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2006 Annual Report—Federal Reserve Bank of DallasThe Best of All Worlds
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Exhibit 5. Global Competition Lowers InflationMore Sellers…World imports relative to consumption have doubled over the past four decades, making more of what consumers buy subject to the broadening competition inherent in international trade.
…Means Tamer PricesWhere markets become more open, the added competition tends to hold down the cost of goods and services.
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Competition forces us to become more and more productive—if necessary, by going back to the drawing board in search of better ways to deliver goods and services at lower prices. This simple dynamic, working on a global scale, lies behind many U.S. companies' oft-heard lament: We have no pricing power.
What confounds sellers often benefits buyers. In the past decade, U.S. prices fell for TV sets, toys, dishes, clothing and many other products facing significant import competition. Prices rose for many products untouched by globalization—cable TV, hospital services, sports tickets, rent, car repair and others. From 1987 to 2003, faster-growing import-to-production ratios wrung inflationary pressures from domestic producer prices in a large range of industries. (See Exhibit 5.) The gains from global markets aren't limited to goods traded internationally. They extend to such nontraded goods as houses, which contain carpeting, wiring and other inputs now facing greater international competition.
Industrial Age globalization largely involved goods, which were usually heavy, bulky and expensive to move from one place to another. The creation of worldwide markets for food, energy, metals, vehicles, electronics, textiles and other products raised living standards around the world by increasing output, lowering costs, boosting incomes and spurring economic progress.
Raw materials and manufactured products still make up the bulk of today's trade, with merchandise exports at record highs.
The globalization of goods has meant more competition for U.S. manufacturers. They've been forced to close plants and trim payrolls, of course, but they've also become more productive. Since 1990, real factory output per U.S. worker has risen from $52,000 to $108,000.
While Industrial Age globalization increased competition among goods producers, service providers largely remained insulated in their home markets. Transportation costs fell, but Industrial Age communications remained expensive, limiting trade in services and keeping their prices high.
Services have become by far the largest part of modern economies' production—77 percent in the U.S. and 66 percent in the rest of the world. The Knowledge Economy's rapid, cheap communications have sparked a new round of globalization, this one increasing competition for services as well as goods.
The ratio of services to goods in U.S. exports now stands at 44 percent, up from about 25 percent a quarter century ago. (See Exhibit 6.) Growth in services trade has been slower for the world as a whole, climbing from 21 percent to 25 percent of goods exports since 1975. The numbers suggest the United States is ahead of other nations in shifting output from goods-producing industries to services. In coming years, other countries will likely follow the U.S. lead in increasing services trade.
Exhibit 6. At Your ServiceSector Climbs as Share of ExportsThe Knowledge Economy, with its freer flow of information, creates new competition as it expands international trade in services. In the past two decades, exports of services have risen faster than goods, particularly in the United States.
Industry Trade Patterns ShiftFrom 1992 to 2005, U.S. exports rose by at least 10 percent a year in 11 industries. Imports have increased that much in only five industries.
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While total U.S. services exports rose a bit faster than goods from 1992 to 2005, many individual sectors have been moving faster in penetrating overseas markets. Eleven categories posted increases of better than 10 percent a year—among them, computer and information services; film and television rentals; research and testing; accounting, auditing and bookkeeping; finance; and education. Just five import categories, however, showed gains of at least 10 percent a year—industrial engineering, finance, operational leasing, insurance, and sports and performing arts. (See Exhibit 6.)
Overall, the U.S. runs a surplus in services trade—a reflection of its prowess in many of the Knowledge Economy's high-value-added sectors.
Resource endowments and talents often lead nations to concentrate on one industry segment or another. Sometimes, though, countries appear to be selling each other the same things.
Computer and information services, for example, led U.S. export growth at 22 percent a year from 1992 to 2005, but the sector's import growth was strong, too, at 10 percent. Nations may indeed exchange similar services, but further analysis reveals trade patterns based on comparative advantage. In computer services, the U.S. exports the highly valued knowledge of researchers, systems architects and designers. It imports the services of basic programmers—the foot soldiers in the information economy.
