Public Sector Procurement Practice and the Principles of External Economies, Clustering and the Global Value Chain

Posted on August 28, 2007

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Can the public sector effectively apply the principles of External Economies to its procurement practice?

“External economies of scale (ES) occur outside of a firm, within an industry.  Thus, when an industry’s scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in costs for a company working within that industry, external economies of scale are said to have been achieved.  With external ES, all firms within the industry will benefit.” (What Are Economies of Scale? By Reem Heakal, January 2003)

While the principles of external economies have traditionally been associated with the manufacturing industry, the emergence of clustering and the global value chain has in effect redrawn the boundaries of its applicability.  Ironically, the idea of looking beyond the “localized” or “regionalized” structure normally associated with external ES, is a concept that was first presented by E.G. Robinson in 1931 and expanded upon in his book The Structure of Competitive Industry (Cambridge Economic Handbooks, 1958).

Specifically, Robinson defined an immobile external ES as one which “require the firms to be in close proximity to one another” for benefits to be realized.  (As an adjunct point of interest, the benefits of proximity have recently been called into question such as in the case of Bombardier.  According to Goldstein, the absence of a dedicated public policy regarding the development of localized clusters “prompts speculation on whether the clusters built through the national lead firms’ (Bombardier) success will consolidate into a self-sustainable and durable regional specialization.”  I will expand upon the role that policy can play in the development of dynamic, global-enabled clusters in which the government assumes the dual role of being the lead firm as well as primary facilitator a bit later.)

Conversely, “external economies of scale which are available to firms located well beyond the territory in which they are provided” Robinson defined as being mobile.  One example of external ES which Robinson cited in the 1930s as being mobile was the Liverpool cotton exchange, which could be utilized by firms both locally as well as globally to the apparent benefits of all stakeholders.  (Note: I cannot help but draw a conceptual comparison between the Liverpool cotton exchange of the early 1900s and the emergence of agent-based modeling and the resultant Metaprise architecture that is behind technological development in 2007.)  Furthermore, Robinson’s conclusion that “the advantages of large-scale industries concentrating in one country were declining as the importance of mobile economies were increasing” represents a remarkable prognostication ability given his era and the absence of the major technological breakthroughs that have defined our modern “global economy” today.

Government Taking on the Role of “Lead” Firm 

In the book Clusters Facing Competition: The Importance of External Linkages (Giuliani, Rabellotti and van Dijk, 2005), reference is made to the fact that the “value chain perspective” extends beyond the realm of manufacturing to include “other activities in the supply of goods and services, including distribution and marketing” (Kaplinsky, 2000; Wood, 2001). With this broadened definition, is there any way for Government to initially assume the “role” of lead firm thereby leveraging the competencies of domestic clusters (or supply chains) to satisfy it own internal requirements?  Furthermore can this redirection of policy focus be used as a springboard to develop competencies that will ultimately establish the viability of domestic stakeholders (in particular SME’s) on the global stage?  (Note: with the latter, it is worthwhile to refer to van Dijk and Wang’s analysis in Chapter 10 of the book regarding the Chinese government’s role in “speeding up the growth process of a software cluster firm in Nanjing,” including the link with that country’s “national innovation system (i.e. universities and associations.)”

The key to leveraging domestic competencies is to fully understand and assess the capabilities of the heterogeneous supply community in servicing public sector needs (a worthwhile exercise that serves the dual purpose of laying the foundation for identifying areas of global strength or leadership within a particular sector.)

This strategy however is often undermined by the failure of the public sector to look beyond the relatively narrow definition of the sound bite “savings” associated with a reduction in spend.  As a result, the majority of purchasing initiatives have been structured around a vendor compression strategy in which direct contracts with larger entities are expected to drive volume savings.

