Home .International Trade Trade’s developmental magic
Trade’s developmental magic
Monday, 27 June 2011 11:05

Some people still question whether trade is a good thing for economic development.  In reality, today, trade is an even more potent instrument for economic development than it ever was. 


Most economists have always believed free trade is a good thing.  Free trade allows us to specialize in our comparative advantage, in order words, in what we are best at compared with other countries.  For example, countries with lots of cheap, low skilled labor (like many Asian countries) should specialize in low skilled manufacturing, like textiles, toys, and assembly of electronic products.  Countries with lots of natural resources (like many African and Latin American countries, and Australia and Canada) should specialize in natural resource industries.  And countries with lots of high technology and high skilled work forces (like Japan or France) should specialize in high tech production.


Historically, one of the big problems in economic development has occurred when countries with lots of cheap, low skilled labor want to develop high tech, heavy industry.  This was the case in Latin America, Africa, India and China (before China’s opening up in 1978).  Because these countries could not produce heavy industrial products efficiently, governments had to resort to protectionism which stifled development.


Specializing in your comparative advantage means that you are doing what you are best at.  It also means that you can reap economies of scale.  When you produce for export markets as well as domestic markets, you increase the scale of your production.  Opening up domestic markets to imports also increases competition which improves economic efficiency.


One problem, though, when you open up to trade, and specialize in what your best at, many other traditional industries might be wiped out.  Open trade provokes structural change.  You just have to adjust.


Back when international trade theory was first developed.  Factories in each country typically produced the totality of a product.  Toyota or Renault produced all of its automobiles.  Panasonic produced all of its televisions.


But trade and production have changed.  They have been fragmented, been sliced up.  Companies, indeed countries, now specialize in “tasks” like product design, component manufacture, assembly and marketing.


Professor Richard Baldwin has referred to this as the second unbundling, the unbundling of factories.  This started in the mid-1980s thanks to rapidly falling transport, communication and co-ordination costs.  Whole production cycles or supply chains, which were previously bundled together in one enterprise were broken up or unbundled.  The value chain was fragmented or sliced up.  Product design, component manufacture, assembly and marketing are now increasingly handled by different enterprises, often in different countries – and no longer under one roof at one enterprise which used to be black-box bundles of tasks.  Traditional international trade theory which was centered on finished goods, now has to think in terms of tasks.


In addition, traditional international trade theory looks at international trade in isolation.  But today, much trade takes place in the context of foreign direct investment.  Nearly 60% of China’s exports come from foreign investment operations.  It is noteworthy that no Chinese brand made it into the top 100 of Asian brands in a recent survey by Campaign Magazine.  White goods and electronics maker Haier was the highest Chinese brand at 102.  Japanese and Korean consumer electronics brands occupied the top five slots with Sony trailed by Panasonic, LG, Samsung and Canon.  


International trade has a special significance for developing countries.  The challenge for developing countries is to climb the development ladder, the technological ladder.  International trade can help do this in several ways: by producing goods for international markets, they are required to meet the high production standards of international markets; when FDI operations are installed in a developing country, local workers and suppliers can gain access to technologies and learn international product standards; and imports of machinery and technology can also give access to technology and knowledge.  So not only does international trade allow you to do what you do best, it allows you to climb the development ladder.


Does this new pattern of international trade in tasks make it easier or harder for developing countries?  In fact, this new pattern of trade in tasks makes it easier to develop than ever before.  You only have to be good at one thing, one task to be able to participate in global supply chains.  For example, not so long ago, the Chinese village Qiaotou, used to be nothing, now produces two-thirds of the world’s buttons.  Tomorrow, it might produce zippers.


