products are homogeneous products in the purest sense, while others are highly differentiated products that require very intense and continuous interaction between producers and users.

The distinction between homogeneous and differentiated products, however, has decreased. Most electronic products have become "high-tech commodities": they combine the characteristics of mass production with extremely short product cycles and periodic trajectory-disrupting innovations. As a result, cost competition must be combined with product differentiation and speed-to-market. Mass production implies large investment thresholds that are necessary to reap economies of scale. Short product cycles imply the rapid depreciation of plants, equipment, and R&D. Only those companies who are able to get the right product at the right time to the highest volume segment of the market can survive. Entering a new market right on time can provide substantial profits. Being late is a disaster which quite frequently may force a company out of business. Probably of greatest importance, however, is the increasing uncertainty that results from periodic trajectory-disrupting innovations: established leadership positions can no longer be taken for granted, and the target of competition becomes fuzzy and can change at any time.

These changes in the economics of competition have had far-reaching implications for market structures. Take, for example, the computer industry. The development of the computer and the invention of the transistor allowed the U.S. to establish a firm worldwide leadership in the electronics industry during the late 1940's. Originally, this leadership was personified by two companies, IBM for mainframe computers, and AT&T Bell Labs for microelectronics. As outlined by Schumpter, competition in the industry was traditionally based on successful R&D investments that created temporary monopolies.⁽²³⁾ The focus was on product differentiation, based on proprietary computer designs and market segmentation. As Flamm has convincingly demonstrated, "...[a] process of technological differentiation, with new competitors defining new market niches, has been central to the way in which competition has evolved."⁽²⁴⁾ Competition in the computer industry was thus characterized by a basic paradox: despite IBM's early leadership and the oligopolistic nature of competition, there have always been possibilities for latecomers to enter the fray by means of product differentiation and market segmentation strategies.

IBM's dominance reached its peak in the mid-1970's. Competition in the computer industry had then settled into a fairly stable pattern, "... with IBM dominating the mainstream of business computing and several well-established but smaller firms nibbling at the margins in emerging markets not covered by the umbrella of IBM's general purpose architecture."⁽²⁵⁾ Since then, dramatic changes have occurred in the structure of the industry. IBM's fall from its position as an industry hegemon is common knowledge. What is less well known is that IBM's decline is representative of a much broader development--the pervasive destabilization of established market structures. This has happened as a result of the continuous down-sizing of computer systems, which has made them increasingly interchangeable, and some progress towards open, non-proprietary computer systems.⁽²⁶⁾ Across the board, none of the leading contenders is strong enough to turn the tables in his own favor. In addition, the distinction between the different segments of this industry has become blurred and nobody's established customer and supply base is immune to raiders from outside. The result is that, for each participant, the scope of competition becomes much broader and requires an increasingly complex set of capabilities. Furthermore, the rules of competition have become much more unpredictable.

Under such conditions, competing in the electronics industry has become a hazardous game. I will discuss in chapter II how electronics firms have been forced to adapt their organization of production in order to cope with such an increase in complexity and risks. We will see that the main response has been a shift from partial to systemic forms of globalization. Let us first, however, briefly consider some key features of competition in the hard disk drive (HDD) industry and ask to what degree this industry fits the general pattern that I have described so far.

3. Competitive Challenges in the Hard Disk Drive Industry

Hard disk drives (HDDs) are the workhorses of mass storage and are widely used in computers of all sizes, from the most powerful super-computers to the tiniest laptop PCs. The world market for HDDs today is almost $26 billion.⁽²⁷⁾ By any standard, this is a large and important sector of the electronics industry.

This industry also provides an excellent example of the increasingly complex competitive requirements that result from the globalization of competition. HDDs are archetypal "high-tech commodities": economies of scale are crucial for most stages of the value chain, and this goes hand in hand with very short product cycles and a hectic pace of technical change. In addition to scale economies (3.1.), this industry is also characterized by very complex capability requirements (3.2.) and a high degree of volatility (3.3.).

There are, however, some important factors which differentiate the HDD industry from other sectors of the electronics industry. We will see that, in terms of the sources of volatility, demand fluctuations and trajectory-disrupting innovations have played a less important role than for final-use products like PCs and consumer electronics. A second important hallmark of this industry is the incredibly demanding requirements of its supply chain logistics: HDD assembly is heavily dependent on a large number of high-precision components, and their sources are typically spread across different time zones and continents. Compared to the extremely demanding requirements in the HDD industry, procurement requirements for PC assembly and consumer electronics are much more mundane.

Despite a peculiar set of industry features, the competitive requirements in the HDD industry are not much different from the rest of the electronics industry: intense price competition needs to be combined with product differentiation, while continuous price wars have drastically reduced profit margins. Addressing these three goals simultaneously comes close to a squaring of the circle. Doing so, however, almost inevitably gives rise to high entry barriers and to an increasing degree of concentration (3.4.).

3.1. Scale Economies

Scale economies are of critical importance in the HDD industry, and continue to increase rapidly. In final assembly, economies of scale are largely attributable to costly overhead investments like the construction of "clean room" environments and expensive test equipment. Huge investments are also required in precision tools, moulds, and dies that are required to make the various high-precision components and parts that go into a drive. For some of these components, like thin-film or MR recording heads, minimum economies of scale are as high as those required for integrated circuits.

Let us look at a few indicators that demonstrate how important mass production is for this industry. Seagate, one of the industry leaders, owes its success to a consistent focus on high-volume, low-cost manufacturing, backed up by an early shift of production to East Asia. Typically, Seagate waited until a market opened before entering with volume manufacturing to dominate the particular market segment. With Seagate's mass production strategy providing large cost advantages, other companies were ultimately left behind.⁽²⁸⁾ Today, out of Seagate's 5.6 million sq-ft worldwide manufacturing capacity, more than 60 percent (3.4 million sq.-ft.) is in Asia.⁽²⁹⁾ This Asian production capacity is concentrated in three Asian mega-plants, with each plant responsible for roughly one third of capacity (i.e. slightly more than 1 million sq.-ft.). By any standard, these are very large production facilities that come close to the orders of magnitude that are typical today for the consumer electronics and semiconductor industries.⁽³⁰⁾

Minimum economies of scale in the HDD industry apparently have grown very rapidly over time. In 1989, an annual production capacity of between 900,000 and 1 million units⁽³¹⁾ was regarded as economic scale.⁽³²⁾ Seagate's Bangkok production facility, for example, had a registered annual production capacity of 940,000 units in 1989. In that same year, Matsushita Kotobuki's new production line for 3.5" drives in Japan was designed to produce 1.2 million drives per annum, making it one of the largest facilities worldwide.⁽³³⁾ Based on a regression analysis which measures the factors that drive differences in the total cost per unit for each major disk drive manufacturer for the period 1984-1992, Christensen (1994, p.18) concludes that "...the minimum efficient scale in the disk drive assembly business is about 4 million units (per annum)."