In the Knowledge Economy, service companies and workers are learning what goods producers have long known: Globalization creates opportunities but also causes hardships. Some firms will prosper; others will go out of business. Inevitably, workers will lose their jobs and face the challenge of finding new ones. Global markets may make more of us vulnerable in terms of job security, but we all benefit because worldwide competition brings lower prices—for consumer goods, for producers' inputs and, now more than ever, for services.
The crosscurrents in services trade show that global markets expand the scope for specialization. We do what we do best and trade for the rest. For an economy as a whole, specialization leads to productivity gains beyond what firms can achieve at the microeconomic level through new technologies and investments in plants and equipment. Indeed, one of globalization's greatest benefits lies in its incentives to reorganize economic activity and reallocate global resources to yield greater output.
Even when communications costs were high, globalization created opportunities for vertical integration in manufacturing, with an international division of labor based on natural resources and other inputs. A textbook example, popularized by Milton Friedman, is the ordinary wooden pencil—made with cedar from Oregon, graphite from Ceylon, brass from U.S. smelters and eraser components from Indonesia.
Today's world shifts the focus to human resources, forging a somewhat different division of labor. The U.S. and other wealthy, well-educated nations supply the world with goods and services steeped in knowledge. Highly skilled workers in these countries produce jet aircraft, pharmaceuticals, cutting-edge electronics and all sorts of high-value-added goods. At the same time, managers, lawyers, entertainers and other knowledge workers have more opportunities to apply their talents on a global scale. U.S. professors, for example, no longer teach students only on campus. With today's advanced communications, they can gather students in Europe, Asia and the Americas into virtual classrooms.
The all-American Barbie doll illustrates how a globalized economy comes together to lower costs. A 1990s study reported that the dolls were made with plastic from Taiwan, nylon hair from Japan and cloth from China, with final assembly in Indonesia and Malaysia. Design, marketing and distribution—the high-value-added service components of the production process—took place in the United States. Including profit, 80 percent of Barbie's selling price stayed in the U.S.
In addition to manufacturing, developing nations are finding niches in service industries. India's doctors perform hip replacements and other surgical procedures at lower prices than U.S. hospitals. Outsourcing of business services has grown rapidly, with companies in wealthy nations pursuing service-sector vertical integration by shipping call centers, data processing and other routine tasks to workers in India, the Philippines and other emerging economies.
The telephone wouldn't have been worth much had Alexander Graham Bell lived on an island of a dozen people, all within shouting distance. It takes large numbers of customers separated by vast distances to make telephone services profitable.
For many goods and services, market size matters—a lot. In addition to their role in widening the search for inputs and human talents, larger markets provide added impetus for innovation, business formation and risk taking. Expanding the potential customer base also helps create viable markets for highly specialized products. Houston-based Encysive Pharmaceuticals, for example, is looking to a global market to make its new treatment for a rare lung condition pay off (see New Hope for Fighting Disease).
New Hope for Fighting DiseasePulmonary arterial hypertension, a rare disorder involving extremely high blood pressure in the lungs' smallest arteries, afflicts an estimated 100,000 people in the U.S.—a number too large to ignore but too small to entice most drug companies. Going global proved the way around this dilemma for Encysive Pharmaceuticals. By expanding the number of potential patients, the international market gave the Houston-based firm the critical mass it needed for Thelin, its brand name for sitaxentan sodium.
"If you are going to put in all the effort to build out an infrastructure, you really have to have enough patients to make it worth your while," says Encysive president and CEO Bruce Given. Pulmonary arterial hypertension is one of 5,000 so-called orphan diseases, those afflicting fewer than 200,000 people in the U.S. The larger market size inherent in globalization makes it far more likely that companies will embark upon the risky business of finding new treatments. "There are some orphan indications so small that to attain enough patients for regulatory filings, there is no other choice than to go global," Given says. Developing drugs is extremely expensive. For every 1,000 that are synthesized, 100 go to animal testing, 10 to clinical trials and only one makes it to the marketplace. Without enough patients, pharmaceutical companies can't justify the time and expense needed for research and the approval process. Encysive is currently selling Thelin in Europe and awaiting Food and Drug Administration approval in the U.S. Approval is also pending in Canada and Australia, and the company is casting its eyes toward Latin America and perhaps beyond.
