Strategies for Global Value Added: GainsComparative advantage

© Professor Daniel F. Spulber

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Midea: Leading Chinese appliance manufacturer

Every major manufacturer is producing air conditioners in China for customers there.

Many of the major manufacturers are exporting from their facilities in China.

These developments suggest that China has a comparative advantage in the production of air conditions and related appliances relative to its trading partners.

How does this fit into the overall pattern of exports and imports and the product mix?

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International product mix

• How do you explain the mix of traded goods?

• How do you explain the location of production in a particular country for a specific product or service?

• How do you explain the types of goods that are imported to a particular country?

• What products should the international business provide?

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A key task of the manager of the international business is to identify gains from trade

• Coordinate serving and sourcing to maximize net gains from trade -- these decisions are connected!

• Identify supplier countries and the products that they can provide

• Identify customer countries and the products they need

• Profit by capturing some of the gains from trade

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Specialization and division of labor

Adam Smith 1723-1790The Wealth of Nations 1776

The division of labor generates “the greatest improvement in the productive powers of labor”

“the division of labor is limited by the extent of the market”

So, greater trade means more opportunities for greater productivity

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“This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.”

David Ricardo 1772-1823Principles of Political Economy and Taxation 1817

“To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth.

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Differences in productivity and technology: The theory of comparative advantage

• Absolute advantage of one industry over the same industry in another country is not the issue

• Comparative advantage means that there are returns to each country specializing in certain activities

• Even if a country is better at both producing clothing and computers than another country, it is still better for each to specialize a bit more in one or the other activity

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What to produce – computers or clothing?

• Comparative Advantage asks which country is relatively better at computers than clothing in comparison with the other country

• A country should focus more on computers than clothing if transferring resources at the margin from clothing to computers will yield greater returns than doing so in the other country

• Correspondingly, the other country should focus more on clothing (transferring some resources from computers to clothing)

• There are some costs of transferring resources and adjusting production

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Comparative advantage

Sweaters Bicycles

England 24 18

France 6 12

So, England would export sweaters to France and import

bicycles from France

England has a comparative advantage in sweaters and France

has a comparative advantage in bicycles

These are the productivities of one unit of labor in each

country

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Comparative advantage

Find the productivity ratios for each good

England compared to France for each good:

Sweaters 24/6 = 4

Bicycles: 18/12 = 3/2

The productivity ratio for sweaters is greater than for bicycles

• England compared to France is relatively more productive in sweaters than bicycles

• England has a comparative advantage in sweaters

• France has a comparative advantage in bicycles

Sweaters Bicycles

England 24 18

France 6 12

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Comparative advantage and gains from trade

• Suppose that England exports 54 sweaters and imports 72 bicycles

• For 72 bicycles, England can shift four units of labor to sweaters since 72/18 = 4

• Shifting 4 units of labor to sweaters produces 4 x 24 = 96 sweaters, therefore England’snet gain in sweaters: 96 - 54 = 42

Sweaters Bicycles

England 24 18

France 6 12

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Comparative advantage and gains from trade

• France imports 54 sweaters. France can shift 9 units of labor to bicycles because 54/6 = 9

• Then France can produce 108 more bicycles since 12 x 9 = 108

• France’s net gain in bicycles: 108 - 72 = 36

Sweaters Bicycles

England 24 18

France 6 12

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Each country has a labor force of 20Suppose that labor is evenly divided by sector.

Table showing total output and consumption

before trade takes place

Sweaters Bicycles

England 240 180

France 60 120

Totals 300 300

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Each country has a labor force of 20. -- Total output risesEngland shifts workers 4 from bicycles to sweatersFrance shifts 9 workers from sweaters to bicycles

Table showing total outputs -- total outputs increase

Sweaters Bicycles

England 14 x 24 = 336 6 x 18 = 108

France 1 x 6 = 6 19 x 12 = 228

Totals 342 336

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Table showing total consumption after trade

Sweaters Bicycles

England 336 - 54 = 282 108 + 72 = 180

France 6 + 54 = 60 228 - 72 = 156

Totals 342 336

Sweaters Bicycles

England 24 18

France 6 12

England gets to consume more sweaters and France gets to consume more bicycles

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Trade and the product mix

Productivity of a unit of labor in each country

for each good.

Good 1 Good 2 Good 3

Country A gA1 gA2 gA3

Country B gB1 gB2 gB3

Prod. ratios

gA1/ gB1 gA2/ gB2 gA3/ gB3

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Trade and the product mix

Production function: Zero profit condition:

QA1 = gA1 LA1 PA1 QA1 = WA LA1

PA1 = WA /gA1

Price of each good equals the unit cost of labor

This shows the tradeoff between the cost and productivity of labor

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Trade and the product mix

General rule: The low-price country exports and the high-price country imports.

Country A supplies the good if PA1 < PB1.

Recall that prices equal unit labor costs:

PA1 = WA /gA1 PB1 = WB/gB1

So, Country A supplies the good if lower unit costs:

WA /gA1 < WB/gB1

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Trade and the product mix

Country A supplies the good if

WA /gA1 < WB/gB1

which is the same as

WA / WB < gA1/gB1

Conclusion: Country with productivity ratio above wage ratio is the exporting country.

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Trade and the product mix

Example: Which country exports which good?

Good 1 Good 2 Good 3

Country A 10 45 28

Country B 5 9 7

Prod. ratios

2 5 4

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Trade and the product mix

Example: Which country exports which good?

Wages: WA = 18 WB = 6

Wage ratio: WA / WB = 3.

Productivity ratio greater than wage ratio:

Country A exports Good 2 and Good 3 to Country B.

Country A imports Good 1 from Country B.

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Trade and the product mix

X

WA/WB

X*

TECHNOLOGY CURVE: List the goods in decreasing order:

Country A supplies goods below X*

Country B supplies goods above X*

Country A Country B

gA/gB

gA/gB

Good 2

Good 3

Good 1

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Effect of wage changeson the product mix

X

WA/WB

X*

Relative wages increase Relatively higher wages in Country AShift in product mix

Country A Country B

W1A/W1

B

X1

gA/gB

gA/gB

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Trade and the product mix

Table showing prices based on unit costs of labor

Good 1 Good 2 Good 3

Country A 18/ 10 18/ 45 18/ 28

Country B 6/ 5 6/ 9 6/ 7

Helps explain inter-country price differences

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Managers should understand constant change in opportunities for sourcing and serving

0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1998 2001 2002

Year

$ pe

r Cap

ita

PHILIPPINES MALAYSIA

KOREA THAILAND

INDONESIA CHINA

Comparative advantage keeps changing: GDP per capitain some Asian countries

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Managers should try to recognize effects of changes in comparative advantagePopulation movements in China reflect shift from agriculture to industrial production

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Effect of technological changeon product mix

X

WA/WB

X*

Lower labor requirements in Country A cause shift in product mix – even assortment of products changes within in each country

Country A Country BX1

gA/gB

gA/gB

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Effect of costs of tradeon product mix

XX*Country Aexports

Country BexportsNontraded

X**

Country A produces goods from 0 to X**Country B’s produces goods above X*

gA/gB

WA*/WB

WA/WB*

gA/gB

Country B sees trade costs as if wages rise in Country A

Country A sees trade costs asif wages rise in Country B

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Effect of lowering costs of trade

• Increases specialization of countries – for given technology

• Reduces the range of nontraded goods

• Increases the range of traded goods

• Improves national incomes and increases total production

These effects define globalization!

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Summary and take-away points

• Managers should understand how gains from trade create value in international business

• The product mix is as much about demand patterns as it is about production patterns

• Managers should consider costs of trade in determining the product mix