Reach for Value: Revisiting Comparative advantage in the quest for value

Factor advantages are passé; quest for value is the new driver.

In 1817, when Ricardo framed his thesis on Comparative Advantage, Industrial Revolution had moved past its infancy for long; the world’s per capita consumption basket that had consisted of two square meals, some decent clothing, simple locomotion to the place of work and some gifts for people, now moved to include a wider range of things that indeed needed international trading. Requirement of raw material and supply took the center stage, industrial production rather than agriculture started to become the key elements of reference. Firms and industrial organizations came into being simply to minimize transaction costs for the society, as Ronald Coase showed much later.

Economics of trade required the vital condition to be fulfilled, which Ricardo was spot on to deduce. For trade to happen, it needed the fulfillment of the condition known as comparative advantage. If it was cheaper to produce consumption goods in the East, while it was cost effective for capital goods to be done in the West, so be it. But the difference in value of the goods produced, measured by the value added, continued to differentiate the fortunes of the East and West for the next two centuries. Prosperity of these two regions depended on the value of goods produced, the disparity in the values depended primarily on the level of sophistication of the industry and the choice of the segment in the value chain where the operation focused on.

Factor advantages differentiated regions for a long time; Africa, South America and Australia had inherent advantages in Mining, while Asia extended from Mining to manufacturing. Europe and North America on the other hand moved up the value chain and anchored on the advantages of producing capital goods that allowed them to move to the more sophisticated manufacturing systems. Only Japan and later on South Korea were the two outliers in Asia. The firms set up bases in originating countries but growth forced them to internationalize in due course and it was no more based on factor advantages alone; development of markets allowed such movements to proliferate.

Moving up the value chain, of all the things, actually changed the ‘value added’ drastically. The disparity in per capita income we see is primarily due to this. Settling for the low valued added meant continuing to do basic mining and manufacturing, while the high value added component meant continuously improving on innovation and technology focus. This had wide ramifications as the institutions needed to support this including the social and political systems were different. The highest educational institutions are not by chance situated in the West, they are by design as much due to the burning need; the migration of talent across the world towards the West also followed suit. The increase in the service sector economies stems from this.

But factor advantages were no more the bone of contention. It was the search for value that made the West look for opportunities; the genesis of comparative advantage was lost in the search for value. To take an example imagine an iPhone, which gets deigned in U.S. alone, sources its inputs from 30 countries all over the world and manufactures everything in China to be shipped to U.S. for warehousing and distribution to 100 countries around the world. The manufacturing value added is not even 20% of the value of the product. So by all means it is in U.S. that the bulk of the value added actually resides, followed by China. In automotive, for a protracted period, the design, engineering and tooling was done outside of U.S. and thus a significant portion of the value added resided outside of U.S. The balance shifted with the rising power of financing as a value added.

Financing as a value added in the whole equation changed the concept of comparative advantage.  Imagine a small country like Switzerland, having almost no natural resource or any factor advantage, could actually develop such high levels of sophistication in their financial services industry that it became one of the dominant sectors of their economy, above agriculture or industry.

Ricardo, could not even dream of predicting Switzerland to be the amongst the highest per capita income economies of the world, going by his thesis on comparative advantage, which relied on factor advantages alone. In fact there is a poem in Bengali, written sometime around the late 1800, which chirped, ‘Switzerland is a poor country amongst the Europeans’ as it relied on basic farming in those days. The industrial resurgence after the Second World War, when the Swiss Mills & Machine Tool factories where the only ones surviving the war, the rapid strides made in manufacturing 'value add' moved into further sophistication in a range of industries including Pharmaceuticals. But the icing on the cake was provided by the services sector led by the financial services.

Moving up the value chain would mean striving for the highest end of the product or service spectrum, which is quite different from the normal objectives of business, which is to maximize shareholder value by doing what you can do best. Steve Jobs, in pursuing the highest level of sophistication in his line of products actually aimed for continually moving up the value chain; shareholder value was a byproduct. 

What is true for economies of the world is true for business as well. When you aim for the highest end of the product or process stream, you create the traction for talent to search for the best in class in everything, not the most economic always maybe. Such traction forces you to reconfigure everything from design to engineering to processes and people to be only the best in class. That is a huge pressure to tune to a beat that is so supremely fixated on doing the best in everything. You are then committed to a credo where you cannot make compromises on anything and when you are surrounded by the best, you are on a different competitive plain.

Shareholder value is secondary; it could at best be a byproduct of what this entails. Quest for value is what drives these habits, you can notice them in very successful firms that have lived long, and by the way are profitable not by factor advantages, but by their sheer desire for value-seeking approach in everything they do from products to processes.