Global production arrangements

The two main types of global production arrangements are a) merchanting and b) goods sent abroad for processing. The extreme case of this last arrangement, when all production is outsourced, is known as factoryless goods production and can be seen as a third type of arrangement.

Merchanting

Under the merchanting arrangement, the domestic firm purchases a good abroad and subsequently re-sells the good without the product entering the resident firm’s territory. The merchant does not own the intellectual property, or any other input materials, associated with the good and is essentially engaging in a global distribution activity. As an example of this type of arrangement, suppose that country A buys books from country B and then subsequently sells those books to country C without them ever entering country A’s territory. The books in question were produced by firms in country B who own all the inputs into the production process including all intellectual property.^Note 1 In this example, country A is simply engaged in trade with both country B and C in a merchanting arrangement (see Figure 1).

Merchanting has grown strongly in the last decade in select small open economies, such as Ireland and Switzerland, with the potential to become an important driver of these countries' current accounts. Because merchanting firms tend to reinvest their earnings abroad to expand their international activities, this practice has the potential to raise national savings in the home country without increasing domestic investment.^Note 2 It is therefore important to understand to what extent Canadian firms are engaging in this practice.

Goods sent abroad for processing

Under the goods sent abroad for processing arrangement, part of the production process is contracted out to a firm in a different country. Under this type of production arrangement, the resident firm owns the input materials as well as the intellectual property associated with the production process and is simply purchasing manufacturing services from abroad to transform the inputs into another product. A common example is that of an athletic shoe.^Note 3 Suppose the production of the shoe can be split up into 3 parts: a) the top of the shoe (the upper); b) the midsole which is the most important part of the shoe as it is the part that cushions and protects the foot; and c) the outsole. Suppose further that the resident firm creates a new innovative design for the midsole and that production of this part of the shoe is done at its domestic manufacturing facility. The firm, however, decides that it would be more cost effective to send the midsole it just created, along with the other materials (the upper and outsole) to another country for final assembly. The resident firm retains ownership of the input materials and of the intellectual property product throughout the entire production process. When the finished shoe is returned, the resident firm pays a processing fee to the non-resident firm who assembled the parts. The shoe is then marketed and sold by the resident firm who owns the output and receives all the revenues for the sale. It is clear in this example that the resident is the economic owner of the material, the intellectual property and the final output associated with the product.

With this production arrangement there could be various degrees of transformation done in the resident country. Part of the product could be assembled in the resident economy; such as was the case in the example above, or all of the production could be done abroad. What is important is the ownership of the materials which are sent abroad for processing. The extreme case where no production is done in the resident economy and where the resident firm may or may not own the input materials is known as factoryless goods production.

Factoryless goods producer

The factoryless goods producer (FGP) is an extreme case of goods sent abroad for processing, where the physical transformation of the goods is 100% outsourced. An FGP arrangement occurs when a resident firm owns the intellectual property (blue prints, technical knowledge, etc.) used in the production process but does not have the physical assets (e.g., buildings, machines) or labour force required to transform the intermediate inputs into the output they are selling. In such a case, the firm must outsource the entire production process to another firm (the firm could be either in the same country or abroad). With regards to FGP activity, this paper is concerned only with the latter, global arrangement, where the goods enter another economy. For example, consider a clothing manufacturer who has designed a new style of shirt. All of the research and development (R&D) and design work was done by this firm (firm A) in its resident country (country A). Firm A decides that it would be more cost effective to have the shirt produced in country B through another firm (firm B). Firm B uses the design provided by firm A to produce this new shirt and then returns the shirt back to firm A. Because firm A owns the intellectual property associated with this shirt, it only pays firm B for the cost of production. Moreover, firm B is contractually obliged to firm A in that it is unable to sell the shirt to any other entities.

These global production arrangements have the potential to cause problems for the measurement of international trade flows as well as global and domestic production. Current international work and recommendations are summarized in Appendix 1. The remainder of this paper is concerned with measuring these arrangements in Canada.

Notes