Since then, a dramatic increase has occurred in minimum scale. This reflects the fact that, with almost $26 billion worldwide sales revenues in 1995, the HDD industry has become a major industry. Capacity requirements in the industry are driven by a very rapid growth of demand; worldwide unit shipments increased by 35 percent in 1994, almost 26 percent in 1995, and are projected to increase by around 18 percent in 1996. To demonstrate the increase of economic scale, let us look at 1996 capacity figures reported by Maxtor, a U.S.-based HDD producer which is now wholly owned by Hyundai Electronics Industries, an affiliate of Korea's powerful Hyundai group. For its main plant in Singapore, Maxtor reports a capacity of 4 million drives, but this capacity is not per year, but just per quarter. In other words, annual capacity at this plant now is around 16 million units. Similar capacity levels are reported for Maxtor's new facility in Dalian, China.⁽³⁴⁾ , i.e. 16 milion units per year.

3.2. Complex Capability Requirements

This industry is also characterized by a breakneck speed of technical change: areal density, i.e. the amount of information that can be stored on a given area of magnetic disk surface, is increasing at about 60 percent a year.⁽³⁵⁾ At the same time, the speed of access to data is rapidly increasing in importance. In order to cope with both these requirements, HDD firms must be able to tap into scientific knowledge across a broad front, covering areas such as magnetics, coding, and electronics. HDD firms must also master a variety of very demanding technological capabilities.

Hard disk drives (HDDs) are high-precision machines that contain and rotate rigid disks on which data is magnetically recorded, and control the flow of information to and from these disks. HDDs require a variety of high precision engineering capabilities, for instance the production of miniature motors able to work under extremely demanding tolerances. This industry also requires the mastery of incredibly complex process technologies that are used for coating disks with very thin films of magnetic materials (the so-called deposition technique) and for producing specialized integrated circuits (ICs). In addition to some of the most sophisticated component manufacturing technologies, the final assembly of HDDs requires leading-edge automation techniques, including surface-mount technology.

Yet, while manufacturing matters, it is only part of the story. Competitive success in this industry also crucially depends on the capacity to develop innovative architectural designs that can provide cost-effective solutions to the manifold trade-offs that exist between size, storage capacity and access time of HDDs. Finally, leading-edge software capabilities are an equally important prerequisite for developing a viable HDD product. Indeed, both architectural design and software capabilities have been of crucial importance as instruments for product development and differentiation strategies.⁽³⁶⁾

An additional complicating feature is that product cycles in this industry keep shrinking. On average, a new product generation is introduced every 9 to 12 months, and for some products the cycle can be as short as six months.⁽³⁷⁾ This leads to a rapid depreciation of plants, equipment, and R&D. Like semiconductors, the HDD industry thus falls prey to a "scissors effect" between rapidly increasing fixed capital costs and an accelerated depreciation of its assets.⁽³⁸⁾ The result is that speed-to-market and economies of scale are of critical importance. The need to combine size and speed implies that a firm must be able to ramp up production quickly to competitive yields and quality. This requires close interaction between design, proto-typing, volume manufacturing and marketing which, as we will see later, has important implications for the organization of international production.

Firms can reduce this complexity by pursuing a selective approach to the use of new technology. The main objective of innovation management is to avoid the unnecessary use of difficult, untested and hence costly technologies and to keep products as easy to make as possible. Take, for instance, recording head technology. MR heads, the current leading-edge technology, are potentially far superior relative to earlier technologies, including the current "best practice" thin film technology. However, as one industry participant noted, "MR heads are the most difficult technology--this industry has ever swallowed--difficult to design and to manufacture."⁽³⁹⁾ In order to implement this technology, fundamental changes are required in all aspects of HDD design, including head, disk, motor, and read-and-servo channels. The result is that most firms will only use MR heads for high-end applications required for work stations, mainframes, and servers. For desktop PCs, cost and time-to-market are crucial; it would thus almost be suicidal to try to implement an immature technology like MR heads.

In order to cope with this perplexing array of technologies, firms need to invest huge amounts in R&D, human resources, and capabilities. Yet, low margins prevent HDD firms from developing all of these capabilities in-house. HDD firms thus need to have continuous access to external suppliers and support industries that possess some of these capabilities. The result is that HDD firms are faced with very high costs of complex procurement logistics. With the industry characterized by heavy periodic shortages of key components, such procurement costs are likely to increase even further.

3.3. Volatility

A third important characteristic of the HDD industry is the prevalence of excessive boom-and-bust cycles. These cycles are due to a combination of three factors: (i) periodic spurts of very rapid capacity expansion; (ii) a complex supply chain that leads to periodic shortages in key components; and (iii) highly volatile demand patterns.

(i) Spurts of rapid capacity expansion

Spurts of capacity expansion result from the importance of speed-to-market. Each time that a new product generation is introduced, HDD firms engage in a frantic race to become the first supplier: " If you're early to market there's a reward for that. You get gross margin, you get a lot of customer action. If you're late, you've missed it. There's no recovery from that."⁽⁴⁰⁾ HDD producers thus have all become masters in ramping-up production at short notice. The result is a built-in tendency for an overshooting of investment relative to demand growth. This has a paradoxical consequence. As mismatches between demand and supply occur periodically, the capacity to exit rapidly becomes as important as the capacity for rapid capacity expansion. Fast ramping-up and ramping-down hang together and require an incredibly short response time to changes in both markets and technology.

(ii) A complex supply chain

In terms of its logistical requirements, the HDD industry is probably the most demanding sector in the electronics industry. The industry requires a wide variety of high-precision components and sub-assemblies, and procurement involves a variety of sources that are spread over different time zones and continents. Such global supply chains are prone to frequent disruptions. Suppliers, for instance, can cause such disruptions through late delivery or through the delivery of defective materials. Of equal importance are periodic supply shortages for key components such as heads, media, integrated circuits, and precision motors. Geographic distance often magnifies the impact of such disruptions.⁽⁴¹⁾ This leads to another paradox. While HDD firms excel in the rapid ramp-up of the final assembly lines, disruptions in the supply chain can easily thwart this achievement; if everything else is in place, but one tiny component is missing, all the efforts to ramp up production in time have been in vain.

