Preliminary draft

The Nature and Characteristics of Production Networks in East Asia:
Evidences from Micro/Panel Data Analyses

October 2009

Fukunari Kimura
Professor, Faculty of Economics, Keio University
andChief Economist, Economic Research Institute for ASEAN and East Asia
(ERIA)

1

Abstract
Production networks in East Asia, particularly being extended by machineryindustries,

have

presented

unprecedented

development

with

their

significance in economies in the region, their geographical extension, andtheir sophistication in combining intra-firm and arm’s length transactions.
In particular, the fragmentation of production activities together with theformation of industrial agglomerations in developing countries is a novel
phenomenon that would lead to an East Asian model of economic
development.

Starting from a brief review of our conceptual framework

based on the fragmentation theory as well as an empirical overview withinternational trade statistics and others, the paper presents a survey on
empirical evidences that have been established by previous micro-data
analyses in East Asia and discusses a list of empirical issues that futurestudies should explore.

Topics include (i) the selection of exporters andinvestors, (ii) organizational structure and spatial design of production
networks, (iii) location choice, (iv) impacts of outward FDI on developed
countries, and (v) learning and impacts of inward FDI on LDCs.

2

1. Distinctive development of production networks and micro data analyses
in East Asia
Production networks in East Asia, particularly being extended bymachinery industries, have presented unprecedented development with
their significance in economies in the region, their geographical extension,and their sophistication in combining intra-firm and arm’s lengthtransactions.

In particular, the fragmentation of production activities

together with the formation of industrial agglomerations in developing
countries is a novel phenomenon that would lead to an East Asian model of
economic development.
A full set of rigorous empirical analyses on production networks inEast Asia, however, is yet to come. Although the existing statistics at theaggregated level including international trade statistics is useful inobserving the nature and characteristics of international production
networks, the detailed structure and mechanics as well as the sophisticatedcombination of intra-firm and arm’s length (i.e., inter-firm) transactions arecaptured only at the micro level.

The impacts of globalizing corporate

activities can also be investigated only at the micro level.

There is certainly

ample room for exploring micro/panel data of manufacturing census or
tailor-made micro data sets to deepen our understanding on international
production networks.
The existing literature of micro data analysis has its own academic
agenda, which is not necessarily served directly for deepening ourunderstanding on international production networks in East Asia.

However,

once we review the existing literature with great interest in production
networks, we can find a number of subtle empirical findings in the related
papers.

Furthermore, if we slightly redirect the focus of empirical studies,

we can surely learn more about production networks. The paper is a sort of“subjective”

literature

survey

on

micro

data

analysisbyaproduction-networks lover.
Starting from a brief review of our conceptual framework based on
the fragmentation theory and new economic geography as well as anempirical overview with international trade statistics, the paper presents a3

survey on empirical evidences that have been established by previous
micro-data analyses and discusses empirical issues that future studies could
pursue.

2. Mechanics of production networks: conceptual framework
Although international production/distribution networks in East
Asia began forming from the beginning of the 1990s, Jones and Kierzkowski(1990) made an early start in developing the theory of fragmentation.

The

theory pointed out fundamental differences between industry-wise divisionof labor and production-process-wise division of labor or between
finished-products trade and intermediate-goods trade, particularly in theflexibility of a firm’s decision-making in cutting out production blocks andthe existence of service link costs.
Figure 1 illustrates the original idea of fragmentation. Supposethat a large factory initially exists in the electronics industry that takes careof all upstream and downstream production processes.

Such a factory iscapital and human capital intensive as a whole and thus is likely to belocated in a developed country. However, a closer look at the factory may
find a variety of production processes. Some processes are human-capitalintensive and require close monitoring by researchers and technicians.

Onthe other hand, some are purely labor-intensive, and a mass of unskilledlabor may suffice. Alternately, some processes need 24-hour operations toaccelerate capital depreciation.

Hence, if we can fragment production

processes into several production blocks and locate them in appropriate
places with different location advantages, total production costs may be
reduced. This is fragmentation.
== Figure 1 ==Fragmentation of production processes makes sense when: (i) thesaving in production costs per se in production blocks is large; and (ii)4

incurred service link costs to connect remotely located production blocks are
small. Firms can cut out production blocks so as to exploit differences inlocation advantages in remote areas. On the other hand, service link costs,
including not only transport costs but also various coordination costs, should
not be too high.

