Thursday, February 21, 2008

China, India, and Captial Intensity

A good article in Bloomberg today reports:

The draw of cheap Chinese and Indian labor is so strong, and the media hype surrounding it so relentless, that some starry-eyed, developed-country executives are losing sight of the bottom line.

A factory worker cost $37 an hour in Germany last year and only $1.40 in China (and $1 in India).

Therefore, it should be cheaper to make a car part in China (or India) than in Germany, even after accounting for the higher productivity of the German worker.

Still, it's reasonable to inquire what, if anything, cheap and bountiful Asian labor has done for these companies.

``Cost savings have been disappointing,'' Nikolaus Lang, a partner at the consulting firm's Munich office, said last month in ``Winning the Localization Game,'' a study he has co-written with two colleagues. ``Nearly two-thirds of the companies we analyzed reported that their unit costs in China or India were equal to or higher than the unit costs in their home countries.''

Sounds improbable? Lang and his colleagues provide a breakdown of what's causing the benefits of inexpensive labor to dissipate. The main culprit, according to their analysis, is that factories in China and India are smaller than in developed countries, thus not allowing economies of scale. Besides, it also costs companies more to ensure product quality in Asia. The in-house rejection rates are higher than they are in the West.

From this it may seem that the path to improved quality must pass through greater automation; fewer workers will, after all, make fewer mistakes.

Basically, what he is getting at here is that automobile production is a capital intensive process. Using robots, capital, is more cost effective than an army of workers, labor.

I'll give you a more intuitive analogy. Say you are digging a hole for a swimming pool. Let's say you get 10,000 people to dig it with spoons. They may be able to dig it in a day. Now, let's say you can dig the same pool with 100 people using shovels, and if one person uses a backhoe they can also do it in a day. Here is the crucial point: The pool company can afford to pay the one person digging using the backhoe more than each of the 10,000 people digging with spoons.

So, what we have in the developed world is less people doing more work with machines. Each time technology improves there is a dislocation in labor. For example, 9,900 people are laid off from one company when they switch to shovels, and 99 more are laid off when they buy a backhoe. However, that one person makes more money. Moreover, if the company invests in more backhoes, which they inevitably will, then you have more and more people making more and more money. It is a painful, and sometimes slow process, but cheap labor is not all it is cracked up to be.

The jobs that are being outsourced are the labor intensive ones, not the capital intensive ones. This does not just apply to physical capital though. Lawyers, doctors, accountants, or IT professionals have human capital, which is equivalent to a bulldoser when it comes to their job.

There are cases where an army of cheap labor is better and cheaper than mechanized production or skilled labor, and those will move to India and China. The issue for Americans is not that they should fear this, as they probably don't want to do the labor intensive jobs anyway, but rather we need to deal with the dislocation that comes from increased use of capital, both human and physical. We need to train people to use and fix backhoes, not protect the jobs of people using spoons to dig holes.

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