Quantum, for example, relies heavily on outside vendors for most of its key components. In a recent filing with the U.S. Securities and Exchange Commission, the company freely admits that "... limited availability of certain key components has constrained the Company's revenue growth. There can be no assurance that similar shortages will not recur in the future, and the Company's inability to obtain essential components or to qualify additional sources as necessary, if prolonged, could have a material effect on the Company's results of operations."⁽⁴²⁾ In order to reduce this threat, Quantum has acquired DEC's MR head division, hoping that this would "... drive our costs down and make sure that we [have] available high technology components...[when we need them]."⁽⁴³⁾ So far, however, doubts remain whether this approach will work. After all, Quantum's corporate culture has been shaped by a long tradition of heavy outsourcing which is difficult to change at short notice.⁽⁴⁴⁾

Another example, Maxtor, illustrates how deadly a reliance on outsourcing can be. Maxtor, which used to be one of the leading U.S. suppliers of HDDs, experienced a dramatic fall in market share and was ultimately acquired by the Korean Hyundai group in 1995. Maxtors main weakness was a lack of strong in-house circuit design expertise.⁽⁴⁵⁾ In a recent 10K report, Maxtor explained how two serious component supply problems contributed to its decline: "The Company is experiencing a shortage of media. The shortage is anticipated to continue at least through [ the second calendar quarter of 1996]."⁽⁴⁶⁾ Maxtor also faced a serious shortage for specialized input/output ICs that link disk and tape drives to computers: "...the Company expects a shortfall of about 1.1 million chips from Milpitas-based Adaptec Inc during the first three months of 1996...The Company has negotiated a payment of $1.4 million to Adaptec to secure 500,000 units to cover the shortfall, and an extra $1.5 million will be paid for the other 600,000."

(iii) Volatile demand patterns

Compared to end-user industries like the PC industry or consumer electronics, demand-related volatility factors are probably less important for the HDD industry. Yet, they still matter and, in some cases, may even be of critical importance.

The main market for HDDs is the computer industry.⁽⁴⁷⁾ As suppliers of an intermediate input to the computer industry, HDD firms compete for design-ins by computer companies. Computer companies thus exert a considerable influence on the product mix, the product cycle, and the pricing strategies of HDD vendors. Decisions on the product mix are shaped by the increasing storage requirements of computers and their applications. Annual increases in areal density and speed are fairly predictable, as long as there are no trajectory-disrupting innovations.

Two types of trajectory-disrupting innovations can be distinguished: (1) a threat from competing technologies, and (2) break-through innovations in the drive design and in component technology that would drastically improve disk drive capacity, performance, and cost.

Let us first look at the threat from competing technologies. Hard disk drives constitute just one approach to the storage and retrieval of digital information. There are a number of competing technologies with different costs and benefits: optical storage offers higher capacity, tape drives lower cost, RAM chips far better speed, and flash EEPROMs more durability for portable applications.

While these technologies compete in niche markets, there is a widespread consensus that, so far, none of these competing technologies poses a serious threat to HDDs: "During the 1990s, it will be almost impossible for any competing storage technology to seriously challenge the rigid magnetic disk drive [i.e. HDDs], except in a few niche applications, as a result of the continuing rapid improvements in disk drive capacity, performance and cost. A few alternatives to magnetic disk recording have found a degree of acceptance in specialized markets and applications, but the proposed substitute must be significantly better, faster, smaller, less expensive or demonstrate some other overwhelming advantage."⁽⁴⁸⁾ However, a note of caution is in order: some engineers and managers who shape decisions in drive companies apparently believe that there may be a potential threat of displacement. Take the following observations by one of the engineering managers of Quantum's technology and engineering group: "When I left school in 1984 and was going to do disk-drive R&D at HP (Hewlett Packard), my friends said the 84-kbit chips were going to kill disk drives. The only reason the disk-drive industry is around is that [the disk drive] is less expensive than DRAM and flash. That always colors our thinking.... ".⁽⁴⁹⁾

The second type of trajectory-disrupting innovations revolves around break-through innnovations. Break-through innovations in architectural design and in component technology have periodically caused quite serious turmoil in the HDD industry.⁽⁵⁰⁾ Thus, HDD companies cannot afford to neglect such a possibility. Much depends on what kind of customers it is linked to. If these customers are established market leaders intent on sustaining the status quo, there is a danger that an HDD manufacturer may become locked into obsolete architectural designs. If, however, the HDD company succeeds in broadening its customer base to include computer companies intent on developing new markets and applications, there are much stronger incentives to proceed with architectural paradigm shifts. A passive subordination to customer needs can be a trap. Indeed, market leaders in the HDD industry often listened too attentively to their established customers and ignored new product architectures whose initial appeal was in seemingly marginal markets.⁽⁵¹⁾

Christensen argues that a firm's competitive position depends as much on the nature of demand as on the constraints resulting from available technologies. An exclusive focus on the development of key components may not be sufficient. Nor, for that matter, does a strength in architectural design alone guarantee competitive success. Both need to be combined with a capacity to identify and develop new markets for new applications. Strong product and market development capabilities are thus of critical importance.

Let me again emphasize an important feature of the HDD industry: drastic demand-related disruptions do not occur as frequently as in end-user industries such as PCs and consumer electronics. But they cannot be excluded. And when do they occur, they can have quite devastating effects on a company's competitive position. The conclusion that matters for our purposes is that no HDD company can afford to neglect the possibility of trajectory-disrupting innovations. This obviously adds quite substantially to the complexity of the competitive challenges in this industry.

Furthermore, due to the very short product life cycles that characterize the industry, demand-related volatility also occurs on a fairly regular basis. Product cycles for HDDs have been drastically cut. For high-end products, notably drives for servers and mainframe computers, they have fallen from 18-24 months to about 12 months. Product cycles are considerably shorter for desktop applications and laptop PCs, where new drive generations are introduced about every nine and six months, respectively. Product life cycles in the HDD industry thus follow the same hectic rhythm that is now characteristic for the computer industry. For some segments of the industry, such as multimedia home computers, product cycles are now almost as short as those for fashion-intensive garments.⁽⁵²⁾

Such short product cycles are an important source of volatility. Even with all the progress made in the flexibility of production, it is very difficult to avoid periodic mismatches between supply and demand. Each time the supply of HDDs overshoots demand, price wars are likely to occur. The result is that HDD producers must combine cost leadership with technology leadership, a combination which does not exist in the textbooks of competitive strategy.⁽⁵³⁾ Both have become inseparable. Some of our Quantum's highest volume products for personal computers rely on some very leading edge technology because our customers are demanding dramatic increases in the amount of storage in order to accommodate multimedia, larger software and access to databases. So they are pushing for very large, very cost-effective storage. To do that, we have to go to very high technology components and design approaches in order to get that kind of capacity in a cost-effective design. So... we're using leading-edge technology to produce very cost-effective, high-volume storage."⁽⁵⁴⁾

3.4. Implications for Entry Barriers and Industry Structure

As competitive requirements have increased in complexity, the barriers to entry have risen across all stages of the value chain. We have seen that scale economies have rapidly increased for disk drive manufacturing. The same, however, is true for key components. Take, for instance, thin-film, the current dominant disk technology. The manufacture of thin-film sputtered disks is a complex, multi-step process that converts polished aluminum substrates into finished data storage media ready for use in a hard disk drive. The process requires the deposition of extremely thin, uniform layers of metallic film onto a disk substrate. To achieve this end, companies use a vacuum deposition, or "sputtering" method, similar to that used to coat semiconductor wafers. Vacuum deposition requires extremely expensive equipment and typically produces very low yields, thus leading to very high entry barriers.

