We are now coming out of the global financial crisis.  But it is a slow recovery, and unemployment is still rising.  There are great temptations for governments to resort to protectionism.

But it would be a folly.  International trade has brought so many benefits, even more than we could ever estimate.  And protectionism provokes retaliation and a race to the bottom. Nobody wins.

So let’s review why countries trade, and what are the benefits, based on the WTO’s excellent 2008 World Trade Report.

Comparative advantage

The benefits of free trade were first identified by David Ricardo and others almost 200 years ago.  When two countries are different in terms of productivity, there will always be gains from trade.  Even where one country is better producing everything (has an absolute advantage), each one will have a comparative advantage in producing something.  These differences between countries can be due to differences in technology or labour costs.

This is just like the case of me and my maid.  I am better than her at both writing globalization and ironing shirts.  But it makes sense for me to specialize in my writing, and for her to specialize in ironing my shirts.

Another variant of the theory of comparative advantage is given by the Heckscher-Ohlin model which argues that international trade is driven by differences between countries’ relative factor endowments.  One country may be relatively well endowed with capital or skilled labour.  That's why the US does and should specialize in building planes, designing computers and making Hollywood films.

Another country may be relatively well endowed in lower skilled labour.  That's why China does and should specialize in assembling computers, and making toys, clothing etc.  Another country might be relatively well endowed in natural resources.  That's why Australia does and should specialize in exporting coal and iron ore, and Saudi Arabia in crude oil.

Where there are productivity differences between countries, every country will have a comparative advantage in something.  When a country opens up to international trade, the country gains as a whole, but there will always be some winners and losers.  But some of the benefits of the winners can be distributed to the losers.

Bytheway, no one of the theories of international trade that we are going to review can explain all trade.  But that are all capable of providing insights.

When economists analyse international trade, they usually compare a situation where there is no trade, with a situation where there is open trade.  In practice, it is very difficult to test such theories.

But Japan provides a good case study.  In the 250 years until the Meiji Restoration in the 19th century, Japan was basically closed to international trade.  And then when Commodore Perry’s black ships arrived, it opened up to international trade.  In fact, Japan’s trading pattern after its opening up basically followed the law of comparative advantage as it exported manufacturing products and imported lots of natural resources.  Further, it is estimated that Japan’s real income grew substantially thanks to this.

As the Economist magazine recently highlighted, Japan’s strengths and comparative advantage comes from its culture of monozukuri (making things) and kaizen (continuous improvement).  You only have to look at its historical excellence in fine ceramics and sword-making.  Today, you see this in companies like Toyota, but also a host of medium-sized firms that dominate specialised manufacturing markets.  For example, Shimano earns around $1.5 billion a year by supplying 60-70% of the world’s bicycle gears and brakes.  Around 75% of motors for hard-disk drives in computers come from a firm called Nidec.  And 90% of the micro-motors used to adjust the rear-view mirror in every car are made by Mabuchi.

Fragmentation of production and trade and comparative advantage

The most important development in world trade in the past few decades has been the acceleration of the fragmentation of production of both goods and services and the associated development of foreign outsourcing and offshoring.  Revolutionary advances in transportation, communications technology and trade liberalization have enabled an historic break-up of the production process by making it increasingly viable and profitable for firms to undertake different production stages in disparate locations.  This has resulted in rapidly growing trade in intermediate products or tasks.  This phenomenon has variously been called fragmentation, unbundling, offshoring, vertical specialization, slicing-up of the value-added chain or trade in tasks.

Each country’s role in this supply chain depends on its comparative advantage.  In East Asia, where supply chains are perhaps the most developed, China’s role is very often that of the final assembly of the product.  Other countries undertake the product design, component manufacture and marketing.  This fragmentation of production has resulted in growing trade in intermediate products and services.

Let’s take the example of the iPod produced by Apple which is assembled in China, and was discussed very recently by WTO Director-General Pascal Lamy.  Although the iPod has an export value of $150 per unit in Chinese trade statistics, the value added attributable to processing in China is only $4!  The remaining value added comes from the United States, Japan, and other Asian countries which specialize in one part of the supply chain according to their comparative advantage.

