Location Economies:

 

V= Consumer Value P= Market Price C= Cost of Production V-P=Consumer Surplus P-C= Profit Margin V-C= Value Added

    

P-C

                   

V-C

     V                                  

                    P

                            C

 

                                   Fig: Location Economies

As we know that countries differ along a range of dimensions, including the economic, political, legal and cultural and these differences can either raise or lower the costs of doing business in a country. The theory of international trade also teaches us that due to differences in factor costs, certain countries have a comparative advantage in the production of certain products. Japan might excel in the production of automobiles and consumer electronics; the United States in the production of computer software, pharmaceuticals, biotechnology products and financial services; Switzerland in the production of precision instruments and pharmaceuticals; and South Korea in the production of Steel.

What does all this mean for a firm that is trying to survive in a competitive global market? It means that, trade barriers and transportation cost permitting, the firm will benefit by basing each value creation activity it performs at that location where economic, political and cultural conditions, including relative factor costs, are most conductive to the performance of that activity. Thus, if the best designers for a product live in France, a firm should base its design operations in France. If the most productive labor force for assembly operations is in Mexico, assembly operations should be based in Mexico. If the best marketers are in United States, the marketing strategy should be formulated in the United States. And so on.

Firms that pursue such a strategy can realize what we refer to as location economies, the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value creating activity in the optimal location for that activity can have one of two effects. It can lower the costs of value creation and help the firm to achieve a low cost position, and/or it can enable a firm to differentiate its product offerings from those of competitors. In terms of above figure, it can lower C or increase V, which in general supports higher pricing (P). These considerations were at work in the case of Clear Vision. Clear Vision moved its manufacturing operations out of United States, first to Hong Kong and then to mainland China, to take advantage of low labor costs, thereby lowering the costs of value creation (C). At the same time, Clear Vision shifted some design operations from the United States to France and Italy. Clear Vision reasoned that skilled Italian and French designers could probably help the firm better differentiate its product, increasing perceived value (V). In other words, Clear Vision thinks that the optimal location for performing manufacturing operations in China, whereas the optimal locations for performing design operations are France and Italy. The firm has configured its value chain accordingly. By doing this, Clear Vision hopes to be able to simultaneously lower its cost structure and differentiate its product offering. In turn, differentiation should allow Clear Vision to charge a premium price for its product offering.