Transactions between production blocks tend to berelation-specific rather than those in spot markets.
Kimura and Ando (2005) propose an expanded version of theframework called two-dimensional fragmentation.

Figure 2 illustrates thebasic concept. The horizontal axis depicts fragmentation along the axis ofgeographical distance, which is the traditional fragmentation, while thevertical axis represents fragmentation along the axis of disintegration or
uncontrollability.

Thesophisticatednatureofinternational

production/distribution networks arises from a sophisticated combination of
two kinds of fragmentation.
== Figure 2==
An important aspect of two-dimensional fragmentation is thespatial implication of disintegration-type fragmentation.

Service link costs

in arm’s-length transactions, in other words “transaction cost” in Oliver
Williamson’s

sense,

arehighlysensitivetogeographicaldistance.

Geographical proximity reduces search costs for new business partners,
monitoring costs for quality and delivery timing, and trouble-shooting costs
when

an

unexpected

event

occurs.

The

intimacy

betweendisintegration-type fragmentation and geographical proximity is one of the
major sources of agglomeration forces. In East Asia, fragmentation andagglomeration have proceeded together.
Although it is very difficult to comprehend intra-firm andarm’s-length transactions in official statistics, the data of foreign affiliates ofJapanese firms collected by METI (Kaiji Chosa) provide useful information.
By-destination sales and by-origin purchases of affiliates of Japanese firms
in East Asia, particularly in machinery industries, present a clear-cut

5pattern of intra-firm and arm’s-length transactions.

Transactions withJapan are predominantly intra-firm while those in the host country’s market
are mostly arm’s-length.

Transactions with other East Asia countries fall inbetween (Ando and Kimura (2009a)).

This is important evidence that

confirm the intimacy between disintegration-type fragmentation andgeographical proximity.
We observe a wide variety of disintegration-type fragmentation in
production/distribution networks.
arm’s-length transactions.

East Asia has a number of prototypes for

The Shitauke system in Japan, subcontractingin Taiwan, and Hong Kong – Guangdong operations are examples of these.
Some of the arm’s-length transactions in East Asia are a direct extension ofthese prototypes in the international setting.

Furthermore, the abundanceof opportunities for exploiting differences in location advantages andfirm-specific assets in East Asia results in the proliferation of outsourcing.
Examples include original equipment manufacturers (OEM), original design
manufacturers (ODM), electronics manufacturing services (EMS), andfoundries.

The designers or managers of networks are also varied, notnecessarily downstream assemblers; vendor-managed inventory (VMI)
services are examples in which logistic companies play a crucial role.
The recent technological and managerial innovation in corporate
management is clearly supporting the proliferation of various businessmodels in East Asia. As mentioned above, the evolution of business models,particularly in the computer industry, from vertically-integrated giants tofirms concentrating on core competences is one of the crucial changes in themindset of corporate managers.

Another significant trend is thedevelopment of a lean production method, a just-in-time system, value(supply) chain management, and cash flow management.

Furthermore, thedeepening of the product architecture argument, namely modular versus
integral, is also crucial to the development of various business models.
The next task for research for the conceptual framework is toinvestigate the spatial structure of production/distribution networks.
Currently, machinery industries are dominant players in East Asian

6

networking, both in quantity and quality.

An assembly plant in themachinery industry uses a large number of parts and components, and the
procurement of parts and components and the sales of products are typicallystratified into four layers primarily in terms of gate-to-gate lead time (Table
1).

For convenience, let us call these “the first layer (local),” “the second

layer (sub-regional),” “the third layer (regional),” and “the fourth layer(world).” 1== Table 1 ==3. Some key evidences from international trade data and others
Production fragmentation is observed in various industries such as
textiles and garment, chemical industry, and software.

However,machinery industries are by far the most important sector, bothquantitatively and qualitatively, in formulating production/distribution
networks.
components,

Machines typically consist of a large number of parts &andproduction

processes

aremulti-layered.

Variousproduction processes require a wide range of resource inputs and different
technologies, and thus the most sophisticated, quick, and high-frequency
networks are necessarily observed in machinery industries.

