Just read an article about China’s shallow integration suggested by Harsh[i]. Very incisive that I have to share a couple of main points here.

China’s industrial policy has been gradually shifting from low-cost manufacturing to innovative products and services, and several so-called pillar industries are proposed recently. We’ll see why this is happening and why this might not be enough.

By facilitating the management and transmission of vast amounts of information, digitization has allowed the codification of highly sophisticated manufacturing processes. Once codified, processes can be split into discrete steps—modules, in effect—and standards to ensure their connectivity can be established. Modularization, in turn, has permitted activities that once had to be co-located geographically and managed organizationally within the confines of a single firm to be spread out across great geographic and organizational expanses.

We can also see that as different firms occupy different parts of the supply chain—whether in high-tech industries or low, capital intensive or nonintensive— some of those firms will occupy high-value activities for which knowledge is embedded and sustainable competitive advantage is possible, while other firms will not, instead relegated to standardized activities for which competition is intense, churning significant, and returns decidedly low. Therefore, across a range of enterprises, we may witness extensive participation in supply chains, but some types of participation can be characterized as deep and integral, while others may be quite commodified and shallow. Fully modularized, open-production architectures virtually by definition entail the manufacturing of standardized, nondifferentiated products. Firms focusing on such activities have little choice but to compete on the basis of low-cost and high-volume.

Several options exist. The modularized producer can attempt to control the supply chain by actively setting rather than passively accepting rules of connectivity in the upstream and downstream directions. Alternatively, the producer might elect to shift away from modularization, and instead move back toward more integral processes, ones that must be coordinated and co-designed with upstream and downstream partners in the network. Finally, as is done by many leading global players, the firm may compete by providing key services— overall product definition, branding, and marketing— that shape the entire supply chain and command the bulk of final product’s value.

Chinese producers in a general sense have to date proven unable to exercise any of these options. It is in that sense that their integration into supply chains is extensive, but shallow. Within the overall process architecture of manufacturing, their activities tend to be those that are most easily duplicable and substitutable across firms—in essence, the activities least contingent upon firm-specific skills, knowledge, and know-how. Because the specialization associated with modularization has led to a blurring of boundaries between industries and growing interaction across them, it now may make more sense to think of matrices and webs of specialized activities rather than discrete, stand-alone industrial sectors. Among other things, such organizational change leads to the phenomenon of modularized innovation and ripple effects of such innovation across formerly unrelated industries.

This therefore underscores the risks entailed in forcing the vertical integration of industries. From a product architecture perspective, it may be impossible to determine the exact boundaries of a given industry. Yet, Chinese industrial policy, by selecting ‘‘pillar’’ industries does precisely this in an artificial sense. It operates under the idea that a country can, from upstream to down, ‘‘build’’ a steel or auto or aerospace sector. Similarly, for various institutional reasons, individual Chinese companies may themselves elect to vertically integrate their activities.

In effect, they push together within a given organizational boundary activities that could just as easily stand alone from one another. In so doing, as such activities are held captive within single ‘‘industry’’ supply chains, policy makers and corporate strategists limit the extent to which modular innovation and cross-fertilization can occur. It is not surprising, therefore, that China perceives itself, probably correctly, as lagging behind India, let alone developed countries, in industries such as software. Similarly, it is not surprising that China lags in high-end semiconductor design capabilities.