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Causes of internationalization Although U.S. manufacturing has been international in scope for most of this century, the past 10 to 15 years have witnessed the evolution of a new global manufacturing environment. Previously, the international mar- ket was the preserve of large multinational corporations and generally was ignored by domestic firms. Today it is essential that virtually all manufac- turers be aware of and participate in international markets. Reasons for the increased importance of internationalization include the following: Foreign competition in the U.S. market has grown incessantly. Rapid increases in foreign demand for manufactured products have created highly attractive markets abroad. The pace of technological development has accelerated as sources of new technology have diffused worldwide. Changes in global political and economic conditions have created a variety of new opportunities and challenges for manufacturers. These factors have created not only a new global market for manu- facturing inputs and products but also a need for international awareness unknown in previous eras. They have also opened an array of options for participating in international markets that were unavailable in the past. Each of these factors affects different industries, even different products, in varying degrees; generalizations are impossible in a sector as diverse as manufacturing. Closer examination will reveal some of the differences and provide a better understanding of the internationalization process. 9

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10 CHAR GES IN GLOBAL MARKETS The nature of global markets and the role of the United States in the world marketplace have shifted fundamentally since the mid-1970s. Relevant changes range from broad economic trends that have altered the relative importance of various national and regional markets to technolog- ical developments that have changed the criteria for competitive success in those markets. Foreign Competition in the United States One of the most important developments Is the increasing openness of the U.S. economy. Import penetration in consumer goods grew from about 7 percent of domestic consumption in the early 1980s to more than 11 percent in 1988 (see Figure 2~. In capital goods, penetration rose from about 14 percent to almost 40 percent in the same period (see Figure 3~.i The rapid increase in foreign-owned production capacity in the United States further expands foreign competition in the domestic market. Assets of foreign manufacturing affiliates as a percentage of total assets of U.S. manufacturing corporations rose from 5.2 percent in 1977 to 12.2 percent in 1987; similarly, the number of employees working for foreign manufacturing affiliates as a percentage of total U.S. employment more than doubled from 3.5 percent in 1977 to 7.9 percent in 1987 (see Figure 4~.2 Foreign competition has become so extensive in virtually every industry that all companies, even small- and medium-sized firms that have not historically produced or marketed products abroad, must contend with foreign firms that are either direct competitors in the United States or have the potential to be. The pervasiveness of foreign competition is forcing domestic manufac- turers to upgrade their manufacturing operations or face serious competitive difficulties. Achieving a combination of cost, quality, delivery, and perfor- mance that maximizes value to the customer has become the determinant of global manufacturing success. Just-in-time and total quality control systems have become the minimum ante for world-class manufacturing operations. Other measures, such as improving productivity by enhancing workers' skills and encouraging their participation in decision making, strengthening customer-supplier relations to instill a sense of partnership, and effectively implementing advanced manufacturing technologies to enhance flexibility and spur innovation, are becoming essential to competitive manufacturing ~ Rudiger Dornbusch, James Poterba, and Lawrence Summers, The Case for Manufacturing in America's Future, Rochester, N.Y., Eastman Kodak, 198S, and Federal Reserve Board, unpub- lished data, 1989. 2 Graham and Krugman, Foreign Direct Investment in the United States, p. 13.

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11 Percent of Domestic Absorption 40 - 38 - 36 - 34 - 32 - 30 - 28 - 26 - 24 - 22 - 20 - 18 - 16 - 12 - , 1 980 '81 ~ / / / ~~' r '82 '83 '84 FIGURE 2 Import penetration~onsumer goods. 1 1 - 10 - 9 8 - 6 1980 '8 1 '82 '83 '84 '85 '86 '87 '88 FIGURE 3 Import penetration~apital goods. '85 '86 '87 '88 Percent of Domestic Absorption 12 - l ,%i t l , . . . . /V

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12 14 12 10 8 6 4 2 O I I i 1977 1978 Percent 1 1 1 , 1 1 1 1979 1980 1981 Share US Mfg 1982 1983 1984 1986 4986 1987 Year i Share Mfg employment FIGURE 4 Foreign role in U.S. manufacturing, 1977-1987 (percentages). Source: Graham & Krugman. in the domestic market. The need to stay abreast of product and process in- novations worldwide and to build genuinely world-class operations is being forced on companies of all sizes, even those with no historical international presence.3 Growth in Foreign Demand The second major development in the global market is the shift in the relative size of markets in the United States and abroad. In 1965 the United States accounted for 40 percent of world gross domestic product; by 1987 the U.S. share percentage had fallen to about 30 percent (see Figure 5~. Over the same period, growth in private consumption abroad exceeded the rate in the United States.4 In particular, rapid economic growth in developing countries has greatly expanded the number, sophistication, and wealth of markets around the world. In the past, U.S. manufacturers could be satisfied with the domestic market or at least confident that the United States was their leading market, but many are now finding that an increasing proportion of their current sales and a large proportion of 3A number of authom have addressed the need to upgrade manufacturing capabilities to be globally competitive. See, for example, Kim Clark, Robert Hayes, and Steven Wheelwright, Dynamic Manufacturing, New York, The Free Press, 1988. 4The World Bank, World Development Report 1989, New Yorl:, Oxford University Press, 1989, pp. 169, 179.