Equally important are the entry barriers that result from the very complex R&D requirements that thin film media suppliers have to cope with. The effective implementation of thin film media technology requires simultaneous solutions to a variety of very complex problems, including magnetics, fly height, durability, and static friction. The same is true for alternative substrates, new magnetic alloys, and sputtering techniques.

Entry barriers are also high for head making, which is an extremely capital-intensive business. The production of inductive thin film heads, the dominant technology, is based on wafer fabrication techniques similar to semiconductor manufacturing and is characterized by very high investment thresholds. Entry barriers are even higher for leading-edge thin-film MR heads. Indeed, both scale and learning economies are orders of magnitude larger than for earlier generations of recording heads.⁽⁵⁵⁾

In addition, due to drastically shortened product life cycles, time-to-market is essential for both media and heads: "...Early design-in wins are important because of steepening production ramps and shortening product life cycles. As manufacturers introduce new programs, companies must seek to qualify their heads in these new programs, which requires significant expenditures of time and resources."⁽⁵⁶⁾

But entry barriers extend well beyond the sphere of production and R&D. We have seen that one of the peculiar features of this industry is the extremely complex nature of its supply chain. This has given rise to substantial entry barriers involved in the establishment of global supplier networks designed to guarantee timely access to key components. In addition, as product cycles have been cut short, this has led to a rapid depreciation of plants, equipment, and R&D, thus further increasing barriers to entry.

The result, not surprisingly, has been a tremendous increase in the degree of concentration in the industry. Since 1993, price wars and the resulting widespread losses that have swept the HDD industry have played an important catalytic role. One indicator of increasing concentration is the rapid decline in the number of worldwide drive manufacturers. The total number of producers has shrunk from 59 in 1990 to 24 in 1995, with most of the decline taking place after 1993.⁽⁵⁷⁾ In 1995, nine companies went out of business while only three companies entered the fray. Importantly, all of the new entrants entered niche markets rather than volume production.⁽⁵⁸⁾

Today, market share data shows that, by all standards, the HDD industry is characterized by a very high degree of concentration. American companies are clearly in a dominant position, with the top six HDD companies are all U.S.-based firms.⁽⁵⁹⁾ Japanese companies play only a minor role: their market share (as a percentage of worldwide sales revenues) peaked at 18 percent in 1990, and but has fallen since then as Japanese firms have been unable to cope with the rapid change in market requirements and technology. In 1994, Japanese firms had less than 15 percent of the market.

In 1994, the last year for which data are available, the four leading disk drive manufacturers control almost 73 percent of the world market (again for revenue shares).⁽⁶⁰⁾ For the non-captive market (i.e. exclusive of the large in-house sales of IBM, Fujitsu, Hitachi and other integrated computer companies), the share of the largest four companies was even higher and reached almost 85 percent.⁽⁶¹⁾

Concentration ratios are also quite high for the two main key components: heads and media.⁽⁶²⁾ In 1994, the largest 6 heads manufacturers accounted for 78 percent of all head-gimbal assemblies (HGA's) shipped, while the next 4 largest companies accounted for another 15 percent. U.S.-owned firms have 72 percent of the market and the Japanese 19 percent. Overall, the 10 largest companies have 93 percent of the market by volume.

Compared with both HDD assembly and head manufacturing, the media industry is less concentrated. In 1995, the largest 6 media manufacturers accounted for 63 percent of all units shipped. The next largest 6 companies accounted for another 27 percent and another 6 or so companies fought for 7 percent of the market. A few of the smallest firms, however, are increasing production in 1996. Again, U.S. firms dominate, with 60 percent of the market, but Japanese firms have a fairly strong 33 percent market share.

The very high degree of concentration that characterizes the HDD industry raises the question whether the industry is controlled by a tight oligopoly. This is an important issue. If the industry is indeed governed by a tight oligopoly, this would imply that the development of technology, products and markets is shaped by a small group of American firms. It would also imply that outsiders from Japan or elsewhere would have very limited chances to expand their market share. The logical conclusion would then be to argue that, if such a stable oligopoly exists, U.S. firms would certainly have a choice to slow down their expansion of international production and may even consider bringing manufacturing back to the U.S.

According to Blair, one of the leading experts on oligopolistic competition, oligopoly begins when the four largest firms hold more than 25 percent of overall sales.⁽⁶³⁾ Between 25 and 50 percent, this oligopoly is loose and unstable, but above 50 percent, it becomes firm and clearly established. If we use this criterion, we would have to conclude that the HDD industry is indeed controlled by a very tight oligopoly. We can also use a second classification of market structure which is widely used in the literature and which goes back to the pioneering work of Bain.⁽⁶⁴⁾ He distinguishes three types of oligopolistic market structures: (1) "very highly concentrated oligopolies," where the top eight firms control 90 percent of the market and the top four 75 percent; (2) "highly concentrated oligopolies," where the respective shares are 85-90 percent and 60-65 percent; and (3) "high-moderate concentrated oligopolies," where corresponding control is 70-85 percent and 50-65 percent. Using this classification, we would again be forced to conclude that the HDD industry is definitely a "very highly concentrated oligopoly."

This conclusion, however, does not square well with the fact that the HDD industry is characterized by continuous price wars, very short product cycles, and highly volatile market positions. Despite a number of major shake-outs (the last one in 1993), we find that the industry remains highly unstable. As a result, no firm, not even the current market leaders IBM and Seagate, is safe from a sudden reversal of its fortunes.

Market leadership positions change hand in this industry at very short notice. Let us look at the figures for the non-captive HDD market.⁽⁶⁵⁾ In 1992, Conner Peripherals was the market leader with 24 percent. In 1993, however, Quantum had leapfrogged both Conner and Seagate to become No. 1. From 15.3 percent in 1992, Quantum increased its market share to nearly 21 percent in 1993 and 23 percent in 1994. Conner Peripherals in turn fell back to the third position, and has seen its market share erode to 16 percent in 1994. Preliminary data for 1995 show that, once again, the industry has experienced another round of swapping market leadership positions, with Seagate now re-capturing the top position from Quantum.