Even though the projected savings have rarely materialized to the anticipated levels, the most significant and negative consequence of a compression strategy is the impact on the development and sustainable growth of a cluster.  Referencing Goldstein once again, he defined a cluster as “a spatial concentration of firms (including specialized suppliers of equipment and services and customers) and associated non-market institutions (universities, research institutes, training institutions, standard-setting bodies, local trade associations, regulatory agencies, technology transfer agencies, business associations, relevant government agencies and departments, etc.) that combine to create (or deliver, per Kaplinsky and Wood) new products and/or services in specific lines of business.”  Given this definition, anything that hinders the ability for various stakeholders to collaborate (re combine) such as a myopic focus on spend reduction will naturally create a strained atmosphere that will limit cluster development domestically and therefore its effectiveness globally.

What is interesting is that the detractors of supply base rationalization share many of the same concerns as those who are opposed to globalization.  In the case of globalization, Heakal’s article cited the claims of opponents that the “effects of expanded business seeking economies of scale” will negatively impact small business (who are actually the primary stakeholders in a cluster).  The fear that Heakal described is that “competition could virtually disappear as large companies begin to integrate and the monopolies created focus on making (or from a buyer perspective saving) a buck.”  An October 2002 U.S. report (A Strategy for Increasing Federal Contracting Opportunities for Small Business) by the Executive Office of the President raised serious concerns regarding the negative impact contract bundling within the public sector was having on the SME community.  This included concerns pertaining to the retardation of the innovation process which many believe is indigenous to and therefore a key tenet of a strong SME (cluster) base.

The emphasis here is that “best value” purchasing and resultant savings can be achieved through a variety of means the most important of which is linked to a strong domestic SME sector.

With a sound strategy for identifying or developing and engaging industry specific clusters (of which SME’s are an integral component) domestically, governments will position these same organizational bodies to compete and succeed on a global basis. Therefore it is incumbent upon government organizations to evaluate all areas of spend from this combined strategic vantage point and where possible leverage (or develop if absent) cluster core competencies.

The Question of Governance in the Value Chain 

According to Humphrey and Schmitz (2002), “value chain research focuses on the nature of the relationships between the various actors involved in the chain, and on their implications for development.”  In this regard, they emphasize that governance is an essential element of a value chain in that coordination is required “to take decisions not only on ‘what’ should be, or ‘how’ something should be produced but sometimes also ‘when,’ and ‘how much’ and even at ‘what’ price.”  (Note: the same questions that apply to production can also apply to purchasing decisions.)

While coordination may occur “through arm’s-length market relations or non-market relationships,” it is the latter that applies best to government procurement practices.  In the area of non-market relationships, Humphrey and Schmitz identified “three possible types of governance; a) network implying cooperation between firms of more or less equal power which share their competencies within the chain; b) quasi-hierarchy involving relationships between legally independent firms in which one is subordinate to the other, with a leader in the chain defining the rules to which the rest of the actors have to comply and c) hierarchy when a firm is owned by an external firm.”

From a domestic public sector procurement standpoint, and only if the more traditional government hierarchy mindset can reconcile itself with an implied “equality of power,” the network mechanism makes the most sense.

An example of where this governance structure has succeeded is in the previously referenced China software industry where according to van Dijk and Wang, “software companies express what they expect from the government and local government, eager to promote the sector, is very willing to act upon their suggestions.”  This high level of collaborative interaction is demonstrated in areas such as when local authorities “push relations with universities and local research and development institutes.”  According to the authors this represents a “pattern of governance” that is commensurate with a “network type” structure.

Given the importance of being able to participate and compete in the emerging global economy countries such as Canada and the United States will undoubtedly take note of the attitudes and actions of China as well as other players (re European Association of Development Research and Training Institutes) on the world stage.  If they do they will likely reach similar conclusions being that the development and utilization of indigenous or domestic clusters (which are largely comprised of SME’s) is a key tenet of building success on a global basis.  According to a study referenced in the book Clusters Facing Competition: The Importance of External Linkages, by focusing on this “interaction between internal clusters and external linkages,” governments will be able to determine “how these interactions will help SME’s to face increasing global competition.”  One of the most effective ways to gain this understanding is through direct participation as a buying stakeholder.

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