"I don't care who you are," Given says. "If you are in the business of developing a drug, you are doing so for a worldwide market. Increasingly, this includes looking for patients in places like India and China, which was not often done in the past." Global markets will ease the way for future generations of orphan drugs. An increasingly integrated world economy may even become crucial to mainstream treatments. "As regulatory authorities continue to seek greater assurances that drugs are safe and effective prior to approving them, patient numbers in dossiers are generally increasing," Given says. "As such, even in larger indications, companies often find it necessary or advisable to go global to enroll enough patients in their trials to meet regulatory expectations in a reasonable period of time." |
Industrial Age tycoons built their fortunes largely from domestic sales. Among the 30 richest Americans in 1918: John D. Rockefeller in oil, Henry Ford in automobiles, J. P. Morgan in banking, Andrew Carnegie in steel, W. K. Vanderbilt and E. H. Harriman in railroads, and J. Ogden Armour and Louis F. Swift in meatpacking. Industrialists in Britain, Germany and other nations rose to supply oil, cars, banking, steel, transport and meat to their national markets.
Knowledge Age moguls are global entrepreneurs. Forbes' roster of the superrich is dominated by business leaders who amassed their fortunes with little regard for borders. America's Bill Gates built the world's largest software company. Sweden's Ingvar Kamprad sells Ikea furniture worldwide. India's Lakshmi Mittal produces steel in 16 countries on four continents. France's Bernard Arnault markets luxury goods all over the world under the Louis Vuitton, Fendi and Christian Dior labels.
Bigger markets may even make for better movies. More than half the 15 biggest-budget films in history failed to break even in the U.S. Hollywood supplements the domestic market with foreign sales, accounting for more than half of some movies' revenue. On a worldwide basis, the top 15 made it into the black, with the foreign take exceeding domestic box office for all but three films. (See Exhibit 7.)
Exhibit 7. Roll It—All Around the WorldU.S. sales for eight (in red) of the 15 biggest-budget movies weren't enough to cover the tab, yet all made handsome profits once the global till finished ringing.
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If the business weren't globalized, filmmakers might have had to curtail spending, perhaps by scaling down sets, doing less research, settling for cruder animation, or getting by with not-so-special effects. The bottom-line contribution from fans around the world allows filmmakers to make bigger-budget movies.
The U.S. economy is huge, accounting for a quarter of world output. But simple math suggests globalization quadruples the size of American entrepreneurs' playing field. The global market gives them—and their competitors around the world—history's largest customer base.
Industrial Age factories usually operated with high fixed and high variable costs. Production became cheaper as companies ramped up output—but only to a point. After that, churning out each unit became more expensive, and serving additional demand increased costs. Decreasing returns to scale eventually led to higher prices.
An information-based world differs from a material one in that more products have high fixed and low marginal costs—that is, they exhibit increasing returns to scale. Knowledge Age products often entail steep development costs because they incorporate large amounts of highly paid brainpower. Once production is up and running, though, the marginal cost of selling to additional consumers is relatively low over a long horizon.
Such products become cheaper when markets are large and global. Developing the typical drug, for example, requires years of research and testing by scientists, doctors and other expensive talent. Pharmaceutical companies then pay lawyers and lobbyists to navigate an arduous approval process. Add it all up and the average cost of bringing a new drug to market is $1 billion. Once in production, though, each pill costs mere pennies to make.
The economics explains why pharmaceuticals have become a highly globalized business. Overseas sales account for more than 40 percent of top U.S. drug firms' revenues, even though they have a huge home market. Companies in smaller countries derive an even higher portion of their sales from beyond their borders.
Installing cellular telephone infrastructure, like developing new drugs, is costly. Over the past two decades, wireless investment topped $200 billion in the U.S. alone—high fixed costs, to be sure. Increasing demand lowers cell phone prices because networks add customers at minimal expense, spreading the fixed costs over a vast number of consumers. Once a luxury only the rich could afford, service is now within reach of the masses. More than 2.7 billion cell phones are in use worldwide, far surpassing the number of wired connections.
Cell phones have become the dominant form of communication in many developing countries, allowing even Guatemalan shoeshine boys to get connected. Indeed, at every level of economic development, the cell phone industry's increasing returns make it easier for more people to afford phone service. (See Exhibit 8.)
