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THE ELECTRONIC SILK ROAD
HOW THE WEB BINDS THE WORLD IN COMMERCE
By ANUPAM CHANDER Yale UNIVERSITY PRESS
Copyright © 2013 Yale University
All rights reserved.
ISBN: 978-0-300-15459-7
Excerpt
CHAPTER 1
THE NEW GLOBAL DIVISION OF LABOR
What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! ... The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep.
—John Maynard Keynes, The Economic Consequences of the Peace
Adam Smith could never have dreamed of the global division of labor that is quickly coming to pass. It would take two centuries after The Wealth of Nations for the global manufacturing process to be perfected. Where the twentieth century saw the rise of the global supply chain in manufacturing, in the twenty-first century technology now permits the rise of a global supply chain in services. Relying on suppliers around the world, a garage entrepreneur can coordinate the production and delivery of a service from anywhere. Firms can transfer processes to foreign third-party vendors, relying on the discipline of the market rather than the discipline of supervisory management. The search for talent has gone global, hurdling the barriers to labor factor mobility posed by restrictive immigration laws.
Not only can firms find inputs anywhere, but they can find buyers everywhere. Firms can offer their services directly to consumers across the world without investing in extensive local distribution networks. They can leverage this worldwide consumer base to achieve economies of scale. Firms can locate their headquarters where they might have most ready access to capital, especially venture capital, and their servers where they can find cheap and plentiful energy. They might locate their operations in a jurisdiction that provides tax incentives to encourage job creation. Because technology now allows firms and consumers to turn to service providers far from home, suddenly the local information broker—from the reporter to the auctioneer to the yenta—must now compete with suppliers across the world.
This organizational revolution puts pressure on law. The movement from make to buy, from status to contract, will require a robust transnational legal framework to facilitate cross-border contracts and information flows. The risks to security and privacy as information crisscrosses the world between consumers and service providers will require a legal response. Rather than the Silk Road's disputes among merchants or modern goods traders' disputes regarding bills of lading and shipping documents, disputes in this new international market for services will grow among household buyers and sellers located across the globe, between ordinary citizens and global websites.
In this chapter, I describe this evolution in the organization of production, arguing that we will likely see increasing cross-border contracting between unaffiliated parties as firms move internal processes to third-party vendors. Where there are contracts, there are eventually contractual disputes, requiring a legal infrastructure of dispute resolution. The open-source programming that drives much of this trade itself relies on the enforceability of contract and property rights across borders—supplemented by reputation and reward systems. In the final section of this chapter, I describe the close and mutually beneficial connection between outsourcing and open-source production methods.
Butcher, Baker, Information Broker
"In the lone houses and very small villages which are scattered about in so desert a country as the Highlands of Scotland, every farmer must be butcher, baker, and brewer for his family." Adam Smith began his 1776 study of the wealth of nations by examining the division of labor. The division of labor, he observed, depended in large part on the size of the market, which in turn depended largely on geography and technology. In remote locations, the absence of extensive markets limited the division of labor. But those with better access to means of transportation could reach larger markets, and thereby improve efficiency: "by means of water carriage a more extensive market is opened ... and industry of every kind naturally begins to subdivide and improve itself." Specialization would improve productivity by reducing the time wasted in transferring among multiple tasks, increasing the dexterity of the individual worker at a specific task, and spur the invention of machines that perform specified functions. Smith critiqued the reigning mercantile political economy of his day, which sought to encourage exports but discourage imports. While Smith spoke in terms of absolute advantage and not comparative advantage, he argued that liberal rules for both export and import would deepen the division of labor and enrich nations.
Smith wrote at a time when the medieval age's dusty silk roads and wooden ships were soon to give way to the railroads and steamships of the industrial age. Industrial revolutions in mechanization, transportation, and communications technology deepened the national and international division of labor. Technology eroded the decisive role of geography in the organization of production. Mass-production techniques and the modern management systems they spawned swelled the international trade in goods.
The economic benefits of this globalization have been distributed widely—but many have also borne the pain and dislocation that follow from global competition. Merchandise producers reduced their costs by shifting manufacturing to advantageous locations, often in maquiladoras or other export-processing zones in the developing world. This shift led to the loss of blue-collar jobs in the industrialized nations, the rise of sweatshops in the developing world in some cases, and the dazzling array of affordable merchandise available at the local superstore.