The proportionof machinery exports in total exports, particularly that of machinery partsand components exports, is a good indicator for judging the degree ofparticipation in international production/distribution networks.
Figure 3 presents the shares of machinery goods (i.e., Harmonized
System (HS) 84-92) and machinery parts and components in total exports toand imports from the world in 2005 for major economies in East Asia andother regions, plotting countries from the one with the highest export shareof machinery parts and components.

We can see active back-and-forth

More detailed explanation on the four layers of transactions, see Kimura(2009).
17

parts and components trade among East Asian countries while somecountries do not simply participate in quick high-frequency production
networks yet.
== Figure 3 ==Figure 4 compares seven regions in China as well as ASEAN
member countries with respect to the ratio of intra-East-Asian machinery
exports to total intra-East-Asian exports.

We can again observe a sharp

contrast between countries/regions that actively conduct international
production networks while others that do not.
== Figure 4 ==The IDE-JETRO GSM Team together with ERIA is now developing
a simulation model called the Geographical Simulation Model.

The model

is based on a setting of new economic geography and currently covers
ASEAN and a part of surrounding East Asia.

From its base data set, Figure

5 presents the location of industries across the disaggregated regions.
White color indicates that manufacturing GDP is less than 10% of total GDP.
For other regions, we pick up the largest one among five manufacturing
subsectors: automotive (red), electric and electronic (yellow), textiles andgarment (blue), food processing (green), and others (grey).

Red and yellow

areas correspond to regions actively conducting quick and high-frequency
production networks.

Blue and a part of green areas are conducting

production networks at a slower pace. The rest has not yet participated in
production networks.
== Figure 5 ==One of the important exercises conducted with international trade
data is a bunch of empirical studies based on the gravity equation.

Among

those, Kimura, Takahashi, and Hayakawa (2007) find consistently low
8penalty from geographical distance in machinery parts and components
trade compared with that in Europe.

Hayakawa and Kimura (2009) findthat exchange rate volatility deters a country to participate in international
production networks.

These suggest the importance of service links in theoperation of international production networks.
Obashi (2009) applies survival analysis on the disaggregate trade
data and finds the stability and long-lasting nature of machinery parts andcomponents trade compared with other traded goods.

This suggests theexistence of sunk cost in the set-up of international production networks.

4. Microdata analyses on the mechanics of production networks
With existing empirical evidences as well as conjecture from casual
observation in our mind, we will review the literature of micro data analyses
in East Asia, try to reinterpret the results in the context of international
production networks, and suggest prospective direction of future research. 2This section covers studies related to the mechanics of production networks;
namely the literature on (i) selection, (ii) corporate organizational structureand spatial design of production networks, and (iii) location choice.
(1) Selection
Melitz (2003), Helpman, Melitz, and Yeaple (2004), and otherrelated theoretical papers ignited a numerous number of empirical papers on
the selection of exporters and investors in both developed and developing
countries.

An important step forward is the introduction of firm

heterogeneity.

Although firm heterogeneity has for long been well known

as a fact by empirical researchers, particularly in studies on small andmedium enterprises, theorists could not cross their psychological thresholdfor discarding their obsession on market clearance even in the short run.
Melitz introduces the setting in which firms are not homogeneous in terms ofIn the following, a number of papers are drawn from Hayakawa, Kimura,and Machikita (2009).

29

the initial productivity by lottery and is successful in making a major
breakthrough in the literature.
In the context of East Asia, selection in exports has been studied bya number of papers including Hallward-Driemeier, Iarossi, and Sokoloff(2002) for Indonesia, Korea, Malaysia, the Philippines, and Thailand; Aw
and Hwang (1995), Liu, Tsou, and Hammitt (1999), Aw, Chung, and Roberts(2000), and Aw, Roberts, and Winston (2007) for Taiwan; Aw, et al. (2000) and
Hahn (2004) for Korea; and Kimura and Kiyota (2006) and Murakami (2005)
for Japan.

Most of these studies find evidence that a more productive

producer tends to self-select into the export market. 3

As for selection in

FDI, Murakami (2005) and Kimura and Kiyota (2006) conduct analyses forJapan.
Do these studies indicate any important findings on international
production networks in East Asia? Relatively strong results particularly on
selection in exports may reflect dynamism of East Asian economies.
However, the results are not in general interpreted closely to the existence of
production networks.
At least in two directions, we can expand the scope of selection
studies in the context of East Asia, subject to the existence of statisticalinformation.

