The Role of Comparative Advantage in Global Supply Chains: Lessons from Semiconductor Production

In our analysis of Global Trade in the Age of Deglobalization we saw how the Theory of Comparative Advantage promotes trade. Trade helps all countries, large and small, even those with few apparent natural resources. It also explains why countries that can easily produce particular commodities are often better off if they shift resources to something else instead. This has become particularly apparent in semiconductor production in recent years, although political pushback is having a major impact on this industry.

Absolute Advantage vs. Comparative Advantage?

If you look at trade possibilities between two countries, across the full range of possible goods and services, you will find that one country can usually produce some items more easily and cheaper than the other, and conversely the other nation is likely to some items where it has the advantage.

The Theory of Absolute Advantage is simple – a country has absolute advantage in the production of a good if it can produce a greater quantity using the same quantity of resources than the other country can achieve. According to the theory, countries should produce and trade items in which they have absolute advantage, while importing those items where other countries have absolute advantage.

The problem with absolute advantage is that it is very simplistic. The theory assumes that there are just two countries trading two commodities. It also assumes that there both countries have homogeneous resources and ignores practicalities like transport costs and exchange rates. It also makes no allowance for different sized economies, or the possibility of trade if one country has absolute advantage in both commodities.

The Theory of Comparative Advantage, however, takes a more nuanced view. It focuses more on opportunity cost, i.e. a nation’s ability to produce particular goods or services at a lower opportunity cost than its trading partners. Under the theory of comparative advantage, there will usually be benefit from trade between countries, even if one country has an absolute advantage in everything. In that case, when comparing two countries, the more efficient country will benefit on focusing on producing and trading those products in which it has the comparative advantage, leaving the other products to the other country.

Comparative Advantage and Global Supply Chains

When countries can trade based on comparative advantage, they are able to specialize their production, allowing them to maximise output and reduce costs. They can use their scare resources most wisely, focusing on their strengths.

For example, the United States has clear strengths in technology and innovation. They have attracted many of the nation’s greatest tech brains to Silicon Valley, and have created world-class software and AI, designing many internationally recognised technological products. The US doesn’t physically make all their companies’ tech products locally, however, as other nations have proven themselves more efficient on the production side.

China and many other Southeast Asian nations have become major players as technology production hubs. They can make many of the products that US companies have planned and designed for a fraction of the cost of producing them within the USA. Vietnam leverages its competitive labour market. Singapore has built world-class infrastructure and has strong government support for R&D. Malaysia has carved out a niche in fintech and cybersecurity. Taiwan and South Korea have demonstrated that they have the workforce and capital to manufacture intricate miniaturised tech products, like semiconductors.

In the era of relatively free trade (the 1990s to the early 2020s), countries found a position on the global supply chain, specializing in those goods and services where they held a comparative advantage.

Lessons from Semiconductor Production

Traditionally, the US claimed dominance in semiconductor production – after all, most of the big-name tech companies originate from Silicon Valley. However, fortunes have changed over the last decade, with many Southeast Asian countries increasing their investment in this area. This should be no surprise, considering how many technological devices are built in Asia.

If examine comparative advantage in semiconductor production, however, we need to look more closely at the production process. There are three distinct phases to semiconductor production:

1.       Design

2.       Manufacturing

3.       Assembly

The US has a clear comparative advantage in the Design phase. Its engineers and technology specialists can map out electronic circuit patterns to continually improve speed, functionality, and other factors, all at an increasingly smaller form. The US also has a robust patent system with talented lawyers, ensuring that it can keep control of its designs (for a while at least).

When it comes to the Manufacturing and Assembly phase, however, things are less clear-cut. Manufacturing semiconductor wafers is a complex process. You need a clear knowledge of semiconductor design to avoid making costly mistakes. As a result of this, Semiconductors Fabrication Plants (FAB) are incredibly sophisticated places. While the USA has a comparative advantage over many countries with this, the US semiconductor companies have increasingly outsourced their manufacturing processes to countries like South Korea and Taiwan (the Taiwan Semiconductor Manufacturing Company (TSMC) produces 50 percent of the world’s semiconductors). These countries have a comparative advantage over the US at the Manufacturing stage.

Semiconductor assembly, which includes testing and packaging, is the final stage of the semiconductor process and requires fewer complex skills or capital. The US has little comparative advantage in this stage compared to many Southeast Asian countries, and unsurprisingly, US tech companies outsourced much of this work overseas.

Realities of Trade Policies and Geopolitical Factors

Recent political developments, however, have seen the large US semiconductor companies recall much of their outsourced manufacturing and assembly processes back to the USA, regardless of where the comparative advantage lies.

In 2022, the US Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act committed $39 billion in incentives for semiconductor manufacturing, plus a separate advanced manufacturing investment tax credit. By 2024, seventy FABs were under construction in Arizona and Texas, ensuring that the nation kept greater control over all stages of the semiconductor production process.

The current protectionist political sentiment in the US under President Trump, adds an incentive for companies like Qualcomm, Nvidia, Broadcom, and Advanced Micro Designs (AMD) to return semiconductor production stateside.