Carlos Perea of Entrada Ventures in Albuquerque, New Mexico, is an engineer, a Stanford MBA, the former Manufacturing Manager at Intel’s largest semiconductor fabrication plant, helped develop operations in Israel and Ireland, and held the roles of CFO and President of high-technology startups.  Just don’t call him a venture capitalist.

Nevertheless, Carlos is a growth capital investor.  Along with his partner, John Gerhart, Carlos is in the midst of the first phase of a two-phased search fund.  Their goal is to acquire and add value to an established manufacturing business, in part by growing the acquired company in New Mexico—maybe even relocating the business to New Mexico.

It seems to me that Entrada’s investment premise is based upon three economic truths:

The profitability of a business is a function of its total cost of doing business, not the level of a given factor.  At the margin, taxes, labor costs, the cost of regulatory compliance, and the cost of real estate matter, but the financial success or failure of a business is predicated upon the company’s total cost of production over time.

Factor costs, by themselves, indicate nothing about competitiveness absent information regarding productivity.  As Martin Wolf, chief economics commentator for the Financial Times, put it, “Chinese labour is cheap because it is unproductive…If an American worker produces $81,000 dollars of value added annually, a German worker $80,000 and a British worker $55,000, while a Chinese worker produces only $2,900, it is not at all difficult for the workers of the high-income countries to compete, even if their wages are vastly higher [1].

Increasing returns—that is, reinforcing feedback—transportation costs, and communication and coordination costs affect the geography of production.

Allow me to elaborate upon the third point, particularly in regard to communication and coordination costs:

Consider two kinds of businesses.  The first category of business is very fluid and is characterized by novelty and uncertainty.  Tasks are highly interdependent and knowledge is, to a material degree, tacit.  New technology development and advanced financial services would fall into this camp.  The second category of business is more stable and familiar.  Tasks are modular and the interfaces between them are well defined.  Much knowledge is codified and readily transferable.  The mass production of automobiles would fall into this second classification, for example.  In the first case, communication and coordination costs are high and there are increasing returns to learning.  There is a premium on face-to-face communication and, hence, geographic proximity.  As Paul Krugman wrote (when he was still, primarily, a highly regarded economist), “Because of the costs of transacting across distance, the preferred locations for each individual producer are those where…the supply of inputs is particularly convenient…Thus concentrations of industries, once established, tend to be self-sustaining [2].”  Consequently, new technology development remains concentrated in Silicon Valley and Boston; Chicago continues to account for a large proportion of derivatives trading; and Hollywood is still the heart of the film industry.  On the other hand, the production of automobiles is a highly distributed affair.

This division is neither binomial nor static.  The authors of a recent journal article noted, “[T]here is ongoing transformation of complex and unfamiliar coordination tasks into routine activities that can be successfully accomplished at remote but cheaper locations [3].”  In other words, novel, creative, and innovative tasks tend to be done in very specific places characterized by unique accumulations of human, physical, social, and financial resources.  However, as the tasks become more familiar, routine, and codified over time, productivity becomes less sensitive to location, and the cost of doing business comes to the fore.  Not surprisingly, the greater the “commoditization” of a task, the greater the emphasis on the cost of doing business.  As a consequence, innovative tasks tend to originate in high-cost, but highly productive, urban areas and then spread to other regions.  That is exactly what happened with automobile manufacturing over the last 100 years, for example.

So, an examination of the manufacturing cost and productivity characteristics of New Mexico will tell us where it lies on the spectrum of high-cost/high-productivity (e.g., Silicon Valley) and low-cost/low productivity (China).  That, in turn, should offer us some insight into the conditions under which Entrada’s strategy is viable.

According to Forbes magazine, Albuquerque is the lowest cost city in the U.S. in which to do business.  Entrada provides further data that indicates that the total cost of business in New Mexico is 30% to 40% lower than in high cost states such as Massachusetts, California, and New Jersey.  So, the cost of doing business in New Mexico is low by the standards of advanced economies, but is still higher than in China.

What about manufacturing productivity in New Mexico?  Intel’s Albuquerque fab achieved best-in-world production costs on 200 mm silicon processing while Carlos was manufacturing manager there.  Impressive, though it’s possible that those particular results are due to highly productive physical capital unique to Intel.  On the other hand, my back-of-the-envelope calculation of manufacturing productivity [4] indicates that the value of manufacturing output per hour per employee in New Mexico was greater than the ratio in California in 2001.  However, that disparity might be attributable to industry mix.  Even so, the productivity of New Mexican manufacturing labor seems to be pretty high—probably much higher than in popular offshoring destinations.

A moderate cost of business and high manufacturing productivity probably puts New Mexico in the upper quartile of the aforementioned spectrum.  Although well-defined manufacturing processes, call center operations, and commodity programming tasks have been subject to the economic gravity of relatively place-independent labor productivity and low labor costs to the benefit of India, China, and Russia, I imagine that Entrada sees an intermediate opportunity.  In essence, I suspect that Carlos—the opportunistic entrepreneur—has seen that there is a category of manufacturing that is mature enough to move out of high cost regions, but is not so well developed as to be amenable to radical offshoring.  New Mexico does seem (at a distance, in any event) to offer an attractive “onshoring” alternative [5].

[1] Wolf, Martin. (2004) Why Globalization Works, New Haven: Yale University Press.

[2] Krugman, Paul (1993) Geography and Trade, Cambridge: The MIT Press.

[3] Storper, Michael and Anthony J. Venables (2004) Buzz: Face-to-face Contact and the Urban Economy, Journal of Economic Geography 4 pp. 351-370.

[4] Gross State Product in Manufacturing divided by Total Labor Hours in Manufacturing for 2001.  Sources: Bureau of Economic Analysis, Bureau of Labor Statistics.

[5] Other places in the US also benefit from a combination of high productivity and low costs.  See Boise’s Productivity Advantage, for example.