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13 United States 40.1 West Germany Un i ted K ~ngdom~,~ West Germany 6.6 United Kin l 5.1 ~ f =~> France ~ \ Ot her 37.4 World Bank World Development Report 1989 / FIGURE 5 Share of world GDP 1965, 1987. United States . 29.7 Japan 15.7 France 5.8 Ot he r 37.6 potential future demand are abroad. Those firms that have aggressively pursued foreign markets have also discovered the benefits of a global presence in smoothing demand fluctuations, creating significant advantages over competitors concentrated in one market. In its discussions with manufacturing executives, the committee found a growing realization that simply exporting to foreign markets may not provide the broad access, interaction with customers, and learning opportu- nities needed for long-term growth in global market share. Manufacturing managers often cite this realization as the primary motivation for siting production facilities abroad. There are a number of reasons. One is the advantages of bringing global assets and capabilities to bear on local markets. For instance, a U.S. medical products firm with a global manufacturing and marketing capability has used integrated global production and R&D to compete successfully with a host of small competitors in protected local markets. Another reason is the advantages of encountering a range of strategies used by multiple competitors. The lessons learned help to identify the critical success factors that apply in any market. Finally, a global presence helps guard against complacency and gives the ability to retaliate against competitors in their home markets. By facing challenges in foreign markets, U.S. firms can preempt competitors' ability to use a strong foreign market position as a lever for aggressive marketing in the United States. For instance, the strength of the Kellogg Company in global markets for ready-to-eat cereals has been a major reason why large foreign competitors such as Nestle have a limited presence in the U.S. cereal market. A company that is unable to retaliate against foreign competitors that enter its domestic market is at a serious disadvantage.

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14 Shorter Product Lives, More Customization, Faster Response Advanced design and manufacturing technology and management prac- tices have given companies in many industries the ability to introduce new products more rapidly and to customize products to define and attack a range of market niches. The result is shorter product life cycles. In mi- croelectronics, for example, the number of functions on a dynamic random access memory (DRAM) chip has doubled every 2 years, creating a new, denser commercial chip every 3 to 4 years;5 the resulting improvements In memory then drive next-generation products in computers, consumer electronics, and a number of other industries as well as demanding rapid improvements in processing equipment. In automobiles the Japanese have compressed vehicle development lead times to less than 4 years, allowing more frequent model changes and better response to customer demand; U.S. and European firms are striving to catch up. The trend Is also appar- ent in industrial goods markets. For instance, Allen-Bradley uses advanced manufacturing technologies to produce customized contactors and relays in batches as small as one; General Electric does the same with circuit breakers. As the technology advances and permeates more companies, rapid response time and customization will become competitive necessities. The implications of this change for corporate and government strategy are becoming apparent. Only a few industries remain in which the tra- ditional product cycle approach to international production still applies.6 Strong intellectual property rights have become more important as com- panies are forced to recoup investments on new products and production facilities over shorter periods. Manufacturers cannot afford the revenue losses associated with misappropriation of intellectual property. The Inter- national Made Commission estimates that inadequate protection of ~ntel- lectual property cost U.S. firms $24 billion in lost sales in 1986.7 Finally possession of the resources, expertise, and production capabilities needed to participate in multiplying market segments with rapid product turnover is becoming a key element in corporate and national competitive success. 1b meet international competition, manufacturers must be able to organize frequent product launches on a global basis, which increasingly requires multinational manufacturing and engineering capabilities. For example, 5Thomas Howell, William Noellert, Janet MacLaughlin, and Alan Wm. Wolff, The Microelec- tronics Race: The Impact of Government Policy on International Competition, Boulder, Colo., Westview Press, 1988, p. 38. 6 For a fuller description of many of the issues related to trade and technology, see Raymond Vernon, "Coping with Technological Change: U.S. Problems and Prospects," in Harvey Brooks and Bruce Guile, eds., Technology and Global Indusay, Washington, D.C., National Academy Press, 1987. 7"The Sun Also Rises over Japan's Technology," The Economist, April 1, 1989, p. 57.

