The Innovation Trap

The US economy faces a number of challenges—among them a lack of job creation and an ever-growing trade deficit. Many policy-makers believe that encouraging business innovation is the best response to these particular challenges. Sounds plausible but experience suggests otherwise.

The best example of why simply encouraging business innovation is not the answer for our employment and trade problems is Apple and its iPhone. 

The iPhone was introduced in 2007 and has been incredibly successful.  U.S. sales soared from 3 million units in 2007 to over 11 million in 2009.  Global sales topped 25 million in 2009.

While the iPhone is designed and marketed by Apple, almost all the phone’s components are produced by foreign companies operating outside the United States.  These components are then shipped to China where Foxconn, a Taiwanese company, oversees their assembly and their export to the United States and other countries.  As a result, the iPhone generates few jobs in the United States.  

Two economists, in an Asian Development Bank working paper, examined the iPhone 3G production process in some detail.  The table below, taken from their study, highlights the main suppliers and the costs of the components they produce for a single phone.  Most of the components are supplied by Japanese, South Korean and German firms, although there are also some U.S. suppliers (although who knows where they actually produce their compnents). 

The total component cost of an iPhone in 2009 was $172.46.    Workers in China assemble the iPhone, but because their wages are low the assembly cost per phone (labeled manufacturing costs in the table below) is quite small, only $6.50 a phone.  The total production cost per phone is $178.96.


Because the iPhone is assembled in China all sales in the U.S. mean an increase in Chinese exports (even though the phone is largely composed of inputs produced outside of China) and an increase in U.S. imports.  In 2009, China exported more than $2 billion worth of iPhones to the United States.  Thus, the iPhone, because of the Apple’s production strategy, also adds to the U.S. trade deficit.

Apple is not alone in embracing China as its production base.  China is now the world’s largest exporter of manufactured goods. And, as the chart below shows, the share of Chinese exports that are labled high technology is growing.  This trend has encouraged many analysts to claim that the U.S. is now locked in fierce economic competition with China. 


However, as we see next, more than 80% of China’s high technology exports are actually produced by foreign companies operating in China.  Moreover, these foreign companies have significantly increased their control over this production.  In 2002 foreign owned firms that were 100% foreign owned (which means that they had no Chinese partner) accounted for only 55% of Chinese high technology exports.  In 2009 they accounted for 68%.   


Why do so many transnational corporations choose to locate production in China?  The answer is obvious: profits. Apple again serves as a good example.  The table below, taken from the Asian Development Bank working paper cited above, shows Apple’s profit margin on the iPhone.  In 2009 it was a whopping big 64%.


Struck by the size of Apple’s profit margin, the authors of the Asian Development working paper considered whether the iPhone could reasonably be made in the United States.  As they note:

The role of the PRC in the production chain of iPhones is primarily the assembly of all parts and components into the final product for re-shipment abroad. The skills and equipment required for the assembly are very basic and there is no doubt that American workers and firms are capable of assembling iPhones in the United States. If all iPhones were assembled in the United States, the US$1.9 billion trade deficit in iPhone trade with PRC would not exist. Moreover, 11.4 million units of iPhone sold in the non-U.S. market in 2009 would add US$5.7 billion to US exports.

For the sake of discussion, they assumed that assembly line wages in the United States are ten times higher than in China.   Given that Chinese production workers earn roughly $1 an hour, that is not an unreasonable assumption.  The higher wages would mean that the total assembly cost per phone would rise to $65 and the total manufacturing cost would approach $238.  If Apple continued to sell the iPhone for $500, the company would still earn a very respectable 50% profit margin.  

Moreover, as the authors point out: 

In this hypothetical scenario, iPhones, the high-tech product invented by the U.S. company, would contribute to U.S. exports and the reduction of the U.S. trade deficit, not only with the PRC, but also with the rest of world. More importantly, Apple created jobs for U.S. low skilled workers; those who could not be the software engineers needed by Apple. Giving up a small portion of profits and sharing them with low skilled U.S. workers by Apple would be a more effective way [than depreciation of the exchange rate] to reduce the U.S. trade deficit and create jobs in the United States.

Of course, shifting production to the United States would mean that Apple would earn less money and there is little reason to believe that the company is prepared to sacrifice its profits for the good of the country.  If we want to tackle our employment and trade problems we are going to have to do more than promote more attractive conditions for business.  

4 thoughts on “The Innovation Trap

  1. Marty, an LC grad here. I like reading your blog, but somehow it leaves me feeling depressed about the world! 🙂

    Anyways, regarding this article specifically, do you think Apple should sacrifice 12% margin on each phone = $1.8 billion (using 30 million phones at $600 each), to employ low-skilled American workers instead of Chinese? I just don’t see that as a viable way to run a business. (Not trying to be argumentative, I promise!)


  2. When asking if Apple would sacrifice profit per phone, perhaps we are looking at this through a lens of instant gratification. If they made the decision to manufacture phones in the states, they create jobs. Create jobs and you increase local demand. They may end increasing their bottom line is all said and done. Although, you may depend if you lose demand by laying off workers in China.


  3. Sorry that so many of the blog entries are depressing. My goal is to highlight existing economic trends and illuminate the forces shaping them. Unfortunately it is the trends that are depressing. That said, to the main question: should Apple stop maximizing its profit, costing its stockholders money, in order to provide jobs for workers in the United States? Well, the answer is simple. Apple wont do that because, as pointed out, “that is no way to run a company” in this economy.

    But, that is precisely my point. We are told that if we provide a better business environment for companies we will get more innovation which will benefit the “national interest.” However, the Apple example shows that there is no reason to expect such a positive outcome. I don’t care about Apple; I care about the U.S. economy. I am not arguing that hurting Apple necessarily helps workers, only that it is a mistake to believe that supporting business will necessarily improve majority economic conditions. If the latter is our goal, we need to formulate and implement policies that will produce that outcome. The conventional wisdom that what is good for business is good for the working majority needs to be challenged. Micro rationality does not guarantee macro rationality.


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