First, in addition to exporting and investing, participating in

local or international production networks is an important threshold forfirms.

In particular for local firms in less developed countries (LDCs),

whether they can have production links with multinationals in industrial
agglomeration is crucially important.

This aspect can be and should beincorporated in selection studies.
Second, the current theoretical setting does not properly capture
firm heterogeneity in terms of their activities or “what to make” in theirinter-firm production links.

Products and activities can be heterogeneous

depending on the positioning of the firm in production networks.
Exogenous productivity differences and fixed cost setting do not seem tocapture such heterogeneity properly.
3

Wagner (2007) provides an excellent literature survey.
10

(2) Organizational structure and spatial design of production networks
Antras and Helpman (2004) and Grossman, Helpman, and Szeidl(2006) incorporate intra-firm and arm’s length (inter-firm) transactions in
the firm heterogeneity setting with FDI.

The basic story is due toheterogeneity in exogenous productivity and a fixed cost story. The higher
the productivity, the wider internalization occurs.
Tomiura (2007) attempts empirical verification of their story andfinds that investing firms are more productive than exporting firms and thatthe firms trading with overseas intra-firm group are more productive thanthose trading with overseas inter-firm group firms in Japan. Murakami(2005) however finds the opposite.

One issue may be the definition of“outsourcing.”
More fundamental issue in the context of East Asia would be toincorporate an informational setting or a transaction cost story behind
intra-firm and arm’s length transactions.

As I mentioned earlier, Ando andKimura (2009a) find that long-distance transactions tend to be intra-firm
while

short-distancetransactions,particularly

agglomeration, are predominantly arm’s length.

withinindustrial

Simple setting ofdifferences in exogenous productivity and fixed cost does not seem to capturesome of the important aspects of international production networks in East
Asia.
(3) Location choice
A huge number of empirical papers have been devoted to analyses
on location choice in FDI, and some of them have tried to capture theimplication of agglomeration with various indicators.

It has been rare,

however, to interpret the empirical results carefully in the context of
production networks.

We observe at the aggregated level extremely uneven

distribution of networking activities.

I believe that it is worthwhile

reinterpreting or redoing location choice analyses with the extension of
production networks explicitly in our mind.

11

5. Microdata analyses on the consequences of production networks
This section reviews studies related to the consequences of
production networks; in particular, (i) resource reallocation or expansion indeveloped countries and (ii) learning and technology spillovers/transfers in
LDCs.
(1) Impacts of outward FDI on developed countries
Outsourcing and off-shoring in LDCs by MNEs raise concerns about
activities in high-income countries.

A popular argument claims thatdomestic employment and operations may shrink due to the relocation of
economic activities taking advantage of a large wage gap between developed
and developing countries. However, even in the case when FDI is pursuing
inexpensive labor in developing countries, the effect of FDI on domestic
operations is not necessarily negative; it depends on to what extent the cost
reduction through FDI allows the firm to strengthen its competitiveness andwhether the firm maintains activities at home that are complementary tooperations abroad, sometimes further shifting their activities to the
procurement of specialized parts and components, headquarters functions,and the development of new products.
Hijzen, Inui, and Todo (2007) apply the propensity score matching
method and the difference-in-difference approach and find positive impactsof becoming MNEs on output and employment though not on productivity. 4
This is an important result because most of the empirical results areambiguous in other parts of the world. Our conjecture claims that firms are
more likely to retain or even expand domestic operations in fragmenting
production processes compared with one-for-all relocation of production sites.
Ando and Kimura (2009b) conduct a more focused study.

They

analyze the impact of expanding operations in East Asia on domestic
operations for Japanese firms; domestic operations here include domestic

Also see Ito (2007). Hijzen, Inui, and Todo (2009) find positive impacts ofinternational outsourcing on corporate performance.
412

employment, the number of domestic establishments/affiliates, exports andimports. While domestic employment in manufacturing sector as a wholehas a slow declining trend, firms expanding operations in East Asia tend to
reduce domestic employment less or even increase it in case of small andmedium enterprises.

Differences across industries are distinctive;

industries that conduct international production networks present stronger
results.
Skill shift is another topic to be explored in the literature.
However, skill composition at the firm level is not directly available in theJapanese data. Ito and Fukao (2005) work at the industry level and findthat vertical intra-industry trade with Asia raises the share of professional
and technical or managerial and administrative workers.