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15 Apple Computer has built an international manufacturing and engineering infrastructure with facilities in California, Ireland, and Singapore, to allow broad, simultaneous product introduction in all of its major markets. Increasing Capital Intensity A number of high-technology industries have experienced escalations in the capital intensity of production facilities that forced them to adopt a global marketing strategy combined with a concentrated manufacturing base. For example, in microelectronics, greater capital intensity, expensive product and process R&D, and escalating costs of capital equipment have made the ability to sell products globally essential to achieving the requisite scale economies for amortizing investments. In 1986 facilities' charges for state-of-the-art semiconductor plants ranged between $50 million and $100 million; recent estimates have priced new plants at $250 million to $400 million. When R&D costs are included, estimates for 16-megabit DRAM facilities exceed $1 billion. This level of capital intensity has two major effects on corporate strategy. First, it forces manufacturers to share the costs and the risks. For example, Texas Instruments and Hitachi, Motorola and Toshiba, and IBM and Siemens have reached agreements for joint work in developing 16-megabit DRAMs and the requisite process technology. High capital requirements also demand that costs be amortized by maximizing capacity utilization, moving rapidly along the learning curve to boost production yields, and attacking markets on a global scale. This demand implies a strategy of concentrating production in a few locations and exporting. These forces help to explain the importance of open markets in semiconductors, as demonstrated by the U.S. demand for greater access to the Japanese semiconductor market. Market Sophistication In a variety of industries a presence in specific markets abroad has become essential to maintaining a technological edge. For historical and other reasons, certain markets have developed an industry mix that demands state-of-the-art products in certain areas. In these state-of-the-art markets, constant improvement in product and process technologies is driven by customer demand; therefore, successful innovation becomes a key determi- nant of competitive success. Participating in these markets is essential both to keep pace with technological advances in a given product class and to provide ready access to a customer base for innovations that can ease the risks and build a basis for global sales. Japan, for instance, has become the state-of-the-art market for semiconductor process equipment and consumer electronics. Germany and Japan probably share this distinction in machine

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16 tools. The United States can still claim to be the leading market in, for example, aerospace, computers, and software technologies, but in many technologies crucial to manufacturing (process equipment) or to capturing large markets for manufactured products (consumer electronics), the United States is not the state-of-the-art market. Firms competing on the basis of the technological sophistication of their products have no choice but to build a strong presence in these state- of-the-art markets. Effective participation through exports alone, though not impossible, is very difficult. Production capabilities in the market, along with significant engineering resources, are essential to identifying and responding to rapidly changing consumer demand or competitors' challenges. The lessons learned can then be transferred to the firm's other production facilities worldwide and used to gain a competitive edge in world markets. These examples illustrate the kinds of issues that the globalization of markets has introduced to manufacturing strategies. Operational im- plementation takes a range of forms, depending on the industry, product sophistication and maturity, size and resources of specific companies, polit- ical constraints, and other factors. Conditions might dictate a wholly owned investment strategy or, increasingly, some form of collaboration with a firm that already has a market presence. Managers at one auto parts company explained that joint ventures are now its favored approach to building inter- national market share in mature product markets, but the firm still depends on direct investment to build a presence in new businesses. In particular, many U.S. manufacturers view joint ventures as the most effective way to penetrate the Japanese market; such alliances can help overcome close manufacturer-supplier relations and language barriers. GLOBAL DISSEMINATION OF TECHNOLOGY Another major factor in the globalization process is the development of technological strengths in many foreign firms and economies that are overtaking the United States in a number of critical areas. Various in- dicators support this contention. Japan, Germany, and France devote a greater percentage of gross national product (GNP) to nondefense R&D than the United States. By 1988 the number of U.S. patents granted to foreign inventors, primarily from Japan, Germany, France, and Britain, virtually matched those to U.S. inventors (see Figure 6~. Finally, the share of the U.S. market for high-technology goods supplied by imports climbed from a negligible 5 percent in 1970 to 18.2 percent in 1986; over that period the sources of such imports expanded beyond Europe to include

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17 Japan (the dominant supplier) and the Asian newly industrialized countries (NICs Hong Kong, Singapore, South Korea, and lbiwan).8 A key ramification of this diffusion of technological capability is the need for U.S. manufacturers to improve their ability to tap multiple sources of technology and to absorb new technologies into their products and processes. Despite many exceptions, certain evidence shows that U.S. manufacturers are handicapped in global competition by their poor ability to absorb new technologies, particularly from external sources, that form the basis for building new competitive advantages and commercializing new products rapidly. A recent study of the time and funds needed by Japanese and U.S. firms to commercialize new technology showed U.S. manufacturers to be at a clear disadvantage in commercializing external technology, though for internally developed technology the two countries were about even. Although this disadvantage may be due to differences in the way resources are allocated in the innovation process, it is also an indication of the costs of a pervasive "not-invented-here" attitude in U.S. industry that must be overcome.9 The global dissemination of technology, both hardware and "soft" management systems, has made this shortcoming of U.S. manufacturers a major detriment to their global competitiveness. Despite the evidence that U.S. companies do not integrate new tech- nologies into their operations as well as many foreign competitors, an increasing number of firms are recognizing the importance of tracking and gaining access to technological developments worldwide. As with the other drivers of the internationalization process, the steps needed to do so can- not be generalized. They depend on the firm's own technological assets, whether competitiveness is based on product or process technology or both, whether the firm strives to be a technological leader or a quick follower, and the relative availability of foreign technology. Techniques used to gain access include creating wholly owned R&D facilities in key foreign mar- kets, contracting with independent research institutions, strengthening ties to local universities, establishing local production facilities in areas with relevant technological concentrations, entering joint ventures with foreign firms in the United States or abroad, buying key technologies (embodied in products or processes) from foreign suppliers, licensing foreign patents, reviewing local technical publications, and informal cooperative research with foreign companies. A few examples will help to illustrate the kinds of steps that manufacturers are taking to ensure global access to technology. These and other statistics on R&D, technology trade, and production are available in National Science Board, Science and EngineeringIndicators 1989, Washington, D.C., U.S. Government Printing Office, 1989. 9 Edwin Mansfield, "Industrial Innovation in Japan and the United States," Science, September 30, 1988, p. 1769.

