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Wednesday, April 25, 2007 10:13 PM

The Knowledge Based Economy

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I received an interesting question today on The Market Traders about the Knowledge Based Economy.

Dear Mish,

Considering the dismal manufacturing news today - three million jobs lost since 2000 - I am wondering what people think about our move into the 'knowledge economy.' Is it just a hoax, or is there really a shift going on, in the same way that America shifted from being an agricultural economy to a manufacturing economy in the last century. I lived and worked in Taiwan for two years, and they are big believers in the knowledge economy. Because they are such a small country - 23 million people - they have a somewhat different model of economic organization than ours here in the US. Below is a draft of an article that I'm working on, and I'm looking for any and all input. The draft originally appeared here: Value Creation in the Knowledge Economy: The Stan Shih Smile Curve. I posted it to Free Republic and got some feedback, but nothing too helpful.

Much appreciated.
Michael Nystrom
Thanks for that question Michael. It is much appreciated. Before answering let's take a look at the key ideas in the above link.
Until very recently, the United States was both the world’s wealthiest nation, and world’s manufacturing powerhouse, leading economists to believe that there was a correlation between the two. This is why the “hollowing out” of American manufacturing was viewed with such alarm throughout the 1980’s and 90’s. Remember Ross Perot sounding the alarm bell during the 1992 election over NAFTA and the loss of American jobs?

Perhaps this was just an overreaction, a misunderstanding. If it is indeed true that we are moving into an “information age” or a “knowledge economy,” as the experts tell us, the new source of wealth becomes something intangible: Knowledge. This is demonstrated by Stan Shih’s smile curve:

Perhaps you’ve never heard of Stan Shih, but in Asia, he is a rock star capitalist –the founder of Acer Computer, a genius business theorist and now a hotshot VC.

Shih’s “Smile Curve” comes from his observations as a contract manufacturer of PCs for US brand name manufacturers. Remember back in the mid-80’s when PC clones first caught fire? There were hundreds of PC clone brands, but most of them were made by OEMs (original equipment manufacturers) – like Stan Shih’s Acer - in Taiwan.

What Shih noticed was that while companies like his did all the hard manufacturing work, it was the name brands – the IBM’s, the Compaq’s and the Digital’s – that got all the glory -- and the profits. The big American firms with the concept, the R&D, the brands and the distribution channels could outsource the 'lowly' manufacturing work to the lowest bidder. This resulted in a bidding war to the bottom in Taiwan, driving down the cost of production not only in the realm of PCs, but chips and components as well.

To explain this using a more modern example and in concrete terms, let's take the example of the Apple iPod. Apple recently announced that has sold 100 million iPods, and the product has been a cash cow for Apple. Everyone seems to have an iPod. But where was the value in this product created? Not in the manufacturing. Apple doesn’t make the iPods, they contract the manufacturing out to a Taiwanese manufacturing giant you’ve probably never heard of: Inventec.

In fact, “manufacturing” is rather a misnomer. Assembly is more like it. An iPod’s chips come from a variety of high-value suppliers (Texas Instruments among them), the hard drives from others (Hitachi), and the hundreds of other electronics components from hundreds of other suppliers. Inventec is really just a very organized assembler of parts from different companies all over the world. And the assembler’s margins are woefully slim. Inventec doesn’t just make iPods, it also makes notebook computers, phones, personal digital assistants, calculators and whatever else it can for companies much more famous than Inventec is or likely will ever be.

The real “value creation” in the iPod came in the knowledge required to conceptualize, create, market, brand and position the player, as well as the ability to leverage that knowledge into a hefty profit. The iPod certainly wasn’t the first mp3 player, but it is by far the most popular, thanks to the unique conceptualization, sleek branding, and superior design and engineering. In short, the value came from knowledge and through leveraging that knowledge.

Apple is able to capture huge margins on sales of the iPod. Say each iPod costs $5 -10 to make, but Apple sells them anywhere from $150 - $250 because it controls the distribution network and can therefore set the price. Because the iPod is a unique item, there are no bidding wars with other mp3-player makers. Let others sell mp3 players as cheap as they like – few people want them.

From this example, manufacturing does indeed appear to be the lowest value input. This is why, the capitalists say, the world has evolved to the point that it has. “We think, they sweat,” they say. We of course, are the Americans and they are the sweating Asians

Clever, isn’t it? But I have a nagging feeling there is something wrong with the theory, though I’m not exactly sure what. Perhaps I’m too rooted in the old economy, unable yet to adjust to the idea of the “knowledge economy.” But I have a feeling there is something more.

What is wrong, if anything, with the model? Or am I just a dinosaur?

Michael Nystrom
Michael there is nothing wrong with that chart. One can clearly look at China, India, and SE Asia in general and see without a doubt what is happening. And in spite of enormous increases in raw materials, the prices of finished goods have barely risen.