If you look at the final products exported by China, you can get a false impression of its comparative advantage.  It does not have a comparative advantage in producing iPods, but only in their final assembly.  In fact, China’s position as the world’s leading exporter is exaggerated, as the Chinese value added in its total exports is very low, because of its comparative advantage in product assembly.  This is in sharp contrast to other nations.  In 2008 the domestic content comprised 80% of the value of the goods exported by the US, 77% in the case of Japan, 56% for Korea and 42% for Malaysia and Chinese Taipei (bytheway, this means that using conventional trade statistics would overestimate the US bilateral deficit vis-à-vis China by up to 50 %!).

Comparative advantage theory can even explain this fragmentation of production and international trade.  Developed countries specialize in the higher technology parts of the supply chain, while developing countries specialize in the labour intensive parts of the supply chain.

Intra-industry trade

Economists who studied comparative advantage were once puzzled by the trade between advanced European countries, like France and Germany, because the countries were not very different in terms of technology or resources.  Much of their trade is “intra-industry” trade.  For example, Germany exports Mercedes and BMW cars, but imports Peugeots and Renaults.

The basis of this trade is that it enables consumers to have access to a broader variety of goods at lower prices, and enables producers to achieve economies of scale in production through having access to a larger market.  When the overall level of output rises, the fixed costs get distributed over a larger number of units, and, hence, the firm’s average costs of production decline.  The reason why, at the extreme, there is not only one firm producing a single type of product is that consumers prefer to choose from different varieties for each product they buy rather than buy the same one each time, i.e. they have a “love of variety”.  Taking the example of food, this means that consumers prefer a selection of different restaurants over one pizza restaurant.

Over half of Germany’s trade with a number of European countries is of the “narrowly” defined intra-industry type. With developing countries, a large part of Germany’s trade is based on comparative advantage.  Countries share more intra-industry trade with each other the more similar they are in terms of economic size.  Theories of comparative advantage remain valid for certain sectors and trading partners, where country differences in technology and resources continue to play a role.

Enterprises matter!

Do firm or enterprise characteristics affect trade?  Until recently, trade literature has not focused much attention on the role of firms in international trade.  Mainly for simplification purposes, trade theorists typically used the concept of a representative firm, assuming that all firms in a given industry are identical.

The evidence shows firm or enterprise characteristics do indeed matter.  In reality, most firms, even in traded-goods sectors, do not export at all.  Of those firms that export, only a few export a large fraction of their production.  At the same time, at least some firms export in every industry, with the share of exporting firms being a function of the industry’s comparative advantage.

Most importantly, firms that export are different from non-exporters in a number of ways.  They are bigger, more productive, pay higher wages and are more capital and skilled labor intensive than non-exporters.  Further, trade liberalization raises industry productivity.

Firms that import are more likely to export than non-importing firms, and firms that export are more likely to import than non-exporting firms.  When entry into new export markets is costly, exposure to trade offers new profit opportunities only to the more productive firms that can afford to cover the entry cost.

Comparative advantage cannot explain why some firms export but many do not.

Innovation and dynamic gains from trade

Trade can provide many dynamic benefits by provide incentives for firms to innovate.

As trade increases the size of the market, it is easier to undertake R&D as these costs can be recoup over a bigger market.  Imports embody technology and knowledge travels with the exchange of commodities and inputs.  Trade enlarges the scope of knowledge spillovers.  Trade can enhance competition in the local market.  These dynamic benefits are particularly important for developing countries because most innovations take place in a small number of advanced economies and are later transferred to the rest of the world.  Trade enriches the process of technology diffusion.

But knowledge does not only travel North-South.  As the Economist argues, one of the strengths of Japanese manufacturing is the quality of its customers.  Good customers impose strict standards, forcing suppliers to raise their game.  But it is more than that.  The components, tools and materials in which Japanese firms excel are highly customised.  And it is only by working closely with clients over many years that suppliers gain insight into their future technical plans and are trusted to learn about thorny problems that a clever supplier might solve.

Once firms become technology leaders, it is harder to unseat them.  All the more so, given that the knowledge about the technology is tacit, not formal. It cannot be transmitted by writing a manual or reading a patent application.

Conclusion

So President Obama, don't forget the many benefits of trade.  Don't give in to the temptation of protectionism.

References:

World Trade Report 2008: Trade in a Globalizing World

http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report08_e.pdf

Comparative advantage is dead, not at all says WTO Director General Pascal Lamy

http://www.wto.org/english/news_e/sppl_e/sppl152_e.htm

Japan's technology champions -- Invisible but indispensable

The Economist, 5 November, 2009

http://www.economist.com/displaystory.cfm?story_id=14793432