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19 Access to Critical Components Perhaps the most common way to gain access to technology is to purchase components from outside suppliers. Sourcing decisions usually involve a sophisticated analysis of which products and components should be manufactured in-house and what can be bought from suppliers. The op- timum balance between make and buy depends on a variety of factors, not just access to technology; they include cost, supply flexibility, necessary pro- cess capabilities, and the role of specific components or products In overall corporate strategy. In some product segments, however, buying components from foreign manufacturers has become the only way to participate in final product markets.~ For instance, Canon dominates global production of engines for facsimile machines and laser printers, with 84 percent of the world market. Similarly, Fanuc holds more than 70 percent of the global market for machine tool controllers. These market shares imply not only monopolistic power over price and deliveries but also virtual control of the pace of innovation in the affected product markets. The customers' need to guarantee access to such critical components can be the determining factor in corporate decisions ranging from plant location to frequency of model changes. In many cases, heavy dependence on single suppliers for critical components can be reversed with appropriate investments IBM, for instance, manufactures its own laser printer engines but the ability to build the necessary production capabilities with the requisite skill and knowledge becomes more difficult with each new generation of component technology. Access to Process Equipment Competitive product technologies often depend on the most advanced process technologies, which in some industries requires that process equip- ment be obtained from foreign suppliers. For example, U.S. semiconductor manufacturers depend on Japanese suppliers for certain advanced mate- rials (glass, ceramics, and some specialized chemicals) and increasingly for leading-edge lithographic equipment. U.S. auto companies now must import state-of-the-art machine tools in some applications to achieve world- class parts quality. The rising level of import penetration in the U.S. capital equipment market in the 1980s is a clear indication of the overall strength of foreign suppliers (see Figure 3~. moor a discussion of U.S. dependence on Japanese suppliers ofmicroelectronic components, see Robert B. Reich, "The Rise of Techno-Nationalism," The Atianac Monthly, May 1987, pp. 63-69. ~ ~ "Canon," Financial Times Supplement, April 27, 1988, p. 16B. i2 Gene Bylinsky, "]apan's Robot King Wins Again," Fortune, May 25, 1987, p. 53.

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23 (the costs of quality), and the importance of a support infrastructure in achieving production goals.l6 In the 1960s and l970s much of the offshore movement of U.S. manufacturing was driven by a strategy based on low labor costs. U.S. managers reasoned that the low prices of many imported products, from automobiles to consumer electronics, were attributable to cheap labor; the only way to compete was to move production offshore to match or beat those labor costs. Over time, however, the importance of labor costs in international investment and production decisions has been diminished by a number of factors: Advances in technology and a long history of squeezing labor out of production have reduced direct labor content in most manufacturing industries to 15 percent or less of production costs; in high-technology in- dustries it seldom exceeds 10 percent and increasingly is under 5 percent.~7 Even wide variations in direct labor costs have relatively insignificant effects on total costs. Many companies have discovered that a strategy based on low labor costs is difficult to implement in the long term. Low-wage locations are equally open to competitors' investments, relative wage levels between locations can change abruptly with changes in exchange rates and shifts in demand, and the extra capital and logistical costs of shifting operations to alternative sites to maintain low wages (so-called "island hoDDin~"N can 1 ~ O. easily consume the resulting wage savings. In most manufacturing industries, labor costs have been outweighed by market access, quality control, timely delivery, and responsiveness to customers as determinants of global competitiveness. Competitive manu- facturers, adopting manufacturing systems for total quality control, have found that siting plants in areas with the skills and capabilities needed to control total costs and quality is more important than siting them to minimize labor costs. These considerations explain the predominance of developed economies in U.S. manufacturing investment abroad (see Figure 7~. Direct labor still receives more attention than it deserves because of accounting systems that continue to allocate overhead costs on the basis of labor load. Still, realizations of the true significance of labor costs are beginning to have important effects on management decisions. Particularly for firms pursuing total quality, international differences in the costs of assuring quality in production are the critical factor in investment decisions. i6The Manufacturing Studies Board is currently engaged in a major study of international dif- ferences in the cost factors driving manufacturers' global production and investment decisions. i7Clark, Hayes, and Wheelwright, 1?ynamic Manufactunng, p. 137.