Are cars, boats, pottery, computers, monitors, printers, light fixtures, etc keeping up with the prices of raw materials that make them? Clearly the answer is no. The curve reflects what is happening. In fact, the curve represents additional profit that can be had by shifting manufacturing to low cost providers. That is in essence the very foundation of global wage arbitrage. However, You are missing several key points.

Key Points
  1. Global wage arbitrage is not just about manufacturing
  2. The US has no intrinsic brainpower advantage
  3. The smile curve is flattening
Please consider the recent announcement: Citigroup Details Massive Restructuring Plan
Citigroup Inc. said it will eliminate 17,000 jobs, or 5 percent of its workforce, as part of a broad restructuring plan designed to cut costs and bolster its long underperforming stock price.

Citigroup plans to move more than 9,500 jobs to lower-cost locations worldwide, with about two-thirds through attrition. It will also eliminate layers of management, often increasing the number of workers reporting to each manager.
Poof! 17,000 jobs are gone and the details show that we are talking about "layers of management", not just low level clerks. Where are the jobs headed? To "lower-cost locations worldwide" is the answer.

We are seeing the same thing in medical outsourcing, tax preparation, and accounting functions. In regards to medical outsourcing we have X-rays being taken here, shipped to India for diagnosis and only the treatment being performed in the US.

Outsourcing Innovation

Next consider Outsourcing Innovation.
First came manufacturing. Now companies are farming out R&D to cut costs and get new products to market faster.

While the electronics sector is furthest down this road, the search for offshore help with innovation is spreading to nearly every corner of the economy. Underlying this trend is a growing consensus that more innovation is vital -- but that current R&D spending isn't yielding enough bang for the buck. After spending years squeezing costs out of the factory floor, back office, and warehouse, CEOs are asking tough questions about their once-cloistered R&D operations: Why are so few hit products making it out of the labs into the market? The result is a rethinking of the structure of the modern corporation. What, specifically, has to be done in-house anymore?

"You have to draw a line," says Motorola CEO Edward J. Zander. At Motorola, "core intellectual property is above it, and commodity technology is below."

Wherever companies draw the line, there's no question that the demarcation between mission-critical R&D and commodity work is sliding year by year. The implications for the global economy are immense. Countries such as India and China, where wages remain low and new engineering graduates are abundant, likely will continue to be the biggest gainers in tech employment and become increasingly important suppliers of intellectual property.

Some analysts even see a new global division of labor emerging: The rich West will focus on the highest levels of product creation, and all the jobs of turning concepts into actual products or services can be shipped out. Consultant Daniel H. Pink, author of the new book A Whole New Mind, argues that the "left brain" intellectual tasks that "are routine, computer-like, and can be boiled down to a spec sheet are migrating to where it is cheaper, thanks to Asia's rising economies and the miracle of cyberspace. "The U.S. will remain strong in "right brain" work that entails "artistry, creativity, and empathy with the customer that requires being physically close to the market."
The idea that "The U.S. will remain strong in "right brain" work that entails "artistry, creativity, and empathy with the customer that requires being physically close to the market." is pure arrogance.

But let's for a second assume it is true. The question then is: How many "right brained" creative jobs do we need vs. how many "routine, computer-like" jobs we need.

Look at the jobs this service economy is creating: jobs at Walmart, Pizza Hut, Home Depot, Lowes, Nail Salons, Grocery Stores, etc etc. Exactly how many of those jobs are needed vs. the creative, artistic, super wiz-bang design jobs.

Is education the answer?

Some have proposed that education is the answer. That presumes China and India and other countries are standing still. But India and China are not standing still. They are churning out engineers and PHDs faster than the US. I am not trying to dismiss the importance of education, but logic dictates that if everyone had a PHD then PHDs would be greeters at Walmart and serving pizzas at Pizza Hut.

In short, this is not a right brained vs. a left blame phenomena, nor does the US have a monopoly on brainpower. The idea that we no longer need manufacturing jobs and the US can thrive on R&D, branding, marketing, and other value added services assumes the world is standing still. It also assumes those jobs are somehow safe from competition. That's a big mistake.

Global competition for jobs at every level in every capacity is increasingly the norm. China and India are churning out enormous numbers of doctors and engineers. Global wage arbitrage has now shifted from manufacturing to other spots on the curve. Look at medical outsourcing and increased outsourcing of R&D as proof. Expect further pressures on wages at every spot on the "Smile Curve" with intense competition at the ends of the curve and you won't be far wrong. Is the US prepared for a flattening of that curve while the world catches up? I think not, but it will happen anyway.

This post originally appeared in Whiskey & Gunpowder.

Mike Shedlock / Mish

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