Exhibit 8. A Cellular WorldWireless service has spread more rapidly than landline phones. Increasing returns to scale have rapidly reduced cell phone costs, allowing more users at all income levels to get connected.
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Landline phone service grew into a mammoth industry long before the microprocessor ushered in the era of cell phones. Electricity, wires and a modicum of electronics were enough to make "Mr. Watson, come here …!"—with all that ensued. Even the earliest cell phones, however, embodied far greater knowledge content—microchips to control the signal, filter out static, move callers from tower to tower and store numbers.
Despite all the technology, cell phones are cheaper than landlines because their chief component is the microchip, an input produced with very high fixed and very low marginal costs. Plunging prices for computer chips have made handsets more affordable. Texas Instruments Inc., for example, has developed a single microchip that performs all the necessary functions at a great savings in production costs, allowing newer models to sell for as little as $30 (see Cell Phones for the Masses).
Cell Phones for the Masses
The LoCosto chip handles the cell phone functions that once required three or four microprocessors. Yet it's powerful enough to enable mobile phones to play music and videos. "You need to have a performance-to-price ratio that people can afford," says Remi El-Ouazzane, a French citizen who's general manager of the TI business unit that markets LoCosto. Cell phones' cost barriers have been tumbling for decades. In the 1980s, the first models sold for more than $4,000, well beyond the means of all but the most affluent consumers. The LoCosto chip will be a critical component in phones selling in developing countries for $30 or less. Cheaper cell phones have emerged from a relentless drive to reduce the number and cost of components. The single-chip technology, developed in 2002 and used in Bluetooth, GPS devices, Wi-Fi and portable digital TVs, allows TI to reap higher effective yields from silicon wafers, the raw material for microprocessors. By cutting the number of microprocessors, the LoCosto chip reduces power consumption and the circuit board's size and cost.
TI won't divulge its costs, but El-Ouazzane acknowledges that developing new technologies requires a lot of research and development money, which can only be recouped over long production runs. "Economies of scale are required to sustain the R&D needed to develop revolutionary architecture," he says. Because it targets emerging markets, the LoCosto chip is by its very nature a global product, intended for mass production. TI sold 15 million units in the six months after LoCosto's launch in September 2006—the fastest start ever for a wireless product at TI, the No. 1 producer of chips for cell phones. Motorola, Nokia and China's original equipment manufacturers are among the dozen handset makers already buying LoCosto chips. "The emerging countries are becoming the fastest-growing markets in the world for all global companies," El-Ouazzane says. "The market for cell phones is untapped, whether it's in India, China or South America." Cell phones are pivotal for bridging the digital divide that separates rich and poor countries. In many emerging economies, a handset in the pocket or purse may be many citizens' primary means of accessing information, including the Internet. None of it would be possible without increasingly cheap microprocessors, made possible by the economies of scale wrought from global markets. |
Software, computers and the Internet also exhibit increasing returns to scale. So do many products whose principal components are microchips and software—digital cameras, DVD players, computer games, GPS devices and MP3 players. Increasing returns find their way into traditional industries, too. Agricultural research involves long and expensive scientific work on ways to increase crop yields and prevent plant diseases. The variable costs of new seeds are usually low.
Goods and services aren't alone in moving more readily across borders. As barriers to capital flows have fallen, investment money—the driving force for economic growth—has been freed to seek the highest returns anywhere around the globe.
It has done so with a vengeance. Since 1980, accumulated foreign investment in stocks and bonds has risen from 1.5 percent to 59 percent of world output. Direct investment in overseas companies has risen from 5.2 percent to 24 percent.
The money helps businesses start or expand operations, invest in new equipment, acquire state-of-the-art technology, and undertake research and development projects. The result: Output goes up; costs go down.
Rich countries still receive the bulk of cross-border investment, but new players are emerging. China has been among the leaders in receiving foreign plant and equipment investment in recent years. What's more, the country trailed only the United States in initial public offerings in 2005, with 15 percent of the world total.
Financial integration has given budding entrepreneurs in many countries access to cheaper capital. In effect, financial markets have been democratized, spreading the available investment money to an ever-widening population.
Monopolies bedeviled Indus��trial Age economies. Many of them owed their existence to the limits inherent in national markets—a single producer able to meet all demand, high costs that imposed barriers to entry or few alternative products. Without competitors to contest for consumers, producers had more power to reap extra profits by keeping prices high.