We are thus faced with an interesting puzzle. Despite an extremely high degree of concentration, the HDD industry does not display any of the features of a stable global oligopoly: market positions are volatile, and late entrance is possible, at least in newly emerging niche markets. In short, we are dealing here with a highly unstable global oligopoly. The consequence is ruthless competition across the board. This implies that firms in this industry may have very little choice but to vigorously pursue their expansion into international production.

One final comment on how the HDD industry fits together with the rest of the electronics industry. Put simply, important differences exist in the competitive requirements that set the HDD industry apart from other sectors of the electronics industry. Nevertheless, we find a strikingly similar impact on market structure: a rapid pace of technical change, combined with extreme volatility has led to an erosion of established market leadership positions. Let us now inquire how this affects the organization of international production.

Chapter II: A Shift from Partial to Systemic Globalization: Key Features of International Production Networks

How has the increasing complexity of competitive requirements that I have described in chapter I affected the organization of international production in the electronics industry?

In order to answer this question, I first describe a fundamental puzzle related to international production (II.1). We then consider some conflicting determinants of international production (II.2). In section II.3, I analyze why partial forms of globalization are inadequate to cope with these requirements. Finally, in section II.4, I introduce the concept of the international production network that I will use in chapters III and IV to describe key features of systemic globalization in the electronics industry.

1. A Puzzle

There are two fundamental reasons why a firm is normally reluctant to engage in international production: (1) it fears that geographic dispersion will weaken existing governance structures, with the result that control over strategic resources and capabilities will erode; and (2) it fears that distance will magnify the impact of unexpected disruptions in its value chain and will thus lead to substantial coordination costs.

One of the great advantages of concentrating production within a region is that material inputs, ideas, and finance can move more quickly back and forth across different stages of the value chain. A region guarantees proximity which facilitates close interaction between different nodes of the value chain. In short, by concentrating production within one region, a firm can generate closer, faster, and more cost-effective interaction between different stages of the value chain than it can ever hope to achieve once it starts moving production abroad.

Yet, despite the fundamental advantages of keeping production at home and at close proximity, electronics firms have almost invariably moved to international production once they reach a certain size. This raises an intriguing question: Why is it that, despite the advantages of proximity, electronics firms have moved to international production?

Logically, there are three possible solutions to this puzzle. First, proximity matters and works best at home. Yet, there may be other more important concerns that force companies to shift to international production and to disregard the advantages that result from co-location. Second, some forms of proximity may be less constraining than others to a redeployment of production overseas; in other words, it may actually be possible to reproduce these particular proximity effects at some of the foreign locations. Third, the link between close cooperation and co-location may be somewhat looser than is normally assumed in the literature. There may thus be alternative and more indirect ways to achieve close cooperation that do not necessarily require physical co-location.

I will discuss in chapter IV the last two of these three possibilities. We will see that, in some cases, there may well be alternative and more indirect ways to achieve close cooperation that do not necessarily require physical co-location. We will also see that, in certain cases, key support functions have migrated abroad, with the result that a firm can now co-locate abroad an increasing variety of value-chain functions. Our focus here will be on those conflicting determinants of international production that may induce a firm to disregard the advantages of home country co-location.

2. Conflicting Determinants of International Production

We are interested in the factors that have shaped the organization of international production. These factors are more complex than is assumed by conventional economic theory. The need to reduce costs to offset an erosion of the home country comparative advantages is an important catalyst, but no more. More fundamental forces are at work. A firm-level perspective can help to identify some of these forces.

There is a rich body of literature that describes what benefits a firm can reap from a shift to international production.⁽⁶⁶⁾ For quite some time, the focus has been on two aspects: the penetration of protected markets through tariff-hopping investments and the exploitation of international factor cost differentials, primarily for labor. This has given rise to a peculiar pattern of international production where offshore production sites in low-cost locations are linked through triangular trade with the major markets in North America and Europe. The hallmark of this pattern of international production was that it led to a clear-cut division of labor and that locational decisions were shaped by fairly straightforward criteria.

Over time, it became clear that while both market access and cost reduction were important, they were no longer the only important factors. Today, international production involves a much more complex agenda. Both market penetration and cost reduction have to be reconciled with a number of equally important requirements, including the exploitation of uncertainty through improved operational flexibility,⁽⁶⁷⁾ a compression of speed-to-market through reduced product development and product life cycles,⁽⁶⁸⁾ learning and the acquisition of specialized external capabilities,⁽⁶⁹⁾ and a shift of market penetration strategies from established to new and emerging markets.⁽⁷⁰⁾

3. The Limits to Partial Globalization

It soon became obvious that, in order to reap such a broader set of benefits, firms needed to be able to coordinate global operations and resources within increasingly tight time schedules and that this required a shift away from partial to more systemic forms of globalization.

Partial globalization is characterized by a loose patchwork of stand-alone affiliates, joint ventures, and suppliers that are scattered across the globe and that co-exist without much interaction. It is partial in the sense that the firm cannot reap the full benefits of international specialization. In essence, this is due to an absence of interactions across functions and locations and to inadequate coordination approaches.

Systemic globalization, on the other hand, implies that a company attempts to network its operations and inter-firm relationships worldwide, both across functions and locations. It is systemic, as the firm can now generate closer, faster, and more cost-effective interactions between the different nodes of these international production networks. By providing more cost-effective ways of coordinating these interactions, systemic globalization enables the firm to internalize, on an international scale, resources and capabilities without running into the constraints of excessive centralization.

Historically, partial globalization came in a variety of forms. All these forms, however, shared a constant tension between centralized and decentralized governance structures. While some forms of partial globalization can have considerable advantages, they all fail to establish two-way flows of information that are essential for a firm's quick and flexible response to unexpected disruptions and changes in markets and technology.

I distinguish four forms of partial globalization: (a) the complete centralization of production in one location, usually the home country of the corporation, that serves as the sole export platform; (b) attempts to shift from export-led to investment-driven international market share expansion through the wholesale transfer of the domestic production system; (c) a progressive decentralization of international production, both in terms of geographic disperson and in terms of the governance structure; and (d) attempts to shift to so-called "global strategies" where the parent company tries to impose centralized control over existing international operations and suppliers.

Global strategies are included under partial forms of globalization because they fail to fulfill an essential prerequisite of systemic globalization: the establishment of two-way flows of information across all network nodes.