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24 EEC 116 At r i ca Asia 33 Canada 35 Lati n Amer ice 10 Eastern Europe / 9 Other Western Europe ~3 FIGURE 7 U.S. manufacturing investment abroad, 1989: acquisitions, joint ventures, new plants. The pursuit of total quality in different manufacturing processes reveals a wealth of information about where costs are created and the resources and capabilities needed to control them. The ability to minimize inventory, to eliminate scrap and rework, to integrate functions, and to shorten time to market depends on trained personnel, a strong supplier base, a streamlined organization, and flexibility. Therefore, international site selections might hinge on the cooperation, flexibility, and trainability of the labor force rather than on its cost. For firms using just-in-time systems, the availability of a responsive supplier base or the ability to create one quickly is another important consideration. The lessons learned about a labor cost strategy and a total system approach to cost control have created different considerations in production location decisions, but direct labor remains important to production costs in some product lines. Managers from several industries told the committee that, as a general rule, if direct labor costs exceed 10 percent of total costs, production can be cheaper in low-wage locations. Assembly of electronic devices is one example. Many of the large companies in this industry use sophisticated models to determine the relative advantages of using automated assembly technologies (when available) or low-cost labor at various wage rates; proximity to customers and suppliers is also considered

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25 as well as various scenarios for overhead costs. The results vary by product. For instance, low-cost labor may be preferred to automation for products with very short model lives to minimize fixed asset exposure. When low- cost labor offers a clear advantage, sites in Thailand, Malaysia, and the Philippines are attracting more U.S. and Japanese investment because labor costs in Korea, Taiwan, and Singapore have increased rapidly in recent years. One land of labor whose costs have begun to receive more attention, at least in knowledge-based industries, is highly skilled technical labor for support services. For instance, Texas Instruments has joined AT&T and other U.S. firms in establishing software engineering facilities in India to take advantage of well-trained, low-cost computer programmers. Other firms are finding that the engineering labor force in Korea, Singapore, and other NICs compares favorably to U.S. engineers but at a fraction of the cost. However, managing high-value offshore activities effectively remains a challenge, particularly product and process engineering activities that often are critical to competitive success. On one hand, the short-term cost ad- vantages of moving product/process design and engineering responsibilities to low-cost locations, where firms often have factories, are evident. On the other hand, the broad infrastructure necessary to maximize engineer- ing's value added may not exist in low-wage locations, and the ability to integrate offshore engineering into the firm's total manufacturing system may be constrained by distance and cultural differences. Consequently, the long-term effects remain unclear. In some capital-intensive industries, such as semiconductors and chem- icals, the cost of capital is the major cost consideration in investment de- cisions.~8 Because labor needs are minimal, supplies are shipped globally, and transportation costs are low, the key factors in site selection are avail- abili~ of low-cost capital and the presence of the appropriate technical and logistical infrastructure. In such capital-intensive industries, government incentives to reduce capital costs using mechanisms such as interest rate subsidies, tax holidays, and cost sharing on plant and equipment can be particularly effective in swaying corporate location decisions. Though the advantages of such incentives to individual companies are undisputed, it 18A number of recent studies have addressed international differences in the cost of capital as a source of U.S. disadvantage in manufacturing competitiveness. For instance, see Robert McCauley and Steven Zimmer, 'Explaining International Differences in the Cost of Capital," Federal Reserve Bank of New York Quarterly Renew, vol. 14, no. 2, Summer 1989, pp. 7-28. The committee's intent in this brief discussion is not to resolve the complex issue of whether U.S. capital costs are higher than those of other nations but to note the importance of access to low- cost capital as a driver in the internationalization process.