As economic historian Alfred Chandler describes, technological innovation shifted not just the location of production but also its organization. By enlarging both output and markets, the nineteenth century's industrial revolution required the creation of the managerial hierarchies (managers who manage managers) characteristic of the modern business enterprise. These colossus corporations, increasingly capitalized through the public markets, brought inside the corporate walls functions that had historically been provided by third parties. These corporations integrated mass production and mass distribution within the firm and its subsidiaries, replacing the invisible hand of the market with the visible hand of management.
The multidivision corporation (dubbed the "M-Form" corporation) would rapidly extend itself internationally to become the multinational corporation that came to dominate the twentieth century. Even at the dawn of the twentieth century, some Europeans labeled this the "American invasion" and fretted about the "Americanisation of the world." The multinational corporation would become a principal vehicle for cross-border trade in services. Hollywood began to recognize the global audience available for its media products. Software enterprises, too, sought global markets. Microsoft has subsidiaries in more than 110 countries, from Albania to Zimbabwe. Financial institutions extended themselves around the world; Citigroup today has offices in nearly a hundred countries worldwide. Western telecommunications companies similarly found opportunities for growth in the developing world. The global wave of privatizations of government services beginning in the 1980s increased the local presence of multinational corporations in a variety of fields from banking to telecommunications to water services.
But with the exception of finance, this cross-border trade in services did not generally require the real-time transmission of large volumes of data across borders. Microsoft and Disney developed their products in one country—typically the United States—and then disseminated that product globally. Local subsidiaries were simply translators and distributors. Thus, while service providers in certain industries in the developing world faced competition from Western corporations with local distribution channels, service providers in advanced, industrialized nations did not face a reciprocal competition from service providers in the developing world.
Unlike merchandise, which typically can tolerate the lag between product design and product production imposed by international shipping, many services require a real-time exchange of information between the service provider and its consumer. Accordingly, for the bulk of human history, services had to be performed on-site or near-site. The digital revolution disrupted this requirement through two related innovations: the creation of global digital networks and the digitization of information itself. First, the introduction of the Internet and other high capacity transcontinental electronic data networks made possible remote collaboration on a real-time basis, with parties separated by continents able to share data almost as readily as if they had adjoining cubicles. Second, the digitization of information spurred its wide dissemination. The adoption of computers as a tool for work meant that information was often created originally in digital form. The World Wide Web established one common information-sharing platform, taking advantage of both digital networks and digitized information. Information that had been held locally now found wide distribution. Take, for example, the US Securities and Exchange Commission's EDGAR database, with its immense storehouse of information about publicly traded companies, and the Patent and Trademark Office's databases, which make every patent and registered trademark searchable. It was not long ago when accessing SEC or PTO public records required hiring a runner to photocopy files in a Washington area basement, delivering a copy by either Federal Express or fax. With the rise of the World Wide Web, these databases became available for free to people across the world. The global information platform allowed the creation of new services, such as search engines, video and other information-sharing depositories, and personal social networks.
Today, cross-border outsourcing includes "typists, researchers, librarians, claims processors, proofreaders, accountants and graphic designers." Cross-border trade in services also includes engineering, architectural services, legal services, animation, and movie special effects. The jobs are both "big—100-page investment reports requiring weeks of work—and small." Chennai-based "Iayaraja Marimuthu, for instance, is designing a program for [the] wedding of Ann and John, a Texas couple proclaiming their joy in being 'together for life.'" (The flower arranging, alas, cannot be outsourced cross-border, even if the flowers themselves come from the tropics.) Today, telecommuting can occur across hemispheres. A Wall Street Journal article offers a vivid example of what it calls "extreme telecommuting": although Paolo Conconi's "work is in Europe and China, his office is a table by the pool of his villa in Bali, Indonesia. As he goes through his mail, he sips his favorite Italian coffee. An attendant lights his cigarette."
Manufacturing, too, has been transformed by electronic networks. Even a trade as ancient as Persian carpet weaving "is guided, these days, in part by e-mail missives on the tastes of rich customers in the West." This is an example of the design services that are a key input into the manufacturing process.