(a) Complete centralization

International market share expansion through exports was rarely a viable long-term proposition. Once these exports became too successful in penetrating foreign markets, this invariably gave rise to import restrictions. Thus, only a few industries were able to sustain complete centralization. Probably the most prominent example is the aircraft industry, where some sort of complete centralization was made possible by a combination of very high investment thresholds, very high transportation costs for heavy and complex parts and components, and the possibility to negotiate access to government procurement markets.⁽⁷¹⁾

(b) Attempts to transfer the domestic production system

Perlmutter [1969] has shown that once a firm decided to shift from exports to international production, it almost invariably started out by "exporting the home organization overseas." American firms had a particularly strong preference for this wholesale transfer of the domestic production system. Given the size of the domestic market, "...it is not surprising that American firms should resist having the international tail of their operations wag the dog." (Kogut [1985b], p. 32). At the same time, a tradition of strong financial control systems has fostered an illusion by American managers that they could easily standardize their international control systems.⁽⁷²⁾

(c) Decentralization of international production

Attempts to decentralize international production, our third form of partial globalization, has been around for quite some time. European firms, many of whom entered international production during a period of severe protectionism, preferred decentralized governance structures "in order to establish an identity as a collection of national companies." (Kogut [1985b], p. 32). Also, the much smaller domestic markets and underdeveloped financial control systems added to this focus on decentralization.

Until around the mid-1980's, decentralized forms of international production were very much in vogue among the leading firms in the electronics industry. Representative examples included numerous powerful market leaders, including Philips, Siemens, GE, and IBM. Their early entry into international production was based on the concept of multi-nationality: overseas affiliates would focus primarily on country idiosyncracies. Decentralization of control down to the level of regional headquarters or even some of the larger overseas affiliates was perceived to be a prerequisite for achieving this goal. Over time, this led to the emergence of powerful regional fiefdoms that were used to acting on their own: "After years of relative independence, many subsidiaries have developed cultures, systems and structures that are incompatible with those of the parent."⁽⁷³⁾ Such partial forms of globalization had their historical advantages; in particular, they were good at exploiting peculiar features of national markets and production systems. The fact that these advantages came at a heavy cost and that numerous overseas affiliates were almost impossible to coordinate did not matter very much as long as many of these national markets were highly protected. Decentralization thus originally reflected the logic of rent-seeking investment.

In principle, as Salter (1960) has shown, plants of very different vintages can co-exist competitively as long as they are producing different qualities for different market segments at different prices. Low productivity production for a particular market can in fact be highly profitable, if the market is highly protected. This logic, however, ceased to work once competition began to cut across national borders and became "global." From that moment on, multinational corporations began to look for approaches to the organization of international production that would allow them to improve the allocation of their different value chain functions across national borders and to integrate them into their global strategies.

(d) Attempts to shift to so-called "global strategies"

Our fourth category of partial globalization is attempts to move toward systemic globalization, albeit largely unsuccessful attempts. Especially for American companies, the first response was to shift to fairly extreme forms of centralization where the parent company tries to recapture control over existing international operations and suppliers.⁽⁷⁴⁾ These attempts included the creation of world product lines (Ford's "world car" concept being the most prominent example), divisions along regions (with the U.S. being the epicenter and Europe playing the role of a "junior partner"), and matrix structures. In the end, these attempts failed as they were based on unrealistic assumptions concerning the capacity to exercise centralized control over worldwide markets and production sites.

Starting in the late 1970's, many American electronics companies became obsessed with the idea that Japanese firms owed much of their success to their capacity to orchestrate, in a highly centralized manner, worldwide market share expansion strategies. Global strategies, in this view, can be defined as "... the cross-subsidization of market-share battles in pursuit of world-wide production, branding and distribution advantages." (Morrison and Roth [1992], p. 40). It was felt that such a strategy could only be implemented if the parent company was able to exercise tight control and coordination over international production activities: "High-value activities are typically located in the home country; the activities of overseas subsidiaries are rationalized with little input in decision-making coming from abroad. That tight central control relegated overseas subsidiaries to primarily downstream, low-value-adding activities where strategy implementation became a critical responsibility." (Morrison and Roth [1992], p. 40-41).

With the benefit of hindsight we know today that this view is only partially true. In their rush to catch up in international production, Japanese strategists may have originally hoped to be able to implement such a globally standardized approach to international production. Yet, reality was very different. Over time, the transfer of the Japanese production system to overseas locations has been faced with increasing constraints. This has forced Japanese firms to adapt key features of their production networks and to introduce at least some elements of decentralization.⁽⁷⁵⁾

However, this did not prevent many American and European firms, at least in their initial response, from adopting centralization strategies. Reducing transaction costs and risks through global sourcing and marketing strategies was one important motivation. Another expectation was that centralized control would help to keep a tighter rein on technology leakage that could benefit their Japanese rivals. While some of these effects did materialize, a high degree of centralization soon turned out to be of doubtful value. Top-down approaches to centralization, combined with pervasive "down-sizing" exercises, created substantial turmoil and resistance. When the parents attempted to rein in unwieldy satraps and to re-establish centralized control, they were often bitterly opposed by foreign subsidiaries eager to protect their independence.

But much more important were some other negative effects of centralization. In many cases, it obstructed a firm's ability to learn and to build capabilities quicker and at less cost than its competitors. Centralized governance structures share one common feature with the ill-fated attempts of central planning: the headquarters is cut off from reliable feedback from local actors. The result is that the parent company frequently knows very little about the real opportunities and challenges in specific markets and locations. This clearly indicates a need to "...move away from a rigid, hierarchical and centralized command structure towards a more decentralized and open management system" that would not repeat the short-comings of the earlier forms of partial globalization.⁽⁷⁶⁾

4. Systemic Globalization: The Concept of the International Production Network

It is with regard to this challenge that firms are now searching to establish more systemic forms of globalization. In essence, this implies that a company attempts to organize its worldwide operations and inter-firm relationships as part of international production networks. The over-riding concern is to generate, across national borders, closer, faster, and more cost-effective interactions between different stages of the value chain.

4.1. Levels of Analysis

The firm as a networked organization is the unit of analysis.⁽⁷⁷⁾ Our network definition originates from debates among industrial economists and management theorists who define the multinational corporation as "a network of activities located in different countries."⁽⁷⁸⁾ Due to the limitations of partial forms of globalization, multinational corporations do not have much choice but to proceed with the development of international production networks. Indeed, they cannot go backward to complete centralization of manufacturing or they will lose access to essential markets. Nor can they remain a disconnected system of geographically scattered operations. International production networks result from an attempt to combine the scale economies of centralization with the flexibility of decentralization and the vast opportunities for learning and time compression that are typical for networks.

The concept of an "international production network" is an attempt to capture the spread of broader and more systemic forms of international production that cut across different stages of the value chain and that may or may not involve equity ownership.⁽⁷⁹⁾ This concept allows us to analyze the globalization strategies of a particular firm with regard to the following four questions: (1) Where does a firm locate which stages of the value chain? (2) To what degree does a firm rely on outsourcing and what is the importance of inter-firm production networks relative to the firm's internal production network? (3) To what degree is the control over these transactions exercised in a centralized or in a decentralized manner? and (4) How do these different elements of the international production network hang together?