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26 remains an open question whether these government programs represent an efficient use of public resources.~9 POLITICAL AND ECONOMIC FACTORS In addition to changes in markets, technology sources, and cost struc- tures, a varieW of political and economic factors have changed the global manufacturing environment. The range of factors extends from exchange rate volatility to specific government-to-government agreements both to open markets and to manage trade. This aspect of the internationalization process Is far too extensive to permit an exhaustive review here, but a few examples will illustrate the importance of such factors to manufacturers' international decisions. Exchange Rate Fluctuations The 1971 breakdown of the Bretton Woods system of fixed exchange rates introduced a new source of risk to international trade and investment. Variations In exchange rates under the current floating rate regime have been large relative to typical profit margins; changes of 1 percent in a day and 20 percent in a year are not uncommon. Many economists argue that this volatility Is more attributable to the portfolio preferences of investors than simply to adjustments needed to balance trade flows. Because shifts in exchange rates are unpredictable, manufacturers are faced with high uncertainty in the costs and returns of many international operations. A wide array of financial mechanisms are available for hedging against currency fluctuations, but they are most effective for short-term variations. Manufacturers have responded to long-term currency shifts by diversifying production geographically, making exchange rate variations an integral factor in the internationalization process.20 For instance, the dramatic cost reductions achieved by major Japanese exporters in recent years were necessitated by the tremendous rise in the value of the yen after 1985-1986. Such cost reductions have not 19The question of the costs and benefits of government investment incentives typically is ad- dressed in the context of local public finance debates. Incentives are typically provided by state, regional, or local governments, both in the United States and abroad, though some national gov- ernments, such as Ireland, have made incentives a matter of national policy. For a discussion of many of the issues involved in the level and form of government investment subsidies, see, for ex- ample, R. Scott Foster, "State Economic Policy An Assessment," Business in the Contemporary World, Summer 1989, pp. 86-97. 20These arguments are made more extensively in Ronald I. McKinnon, "Monetary and Ex- change Rate Policies for International Financial Stability A Proposal," Journal of Economic Perspectives, vol. 2, no. 1, Winter 1988, pp. 8~103.

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27 only been applied to domestic manufacturing operations but also have led to more offshore production and purchasing by Japanese corporations. The effect has been to accelerate the internationalization of the Japanese manufacturing base.2i U.S. companies pursued similar responses to the strong dollar of the early 1980s. Another response is for companies to establish production facilities in local markets to minimize their dependency on exports to that market and, therefore, to reduce the effects of currency swings on product prices and market share. This reasoning has been an important motivation for the recent increases in Japanese manufacturing investment in the United States and Europe. Though reducing exposure to currency swings may not be the primary driver in decisions to locate production facilities or to buy components in specific countries, it can speed such decisions and make an international production strategy both unavoidable and competitively sound. Europe 1992 The multigovernment initiative under way to create a unified European market by 1992 is dramatically changing corporate plans and strategies in Europe. The prospect of a single market of 320 million consumers is already spurring new investments, plant rationalization, and strategic alliances that would be unlikely otherwise. For many manufacturers in Europe, 1992 offers opportunities to consolidate small plants built to serge individual national markets into European-scale facilities. For firms that have had no production facilities in the European Community, the fear that 1992 may bring greater trade protection in Europe is prompting reevaluation of the viability of export strategies and boosting investment plans. Europe 1992, more accurately described as a process than as a specific event, Is stimulating changes in strategies among manufacturers worldwide and will change the role of Europe in an increasingly interdependent global economy.22 U.S.-Canada Free Trade Agreement The U.S.-Canada Free Made Agreement of 1988 is sparking similar changes in the North American market. Both U.S. and Canadian com- panies have announced rationalizations In output and steps to determine 21Japan's offshore production is expected to be 8.7 percent of total Japanese output in 1990 compared to 3.5 percent in 1986. See "Remaking Japan," Business Week, July 13, 1987, p. 54, and Eileen M. Doherty, Japan's Foreign Direct Investment in Developing Countries, Japan Economic Institute, August 11, 1989. 22For an instructive sunrey of the 1992 process and its implications for business, see Nicholas Colchester, "ASurvey of Europe's Internal Market," The Economist, July 8, 1989.

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28 which plants will serge what market. The resulting integration of the two economies will further complicate the already difficult problem of account- ing for trade between the two nations. Trade Protection The General Agreement on Tariff and Made (GATE) has been very successful in achieving major multilateral reductions in tariffs since World War II. In terms of tariffs alone, the level of trade protection has fallen dramatically, resulting in the virtual elimination of tariff for most industrial goods traded among developed countries.23 The predictable result has been explosive growth in world trade. With GATE deterring tariff increases or additions, however, nontariff barriers to trade have become a widely used alternative for many national governments. Nontariff barriers take a varied of forms, resulting in a range of responses by manufacturers. Go forms of nontariff barriers voluntary export restraints and trigger price mechanisms have been used by the U.S. government in recent years. The use of voluntary export restraints (VER) on Japanese automakers ef- fectively imposed a quota on U.S. imports of Japanese cars. The Japanese response has been (a) to upgrade the mix of cars exported to this country to maximize revenue per unit sold, and (b) to invest in U.S. production capacity to build market share unconstrained by VER agreements. Presi- dent Reagan initiated S-year VER agreements on machine tools with Japan and Taiwan in May 1986. In this case the foreign response has been to purchase existing domestic capacity, to build new manufacturing facilities in this country, to license domestic builders, and to create joint ventures with American machine tool builders.24 The government has used trigger price mechanismsestablishing a minimum price for sales in the U.S. market in both semiconductors and steel as a way to eliminate dumping by foreign manufacturers. The result has been excess profits for low-cost foreign pro- ducers, allowing greater investment to reduce production cost, to advance the level of product and process technology, and to build manufacturing capacity in the United States. Foreign governments have used similar nontariff barriers with similar effects on the strategies of foreign manufacturers. Europe is a good exam- ple. Japanese companies have dramatically increased their manufacturing 23A current GATE tariffstudy gives these average tariff levels (in percent of value of imports) for selected countries: Canada~.9, United States 4.2, the European Economic Community 4, Sweden 3.8, Japan 2.7, and Switzerland 2.2. 24For additional information on the internationalization of the U.S. machine tool industry, see U.S. Department of Commerce, US. Industrial Outlook, recent years, and Nicholas S. Vonortas, The Changing Economic Context: Strategic Alliances Among Multinationals, 'Troy, NY, Rensselaer Polytechnic Institute, 1989.