Globalization erodes market power. Natural monopolies that might rise in national economies—airlines, electricity or telephone service, for example—don't exist on a global scale.
The integration of world capital markets makes it more likely competitors will enter highly profitable markets. No financial hurdle is too high. A world awash in money can supply any amount of up-front investment needed to start new businesses and challenge monopolists.
While economies of scale in knowledge-based industries may encourage large producers, globalization has made markets more contestable by promoting freedom of entry and rival products. Simply put, there is no monopoly on ideas. Software developers can create alternative batches of code to program computers. Microchip designers can find new ways to increase the product's power.
The threat of new competition keeps prices low. Today's world economy, saturated with knowledge more readily shared across borders, will be quicker to bring alternative products to market, replacing monopolies with competition.
Knowledge can be found in all corners of the world—but it's not distributed equally. In the U.S., for example, more than 30 percent of those age 25 and over are college graduates—tops in the world by far. In an increasingly globalized world, knowledge produced in one country rarely stays there long. It readily flows to where it has value. (See Exhibit 9.)
On the MoveIn the past decade, more educated workers have crossed borders in search of opportunities.
Not long ago, many Chinese who studied overseas stayed there. But now a fast-growing economy is luring them home.
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Intellectual property deserves strong legal protection, but knowledge spillovers generate significant benefits. They come in two broad categories—those embodied in goods, services and capital moving from one country to another, and those that exist apart from trade and investment.
Often not industry-specific, disembodied knowledge can greatly expand countries' capacity to produce goods and services for world markets. U.S. professors W. Edwards Deming and J. M. Juran developed techniques for quality control that vastly improved manufacturing processes. After embracing their approach in the 1950s, Japan transformed its war-ravaged economy into a high-quality, low-cost manufacturing powerhouse. With Japan's success, the ideas gained currency in the United States and many other parts of the world.
A modern-day application of disembodied knowledge can be found in the Human Genome Project. Scientists unlocked the secrets of DNA in 2001, and already it has led to new treatments for disease. The genetic code has been posted on the Internet, making this deep reservoir of medical knowledge available to researchers around the world.
Disembodied knowledge goes well beyond scholarly and scientific work. It includes financial news, print and electronic media, analytical reports, databases and even gossip. This kind of knowledge moves between countries when people migrate or travel and when far-flung colleagues interact via the Internet, e-mail and cell phone. Students studying abroad are particularly important in diffusing knowledge. Today, they're doing so in record numbers, with the U.S. the top destination.
An interconnected world facilitates the transfer of disembodied knowledge across national boundaries. For example, an Internet search led BrassCraft, a valve manufacturer, to a company in a small European village, the only source of the specialized knowledge needed to automate its operations (see Finding Technology in Faraway Places).
Finding Technology in Faraway PlacesBehind every sink and toilet, you'll find a water ball stop—a valve to turn the water on and off. Traditional stops, dating to the 1940s, require eight or nine wrist-wrenching rotations. BrassCraft made this kind of stop but figured a nice market could be built for one that accomplished the task in a quick quarter turn. The company's Lancaster, Texas, plant produced traditional stops in two 10-hour shifts. A semiautomated process limited output per operator to 6,500 valves per shift.
"It was all about manual dexterity, and the operator would go on autopilot pretty quickly," says director of operations Jim Bevan. Using the same technology to produce quarter-turn valves would require too much handling to make operations profitable. So BrassCraft faced the same challenge as Henry Ford: How to mass produce in the U.S. with lower labor input. The obvious solution was a higher degree of automation, but the technology simply didn't exist. Or did it? Don Glover, engineering vice president at BrassCraft's Novi, Mich., headquarters, had heard of a European company that made equipment to produce quarter-turn gas valves. Gregg Koehn, director of manufacturing engineering, scoured the Internet, finding his mark in a small town he'd never even heard of. In January 2002, Bevan and Koehn took off on a quest key to their company's future. "What's impressive about the equipment we found is that they've forgotten more than anyone's ever known about this type of assembly," Bevan says. BrassCraft's goal was technology that could produce a ball stop valve every three seconds, with operators limited to troubleshooting. In the first meeting, working through translators, the equipment maker concluded that it could build machines to make one every 3.25 seconds. The European company vowed to find a way to squeeze out that quarter-second. Seeing similar equipment in motion sealed the deal. Bevan and Koehn observed a machine that turned out valves with grand efficiency, controlled by a single operator who only had to touch every 100th piece. Bevan had his nirvana moment. "It was just beautiful to someone with an engineering background," he says. "Every single principle I had learned was there in glorified form. The process was quiet and precise."