Another more powerful example is the case of the iPhone.  China appears to be a technologically advanced industrial giant because it exports iPhones all around the world.  According to a recent ADBI paper, this is not the case.  China merely assembles the iPhone from components imported from other countries.  Its comparative advantage is in product assembly, not the complex manufacture of the whole product.  Out of the total cost of $178.96, China’s value added is a mere $6.50.  The high tech components are made by Japan’s Toshiba and Murata, Korea’s Samsung, Germany’s Infineon and Dialog Semiconductor, and America’s Broadcom and Numonyx and Cirrus Logic.  And when all these components are brought together in China, they are assembled by Chinese workers in the factory owned by the Taiwanese company Foxconn.   


This unbundling started between the US and Mexico through the Maquiladora program with emergence of ‘twin plants’, one on the US side of the border and one on the Mexican side.  The next phase was the launching of a system of production networks in East Asia after the 1985 Plaza Accord which resulted in a dramatic rise in the value of the yen. 


After the Plaza Accord, Japanese multinational enterprises offshored labour-intensive production tasks to nearby East Asian nations.  Distances were short compared with wage differences.  It started with triangular trade as Japanese firms produced hi-tech parts and then shipped them to factories in East Asia for labor intensive stages of production and assembly, and then shipped them back to Western markets or Japan.  By the late 1980s, wages and exchange rates in Korea and Taiwan had skyrocketed, and their locational advantage for assembling labor-intensive products disappeared. 


So, Japanese companies firms transferred production to South East Asian countries.  These companies provided South Asian firms with detailed engineering and managerial instructions and specifications, facilitating the assimilation of the new technologies.  A virtuous circle of learning and growth developed.  When China joined the WTO in 2001, there was a surge in inward FDI and parts and components from other East Asian countries.  China quickly became the final assembly point of intricate production and distribution networks.  It imported parts and components and exported the final assembled products throughout the world.  The iPhone is just one case in point.


What role can government play in helping maximize the developmental benefits of this new form of fragmented trade?


As Justin Lin argues clearly in his new structural economics, economic development is a dynamic process along a wide spectrum from a low-income, subsistence agrarian economy to a high-income industrialized economy.  It requires continuous structural change, upgrading and diversification.  The market is the most effective mechanism for allocating resources.  But the market needs to be complemented by an active role by government in providing both hard and soft infrastructure. 


In this context, government policy can play a very important role.  First, we need markets to be open to international trade and investment.  Second, physical infrastructure, like roads, ports, airports etc are necessary, as is soft infrastructure like a stable and clean policy environment.  Third, to maximize the learning experience from trade and investment, workers should be well educated.  Especially important for assimilating new technologies is the quality of local engineers.  Efforts should be made to minimize the barriers to the development of local entrepreneurs.


Lastly, breaking up the supply chain enables each part of the production process to take place in the most efficient location.  Firms decide to fragment production when the production saving arising from fragmentation exceeds the cost of linking geographically separated production blocks (the service link cost).  The service link cost varies across two dimensions.  The first is geographical distance and includes transport costs, telecommunication costs, and intra-firm coordination costs.  The second is managerial controllability and includes the costs of imperfect information, lack of credibility and loss of stable contracts.


There are several ways to lower service link costs including strengthening physical infrastructure (highways, ports, airports, and information technology infrastructure) and market-supportive infrastructure like enforcement of the legal system, information on vendors, corporate governance and intellectual property rights protection).  One interesting example is the production network for notebook PCs centered in China’s Yangtze River Delta.  Taiwan’s government deregulated FDI for notebook PC companies wishing to invest in China.  Then the Chinese government established a superb network of modern highways, ports and airports in the area, which induced many firms to locate in the area.  The resulting agglomeration resulted in economies of scale.  Service link costs fell because the large number of firms in close proximity made it easier for firms to procure parts and components and to handle frequent specification changes.




Thorbecke, Willem, and Nimesh Salike, Understanding Foreign Direct Investment in East Asia. 


Xing, Yuqing and Neal Detert, How the iPhone Widens the United States Trade Deficit with the People's Republic of China


New Structural Economics and Development


Camapaign Magazine




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