As a first approximation, an international production network combines a lead firm, its subsidiaries, affiliates and joint ventures, its suppliers and subcontractors, its distribution channels and VARs, as well as its R&D alliances and a variety of cooperative agreements (such as standards consortia). The lead company derives its strength from the intellectual property and know-how associated with setting, maintaining and continuously upgrading a de facto market standard. This requires perpetual improvements in product features, functionality, performance, cost, and quality. The lead firm outsources not only manufacturing, but also a variety of high-end support services. The result is that an increasing share of the value-added shifts across the boundaries of the firm as well as across national borders. Competitive success thus critically depends on a capacity to orchestrate and coordinate such complex international production networks and to integrate them into the firms organization.

4.2. Basic Definitions

In a moment, I will describe some of the indicators that can help us to address these four questions (see section II.4.5.). First, however, let us look at some basic definitions. Networks differ from both markets and hierarchies (as defined by Williamson [1975 and [1985]) and constitute a sui generis form of organizing economic transactions.⁽⁸⁰⁾ International production networks constitute an important departure from traditional forms of organizing international trade, production and technology flows. In short, arms-length market transactions and equity forms of investment no longer are the only forces which shape the organization of cross-border economic transactions.

I talk about production networks, and define production broadly to include the production of goods as well as services. Such a broad definition is used in order to avoid some of the shortcomings that result from a narrow analytical focus that is exclusively concerned with manufacturing. Companies increasingly seek value-added (i.e. profits) in the non-manufacturing side of production, or what others call "intangible investments" or "production-related support services."⁽⁸¹⁾ This is true in particular for design and engineering, supply logistics, and sales and marketing (especially distribution). The choice of a broad definition of production reflects our specific interest: we want to understand to what degree the redeployment of manufacturing to overseas locations will lead to a concomitant redeployment of production-related support services.

The term international production is used when a firm " controls production assets in more than one country,"⁽⁸²⁾ with the result that national production systems interact. This definition immediately raises the question of how we define control. For some observers, like John H. Dunning, control requires some sort of equity ownership. For Dunning, "international production" requires a "framework of common ownership" where the parent company acquires an equity share in the overseas operation.⁽⁸³⁾ International production thus requires FDI, while non-equity forms of overseas operations are called "international sourcing."

There is now a large body of literature which clearly indicates that non-equity forms of international production have considerably increased in importance over the last decades.⁽⁸⁴⁾ Examples include the spread of licensing agreements, management contracts, subcontracting and contract manufacturing arrangements, consignment manufacturing, and product franchising. It thus appears to make little sense to base a definition of "international production" simply on the criterion of equity ownership. Levy and Dunning (1993, p.18) admit this, at least implicitly, when they characterize both subcontracting and strategic alliances as "...hybrid structures of ownership and control that blur the distinction between ... [international production and sourcing]." In line with the United Nations World Investment Report (1994, p.18), we use a broader definition of international production where control over foreign production assets" is typically established through FDI, but can also be exercised through various non-equity forms."

This in fact is the Achilles' heel of research on globalization. Most research has focused on the spread of equity FDI but has neglected the role of a variety of non-equity links, especially with smaller firms which would not have been able to participate in international production on their own. Indeed, small and medium-size enterprises (SMEs) have become important carriers of systemic globalization and help to fill in the interstices of international production that large MNCs are unable to detect and deal with. As suppliers, subcontractors, and matchmakers for market penetration, SMEs act as a convenient buffer against uncertainty and provide cheap, flexible and quick sources of supply for a variety of production inputs. Our definition of international production is thus deliberately broad in order to be able to address this important blank spot of globalization research.

4.3. Intra-Firm Versus Inter-Firm Production Networks

Production networks can exist within a firm (intra-firm networks) or they can link the firm to other, formally independent companies (inter-firm networks). Intra-firm networks link together, within a firm, different divisions and business functions, such as R&D, design, engineering, procurement, production, marketing, sales, and customer services. They enable the firm to overcome the "Taylorist" separation of different business functions and to pursue them simultaneously. Empirical research has identified three main impacts of such networks: (1) links between marketing, design, and manufacturing become closer; (2) throughput time and speed-to-market are shortened; and (3) feedback information on customer requirements and supplier capabilities are channeled more rapidly to product design and production planning.⁽⁸⁵⁾

Inter-firm production networks are an important feature of the shift to systemic globalization; indeed, firms are increasingly developing a variety of increasingly dense linkages with formally independent firms. Frequently, these linkages cut across national boundaries. Such cross-border inter-firm production networks cover the whole gamut of industrial manufacturing, from component production to final assembly. Increasingly, they also include such knowledge-intensive activities as marketing, standardization, product design, the development of production technology, generic technologies, and scientific knowledge.

I distinguish five types of inter-firm production networks:⁽⁸⁶⁾

(1) Supplier networks between a client (the "focal company" which can be either a manufacturer/final assembler or mass merchandiser) and its suppliers of intermediate production inputs, such as materials, parts and components, sub-assemblies, and software. Supplier networks are defined to include subcontracting and a variety of other arrangements, such as consignment assembly, original equipment manufacturing (OEM), original design manufacturing (ODM), "contract manufacturing," and "turnkey production."

(2) Producer networks are defined to include all co-production arrangements that enable competing producers to pool their production capacities, financial capabilities, and human resources in order to broaden their product portfolios and geographic coverage.

(3) Customer networks are defined as the forward linkages of manufacturing companies with distributors, marketing channels, value-added resellers, and end users, in order to facilitate the penetration of existing markets or the development of new markets.

(4) Standards coalitions are initiated by potential global standard setters with the explicit purpose of locking-in as many firms as possible into their proprietary product, architectural, or interface standards.

(5) Technology cooperation networks facilitate the exchange and joint development of product design and production technology, involve cross-licensing and patent-swapping, and permit the sharing of R&D. Under such arrangements, knowledge typically flows in both directions and all participants need to master a fairly broad array of technological capabilities.