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29 investments in Europe for example, in automobiles (Nissan, Toyota, and Honda in Great Britain), semiconductors (Fujitsu in England), and con- sumer electronics (Matsushita, Toshiba, Hitachi, Sony, and Canon, among others, in Germany, France, Spain, and England). U.S. companies have also established manufacturing facilities to breach trade barriers. For ex- ample, both Texas Instruments and Intel plan to build new semiconductor fabrication facilities in Europe (Italy and Ireland, respectively) in response to increases in the amount of semiconductor processing that must be done in Europe to avoid import restrictions.25 Local content requirements, as illustrated in the European semicon- ductor example, are a particularly prevalent form of nontariff barrier. Such requirements historically have been used to support local development of key industries. Consequently, they have been an important factor in for- eign direct investment decisions and a potent driver of internationalization. In some cases, local content requirements may preclude penetration of a specific market. The firm may deem the sales potential in the market too small to justify a manufacturing investment or may view the local supplier base as inadequate to fulfill quality specifications. In other cases, market presence may be essential to tap sales potential or to gain access to specific resources, but the local content rules force decisions on the amount and form of manufacturing investment that are suboptimal from the firm's per- spective. The rules introduce constraints on management flexibility, dictate the type and scale of technology used in certain locations, and preclude desired plant and product rationalizations. Finally, local content require- ments may interact with other trade barriers to complicate the ability to export from a given plant. Examples are the recent disputes in Europe over the nationality of cars produced by Nissan in England and photo- copiers produced by Canon in California. The value added locally to these products is deemed insufficient to qualify them as English or American; the final products therefore would be deemed Japanese and subject to ex- isting trade barriers. Such disputes may proliferate as governments find it increasingly difficult to define a local product unambiguously as companies integrate production of components, subassemblies, and final goods into global manufacturing systems. Nontariff barriers take a range of forms in addition to those described above. They include public sector policies such as government procure- ment, subsidies, standards, regulations, and patent policy. They also include private sector moves such as supplier qualification, distribution constraints, collusion, and oligopoly. Each type of barrier tends to have characteristic 25"Intel Will Make Chips in Ireland," Semiconductor Industry and Business Survey, October 9, 1989, and Stuart Auerbach, "Europe 1992: Land of Opportunity Beckons," Washington Post, March 20, 1989, p. A 1.

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30 effects on firms' international production and marketing strategies, partic- ularly in high-technology industries.26 For instance, many foreign firms use joint ventures with local firms to overcome nontariff barriers in Japan. As these nontariff barriers affect manufacturers striving to compete on a global basis, the emphasis on them in trade negotiations is likely to continue to increase, resulting in further blurring of trade policy and domestic policy and continued disputes about the proper role and mechanisms for each. CONCLUSION Markets, technology, costs, and politics have been the major forces for change in the international manufacturing environment in the past 10 to 15 years. Market access has become the dominant driver of international investment decisions, but other factors retain varying influence in specific situations. Low-wage locations are still advantageous for manufacturing products with high labor content. Companies that base their competi- tiveness on technological leadership give priority to access to technology. Other companies may focus on global proliferation of production capacity to speed response to customers and to tailor products to local demand. Firms with high capital requirements, in contrast, need to centralize pro- duction. The relative weight given to each factor varies by company and product and over time. No two companies face the same international challenge. Managers at several U.S. multinational corporations told the commit- tee that their primary challenge in coming years is integrating their existing global operations to perform as a single system rather than as islands of manufacturing and technological capabilities. These firms have extensive international networks of marketing and production facilities, based pri- marily on a multidomestic model of international business. In this model, foreign operations tend to duplicate those of the parent and are given sub- stantial autonomy over production, distribution, product development, and research. The resulting global production base, rather than U.S. exports, has been the vehicle for U.S. penetration of global markets. Few companies have progressed far in coordinating this extensive infrastructure on a global basis, but the emergence of advanced communication and manufacturing technologies has made global integration possible. The challenge of global integration is magnified by the still poorly de- fined nature of prospective global organizational systems. In the computer and information industry, for instance, rapid escalations In the costs of 26For a full discussion, see Michael F. Oppenheimer and Donna M. ILths, NontariffBarners: The Effects on Corporate Strategy in lIigh-Technology Sectors, Boulder, Colo., Westview Press, 1987.