The Organisation for Economic Co-operation and Development (OECD) estimates that one-fifth of all service jobs in the developed economies will be affected by cross-border trade in services. This does not mean that such a large fraction of jobs will soon be outsourced but, rather, that the terms of these positions will change as a result of international competition. The deepening division of labor represented by cross-border outsourcing of services increases efficiency, just as the international division of labor in manufacturing increased efficiency. An inefficient service sector functions as "a prohibitive tax on the national economy." By removing this unproductive tax, trade in services should improve growth across the world. Of course, even while many more will gain, many will lose. The personal misfortunes that will result will be enormous. Retraining and adjustment programs are necessary measures, but not all countries can afford them.
Vendor or Captive? Reinterpreting "Make or Buy"
The first claim to fame of the economist Ronald Coase was his 1937 inquiry into why firms existed at all, rather than individuals who contracted with one another in the marketplace. The question has been translated into the query: Make (inside a firm) or buy (through a market)? Often overlooked is that Coase placed technology at the heart of his explanation of the determinants of the boundaries of the firm, recognizing that technology would influence both the transactions costs of marketplace contracting and the organization costs of internal hierarchy. In 2000, the New York Times linked the organizational shift to a prediction of Coase's theory: "Sixty years [after Coase's paper], transaction costs have plunged, thanks to the Internet.... As a result, companies can get complete information about potential suppliers and business partners within a few clicks, and can therefore set up supplier agreements or form alliances with other companies for a fraction of what it would have cost even a decade ago." Electronic data networks reduced not only the costs of marketplace transactions but also the costs of managerial hierarchies. The first effect—the reduction of transaction costs—tends to reduce the size of the firm by increasing the use of the marketplace for purchasing inputs into the production process. However, the second effect—the reduction of hierarchy costs—tends to increase the size of the firm as the costs of internalizing production inputs fall. In his original paper, Coase was uncertain whether improvements in communications technology (he offered the example of the telephone) would put greater downward pressure on market transaction costs or internal organization costs. Today, the standing view seems to be that the greater effect has been on market transaction costs, implying an increase in third-party outsourcing.
Yet the choice of employing a service provider abroad does not necessitate a turn to the market. Many Western corporations outsource by establishing local subsidiaries rather than by employing independent vendors. In the parlance of international businesspeople, nonchalant about the evocation of colonial rule, these are "captives." Restated in the language of organizational economics, the Western corporations that outsource through captives choose "make" over "buy." (Economists consider obtaining an input from a foreign subsidiary "making," not "buying," the input because it is produced in-house by a corporate arm.) The General Electric Company pioneered this type of outsourcing in India, in large part by accident. In 1997, as GE was establishing an Indian office to process credit applications from Indians for a credit card joint venture with an Indian bank, the "light went on." "We started to think, we can do this for the rest of the world," says Pramod Bhasin, a former GE Capital executive who helped create GE Capital International Services ("Gecis") and serves as its chief executive. Now Gecis reviews credit card applications from New Delhi to New York. "By the late 1990s," the Wall Street Journal reports, "GE began turning its attention from simply buying software from India to using the country as a base for data entry, processing credit-card applications and other clerical tasks." GE realized "savings on backroom operations alone" of about $300 million a year. By 2000 the outsourcing had deepened further, as GE established the John F. Welch Technology Centre in Bangalore, named after its storied CEO, employing "thousands of researchers working on everything from new refrigerators to jet engines."
New institutional economists have refined Coase's insights into the determinants of the organization of the firm. Today economists explain the decision to make rather than buy as turning in part on the existence of asset specificity. Certain types of marketplace contracts might be subject to post-contractual opportunistic behavior, leading companies to bring those functions within the corporate hierarchy. When either party invests in assets specialized to that particular contract, the counterparty can exploit that investment by renegotiating the terms of the contract, recognizing that the party making a specialized investment cannot readily divert its resources to alternative productive uses. In cross-border outsourcing, either the vendor or the procurer of services may face the risk of exploitation: the vendor might be required to engage in extensive information gathering about its client or create processes and systems narrowly tailored to the client's needs; the client, meanwhile, might come to rely on proprietary systems owned and supported by a particular vendor. The vendor's investment in knowledge may leave the client vulnerable, at least in the short run, if such knowledge will be difficult for another vendor to replicate readily in the future. At the same time, the vendor may be vulnerable because of its extensive asset-specific human and other capital investment in the project of the procurer, an investment that will be amortized only over a long term.
(Continues...)
Excerpted from THE ELECTRONIC SILK ROAD by ANUPAM CHANDER. Copyright © 2013 by Yale University. Excerpted by permission of Yale UNIVERSITY PRESS.
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