Intra- and inter-firm networks hang together and cannot be separated from each other. A firm that tries to improve the integration of its internal value chain, for instance through "just-in-time," "concurrent engineering," or "design for manufacturing" techniques, can only do so if it succeeds in integrating a multitude of relationships with outside firms.⁽⁸⁷⁾ Today, firms invariably depend on external sourcing for a variety of intermediate inputs, including materials, parts, components, and sub-assemblies, as well as software and knowledge-intensive support services. At the same time, firms are critically dependent on close links with customers, as "...it is no longer sensible to assume seller-dominated markets where the firm, as the focal unit, sets the parameters and the faceless market responds."⁽⁸⁸⁾

In short, the expected advantages of intra-firm networks will only materialize if they are extended to integrate at least some of the more important outside suppliers and customers. The difference between the internal organization of a firm and its outside relations becomes blurred, however, as external sourcing for parts and components as much as for product designs and production technology gains in importance and as organized markets within firms expand. As we will see in chapter IV, the cost of coordinating such outside relations now exceed the cost of internal value generation for many firms. Coordinating inter-firm production networks has thus become a crucial concern for strategic management.

4.4. Governance Structures

This then raises one last set of issues: the search for adequate governance structures. Governance describes how, within any particular network, control and coordination is exercised and by whom. It consists of common methods and procedures that shape the behavior of network nodes, including budgetary rules and procedures, evaluation procedures, personnel management practices, database management, and quality control norms. Network nodes can be equity-owned affiliates and those legally independent firms that participate in the core company's inter-firm networks.

Governance structures can be centralized or decentralized, and they can be strong or weak. A centralized governance structure, in turn, implies that the core company (the network center) exercises full control over all network activities. A decentralized governance structure implies that individual network nodes have a certain degree of decision autonomy. Strong governance implies that control and coordination are enforced over a broad range of value chain activities and are shared by a large number of network nodes. Weak governance, in turn, implies that control and coordination can be enforced only over a limited range of activities and that only a limited number of network nodes are subordinated to the core company.

Our earlier discussion (in section 3 of this chapter) of the limits of partial globalization demonstrated that neither extreme forms of decentralization nor extreme forms of centralization are able to provide sufficiently strong governance to cope with the increasingly complex competitive requirements. In essence, the spread of international production networks is an attempt to steer clear from both extremes and to develop more cooperative, two-way forms of cooperation between the parent company, its affiliates, and network partners.

Attempts to move to network governance structures gives rise to two fundamental dilemmas. First, by moving away from a centralized, hierarchical governance structure to improve responsiveness and flexibility, the company may lose its ability to coordinate its global operations, leading to a duplication of efforts, lack of compatibility, an increased potential for intense rivalry among individual network nodes, and to a sub-optimal allocation of resources. Decentralization of control thus needs to be complemented with some centralization of coordination functions.

A second dilemma relates to the control over key resources and capabilities. If the core company continues to rely on centralized control, it may forgo important learning and capability formation possibilities, and hence end up with a non-competitive production system. If, on the other hand, the core company proceeds too quickly with decentralization, this may lead to a substantial leakage of core capabilities to individual network nodes. Sooner or later this may lead to the disintegration of the network and the emergence of strong new competitors.

The search for adequate governance structures is thus bound to be a slow process based on trial-and-error. The result is that different firms may pursue quite distinctive approaches. They may also try to blend elements of different governance structures, with the result that hybrid forms of organization are likely to emerge.

4.5. Indicators

Empirical research on the structural features of international production networks is still at an exploratory stage and we thus lack a widely accepted set of indicators. I have chosen a broad set of indicators in order to demonstrate the tremendous complexity involved. Later research will have to narrow down and simplify these measures in order to be able to quantify them. The Sloan Foundation study on the hard disk drive industry provides an opportunity to do this for a limited set of indicators that are of relevance for the HDD industry.

I distinguish two fundamental aspects of systemic globalization: geographic dispersion and increasing complexity. Under the first heading, I distinguish a quantitative dimension, where a company extends its global reach, and a qualitative dimension, which describes the development of spatial concentration and the resultant specialization patterns. Indicators on the quantitative aspects of geographic dispersion include: (1) information on the location of affiliates, suppliers, and distributors; and (2) information on the location of other value-chain activities, such as engineering and R&D.

Indicators on the qualitative aspect of dispersion include: (1) changes in the mix of products that are produced overseas, where we find that the product life cycle (PLC) theory ceases to hold; (2) a broader scope of value chain activities that move abroad, with a special emphasis on the migration of key support functions; (3) the increasing importance of global sourcing and its continuous tension with integration; and (4) systemic rationalization which, by incorporating proximity advantages abroad, leads to the joint migration of key support functions.

Chapter III deals with geographic dispersion, while chapter IV addresses the complexity issue. I will use the above set of indicators to trace the shift from partial to systemic forms of globalization in the electronics industry. Again, I will proceed from the general to the specific. I will first try to paint a broad picture of developments in the electronics industry. Wherever possible, I will try to specify some of the peculiar features of the HDD industry. Where this is not possible, I will use examples from other sectors of the electronics industry and identify possible implications for research on the HDD industry.

Chapter III: Geographic Dispersion

1. The Concept of Geographic Dispersion

The most basic feature of an international production network is that its different nodes become increasingly dispersed. This implies, first and foremost, a rapid geographic dispersion, with the result that a particular firm now has to coordinate its value chain across different time zones and continents. Dispersion also implies that individual network nodes become more distinct from one another, as they are exposed to a wider sets of environments. We will see that there is a strong link between spatial expansion and growing diversity and that, as a result, firms differ in how they approach the organization of international production.

A second important issue is that geographic dispersion is not only a quantitative phenomenon (i.e. where a company extends its global reach) but also has a qualitative dimension which involves the development of spatial concentration and the resultant specialization benefits of such dispersion. I call the first effect "geographic widening" and I use the term "geographic deepening" to describe the second effect. Both widening and deepening hang together, with the result that an analysis that only focuses on widening effects would loose sight of important elements of the overall picture.

This brings us to a third important issue. As geographic dispersion proceeds, new opportunities for specialization open up. Specialization implies that, by devoting itself to a particular set of goals and capabilities, a firm can reap substantial advantages. Thus, in establishing an international production network, a firm has to struggle with a number of intricate trade-offs: should the focus of specialization be on individual country idiosyncracies, on establishing a regional division of labor (i.e. within a macro-region such as East Asia), or on the firm's global strategy?

For each node of an international production network, three sets of indicators can be used to determine specialization; (1) the destination of sales and their product composition; (2) the origin of purchases and their product composition; and (3) the degree of interdependence between different network nodes. Following McKendrick et. al. [1994, p.18], I use four indicators to describe the progression from partial to systemic forms of specialization along a continuum that ranges from total independence to close interdependence; (i) independence: network nodes neither share the same processes, nor do they have common input requirements nor output destinations; (ii) pooled interdependence: nodes use similar processes and technologies and have similar output destinations, but they operate largely independently from each other; (iii) sequential interdependence: the output of one sub-unit becomes the input of another sub-unit; and (iv) reciprocal interdependence: the output of the corporation requires continual interaction between its sub-units/network nodes.

A fourth aspect needs to be