Head and Ries

(2002) employ Toyo Keizai’s data and find that additional foreign affiliate
employment in low-income countries raises non-production share of the wage
bill at home.

It would be interesting to dig into differences across industries

in order to pick up the nature of international production networks.
How a firm allocates economic activities at home and abroad is notformally checked yet.

Ando and Kimura (2005) find that firms pretty often

switch its activities at home and abroad; i.e., industrial classification ofmajor activities at home and that of affiliates abroad are occasionallydifferent.

Hayakawa, Kimura, and Matsuura (2009) start from theimplication of the fragmentation theory and test a theoretical prediction thata firm that successfully makes a larger difference in factor intensity between
home and abroad performs better.

The result is affirmative.

(2) Learning and impacts of inward FDI on LDCs
There is another literature that explores learning from exporting.
Hahn and Park (2009) find positive for Korea. Other studies in East Asia
often seem to present positive results, which contrasts from studies in otherparts of the world reviewed by Wagner (2007).

In the case of local firms in

East Asia, learning from participation in domestic/international production
networks must be assessed if such statistical data are available.
Impacts of cross-border M&A have also been investigated by13

checking domestic firm’s productivity before and after cross-border M&A.
Arnold and Javorcik (2005) and Petkova (2008) for Indonesia and Fukao, Ito,
Kwon, and Takizawa (2006) for Japan are examples; they consistently findsignificantly positive impacts.

Some also find larger impacts withcross-border M&A than local M&A.
The literature of spillover, i.e., technology leakage from MNEs tolocal firms, has been grown for long. Four channels of spillover effects areperceived in the literature: imitation, skill acquisition and proliferation,competition, and exports.

Competition may actually work negatively, too.

Statistical tests typically check whether the presence of MNEs enhances
productivity of local firms or not.
impacts in Taiwan.

Chuan and Lin (1999) obtain positive

However, most of the studies in the rest of the world failto find positive association.
The

literature

furtherscrutinizes

mixed

results

heterogeneous combination of MNEs and local firms.

among

As for theheterogeneity on the MNEs side, Todo and Miyamoto (2002, 2006) work withIndonesian data and find that MNEs conducting human resource
development on site provide positive influence on local firms’ productivity.
As for the heterogeneity of local firms, absorption capacity, geographicalproximity, and input-output relationship are tested.

Particularly on

input-output relationship, the implication of international production
networks may be detected.

Unfortunately, however, studies exploring

input-output relationship cannot utilize information on actual production
links at the firm level but employ input-output tables to infer the
input-output relationship between MNEs and local firms.
ERIA (2009) conducts an extensive questionnaire survey in
Bangkok, Manila, Jakarta, and Hanoi and tries to identify andquantitatively assess channels of innovative information.

They find that

production linkage with MNEs is crucial and daily communication isimportant.

6. Concluding remarks
14

Studies on international production networks in East Asia bear avery important mission for actual policy making.

The formation ofinternational production networks in East Asia is an unprecedented event,which is presenting a new model of economic development with aggressively
utilizing globalizing forces. There may also be important implication forinvesting countries.

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18Figure 1.

The Original Idea of Fragmentation: An Illustration

Source: Author.

19

Figure 2.

Two-dimensional Fragmentation: An Illustration

Disintegration
Competitive
spot bidding

Internet
auctionDomestic / arm’s
lengthfragmentation

Cross-border / arm’s length
fragmentation
EMS
OEM contract

Subcontractin

Outsourcing(Boundary of a firm)

Domestic / intra-firm
fragmentation

Original position

Cross-border / intra-firm
fragmentation(National border)

Source: Kimura and Ando (2005).

20

Distance

Table 1.

Four Layers of Transactions in Production/Distribution Networks

Lead time
Frequency
Transportmode
Trip length

1st layer

2nd layer

3rd layer

4th layer(local)(sub-regional)(regional)(world)1 to 7 days

1 to 2 weeks

Less than 2.5
hours
Once or moreOnce or morein a dayin a week

TrucksTrucks/ships/
airplanes

Once a week

Ships

Ships

Less thanLess than

100km

1,500km6,000km21

2 months

Once a week

Less than

Source: Kimura (2009).

2 weeks toLongerFigure 3

Source: Ando and Kimura (2009).
22

Figure 4

23

Figure 524