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31 R&D, capital equipment, software, and customer support are forcing com- panies to strengthen their global market presence and to integrate global operations to eliminate redundancy. At the same time, the global diffusion of technological and scientific expertise in the industry calls for ready access to sources of innovation around the world. This need tends to restrict the ability to rationalize global operations to achieve efficiencies. Balancing these two pressures appropriately has become a fundamental challenge to the industry. Managers in most other industries face similar challenges in creating integrated global manufacturing systems. For emerging multinational companies, the challenge is not to integrate but to expand global presence. Managers must consider the types of marketing, distribution, and manufacturing presence necessary to build foreign market share; the advantages of various locations; the possibilities for partnerships with domestic companies (and in some cases the necessity of partnerships); the source and level of control of foreign production; and the likely impact on the existing production base. Careful attention to these issues, with decisions based on accurate information, can avoid investments that fail to perform as intended or alliances that give up more than they gain. Small and mid-sized U.S. companies also face the challenges of building an international infrastructure. Often they are suppliers to large corpora- tions striving to penetrate global markets, and in some cases, such as auto parts, they are subject to direct competition from new foreign investment in this country. The growth of international competition in the markets served by small firms has set new standards for their production operations and put a premium on staying abreast of technological developments world- wide and attacking foreign markets. Most small firms lack the resources to spread their production base to foreign markets, but options are available. For instance, supplier firms can forge closer links with customers to take advantage of larger firms' resources and international experience whenever possible. Direct experience abroad can be gained by expanding exports. Opportunities for foreign sales are often underestimated. A 1987 report from the American Business Conference demonstrated that small to mid-sized firms the bulk of the U.S. manufacturing base can succeed in building international sales, given management commitment.27 For the firms studied in this report, the first step was to build foreign distribution capabilities, leading to overseas production once sales reached a critical mass. The required initial investments were fairly small, the first target markets were often English-speaking ones to minimize cultural risks, and success was quick the companies studied increased their foreign sales nearly 20 percent annually in the 1980s, and most showed profits on foreign 27American Business Conference, In=, Wnningin the World Market, Washington, D.C., 1987.

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32 sales within the first year. The success of these companies clearly indicates the potential for greater foreign sales by U.S. manufacturers, given the required commitment. For firms without their own sales networks, export trading companies have been formed to provide marketing and distribution services. Learning what is necessary to serge foreign customers through exports is probably the most important step for small firms wanting to benefit from the internationalization process. Japanese manufacturers tend to face a somewhat different challenge than U.S. firms. With only a few exceptions, the Japanese have relied on an export strategy to achieve broad penetration of world markets. Though their marketing and distribution infrastructure is well established, they now face the need to create a global manufacturing infrastructure. Changes in the value of the yen, improving capabilities of other Asian nations, and fear of increased protectionism in world markets are spurring a dramatic increase in Japanese offshore production. By far the preferred mechanism has been wholly-owned greenfield investment, with North America the favorite site, but joint ventures with local producers have been common in industries such as automobiles, steel, and machine tools. Many of these facilities continue to be assembly operations that receive components from Japan (standard practice for new plants by multinationals of all nationalities), but several firms have said they intend to increase local value added in the next few years. Honda, for example, plans to introduce to the U.S. market a new automobile designed, engineered, and manufactured entirely in the United States. European manufacturers face the same kinds of issues. Major Euro- pean multinationals, like similar U.S. firms, have extensive international marketing and manufacturing capabilities; their main challenge is coor- dinating these global operations. To a greater degree than their U.S. counterparts, however, European multinationals have tended to retain management control and strategic direction for global subsidiaries at their European headquarters, creating a somewhat different basis for building a globally-integrated manufacturing system. European firms that are multi- national only within the European market face the challenge of expanding their marketing and manufacturing presence in other world markets. To an increasing extent, effective responses to the causes of inter- nationalization will push manufacturers from each region toward similar objectives. The need for a global marketing scope is well understood, but the importance of a global manufacturing scope is only beginning to be realized and the means of achieving it are still not well understood. The differences in starting points among various companies and nationalities will sometimes constrain the tools available and color the challenges to be overcome. Because they have the most extensive global marketing and

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33 manufacturing infrastructure,28 U.S. companies are potentially in an ad- vantageous position. Unfortunately, too few U.S. firms recognize the value of their existing infrastructure or the steps needed to strengthen it. 28According to the Federal Reserve Board, all U.S. assets abroad currently continue to exceed foreign assets in the United States by a wide margin if assessed at market value, $785 billion versus $466 billion.