In its first four years, the machine has produced millions of valves. Productivity is up almost 700 percent—and not one valve has been returned as defective. Globalization facilitates the kind of knowledge spillovers that gave BrassCraft a big productivity boost. As ball stop valves keep coming off the machine, BrassCraft continues to reap the dividends of an integrated world economy. |
Knowledge workers have more mobility today than they did even a decade ago. (See Exhibit 9.) A headlong rush toward a market economy has made knowledge worth more in China. As a result, a growing number of Chinese students educated in the U.S. and elsewhere are returning home, taking with them knowledge they can use in their country's fast-moving economic development.
Embodied knowledge spillovers proliferated in the Industrial Age. Physical goods dominated world trade and long-distance communication was expensive. We still see a lot of these spillovers, but today's information-rich globalization creates far greater opportunities for transferring know-how not internalized in goods and services.
Most material goods are rivalrous. A shirt can be worn by only one person at a time. A meal can be eaten only once. However, billions of people log on to the Internet at the same time. One person's use doesn't inhibit use by someone else down the street or, for that matter, in the deserts of Mongolia. The Internet is nonrivalrous in consumption.
Newly added TV viewers don't reduce the consumption of those already tuned in. Oprah Winfrey's talk show broadcasts to 126 countries. She's not alone. A large and growing number of TV channels are reaching global audiences. MTV, for example, was seen in 496 million households in 2006. (See Exhibit 10.) As broadband Internet connections spread, all forms of audio and video will become truly global extensions of nonrivalrous consumption.
Exhibit 10. On the Air, EverywhereTelevision provides nonrivalrous consumption and faces few technological barriers to reaching a global audience.
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Many people consuming simultaneously can even make for a better product. The more households with phones, the greater value in owning one. A bonus from popular movies and TV shows lies in the added enjoyment of talking about them with other viewers. From e-mail to package delivery, networked services illustrate how nonrivalrous consumption adds value.
The Industrial Age was one of rivalrous goods. Supply was limited, and increases in demand tended to bid up prices. More of today's consumption is nonrivalrous, made possible by the technologies that disseminate information quickly and cheaply to large audiences. When it comes to knowledge products, supply isn't limited in the traditional sense. An increase in demand doesn't necessarily raise prices. In fact, it often lowers them.
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Choosing a color scheme to weave through the next few seasons had taken five months. A photospectrometer now scans colors digitally and shoots them around the world via the Internet, saving four weeks.
U.S. and European retailers are becoming multinationals that reap enormous efficiency gains from extending production functions backward into the supply chain and forward into the consumer market. They buy what's cheap in China, India, Vietnam and elsewhere, so they can sell for less in the United States. At the same time, major retailers like Wal-Mart Stores Inc., Home Depot Inc. and Starbucks Coffee Co. are crossing the Pacific, not only to source product but also to compete in China's burgeoning consumer market. They're also eyeing India, which just opened its retailing sector to foreign participation.
Going into Europe doubled the potential market to 200,000 patients, big enough to make Thelin a viable drug. Encysive markets Thelin directly in Europe and plans to do the same in the United States and Canada. Elsewhere, it will probably partner with a big pharmaceutical company, which will handle distribution and pay Encysive royalties.
The name says a lot: LoCosto. Texas Instruments Inc. picked that moniker for the industry's first single-microchip cell phone modem, designed for low-cost handsets aimed at customers in emerging economies.
Despite being key to low-priced phones, the LoCosto chip is anything but low tech. "We are using the most complex and advanced technology to address the needs of the less advanced parts of the world," El-Ouazzane says.
A custom-made machine arrived at the Lancaster factory right on schedule, in November 2002. Three European technicians spent three weeks installing it, sipping espresso on their breaks, thanks to a machine BrassCraft bought to help them feel at home.