CHAPTER 2 FUNDAMENTAL LITERATURE ON INTRA-INDUSTRY TRADE

Transcription

1 Unversty of Pretora etd Sche, M M (2005) 23 CHAPTER 2 FUNDAMENTAL LITERATURE ON INTRA-INDUSTRY TRADE Only two emprcal fndngs seem to have had a major mpact on the way that economsts thnk. The frst was Leontef s (1953). The second major emprcal fndng was the extensve amount of ntra-ndustry trade catalogued by Grubel and Lloyd (1975) of the mportance of ntra-ndustry trade Edward E. Leamer (1992:5) 2.1 INTRODUCTION Ths chapter hghlghts basc lterature on IIT wth specal reference to nternatonal trade n servces. The chapter surveys fundamental lterature that nforms the two research ssues: determnants and the consequences of South Afrca-US IIT n servces. The rest of the chapter s organsed as follows. Secton 2.2 provdes a bref descrpton of the unque characterstcs of servces and the lnk between these characterstcs and the dfferent modes of servces (mode 1, mode 2, mode 3 and mode 4). Sectons 2.3 through 2.6 address controversal ssues n the lterature on IIT hghlghted n Lloyd (2002) and Greenaway and Mlner (2003). Secton 2.3 addresses the specfc horzontal ntra-ndustry trade (HIIT) and vertcal ntrandustry trade (VIIT) models and mplcaton to IIT. Secton 2.4 deals wth lterature that attempt to ncorporate IIT nto the factor content of balanced trade. Specfcally, the secton analyses the standard Heckscher-Ohln Vanek (HOV) model as well as the modfed HOV model, wth an assessment of the usefulness of these models to servces.

2 Unversty of Pretora etd Sche, M M (2005) 24 Secton 2.5 deals wth aggregaton ssues at both theoretcal as well as emprcal levels. The key concern s how to map nternatonal trade statstcs of exports and mports on to ndustres defned n an economcally meanngful way. Ths entals an analyss of dfferent aggregaton approaches, relatve factor ntensty and ndustral organsaton defntons of an ndustry. Secton 2.6 presents dfferent measures of IIT wth partcular reference to statc measures. The dynamc measures are dealt wth n Chapter 6, where ssues of trade-nduced labour market adjustment costs are addressed. The chapter concludes wth a summary of the man nsghts that emerge from the survey. 2.2 THE NATURE OF SERVICES AND ITS IMPLICATIONS ON IIT The dstncton between goods and servces Hll (1977:315) notes the dstncton between goods and servces was emphaszed by Adam Smth and regarded as a matter of great mportance by classcal economsts. The neoclasscal economsts n the quest for nternal consstency of ther models argue that servces can smply be consdered as ntangble products (Hll, 1977:315). Hll (1977), Wong et al., (2001:1) and Lnders (2001:38-44) hghlght some characterstcs that are mportant when analysng servces. Frstly, servces are ntangble and transtory (non-storable or transportable). Ths emanates from the fact that a servce s absorbed as t s produced mplyng that t s ntangble and consequently non-storable. The fact that consumpton and producton of servces take place smultaneously calls for servce provders and consumers to be located near each other, ether physcally or through telecommuncatons networks. There are, however, some servces that can be emboded n a physcal object, lke a computer dskette and vdeotape (IMF, 1993). In ths case the non-separaton condton does not hold snce producton and consumpton can be separated.

3 Unversty of Pretora etd Sche, M M (2005) 25 The second characterstc s heterogenety and hgh flexblty of producton. The fact that servces are ntangble and non-storable ncreases the need for customsaton. The close relatonshp between the producer and consumer mples that the latter s capable of provdng mmedate feedback to the former, who can contnuously adjust qualty of the servce. Lnders (2001:39) argues that the modern servce economy captalsm, based on dfferentaton and customsaton, s dametrcally opposte of the ndustral revoluton whose credo was standardsaton. The modern servce economy s ntertwned wth servces. Indeed, Salvatore (2004a: 421), opnes that Globalsaton s a revoluton, whch n scope and sgnfcance s comparable to ndustral revoluton, but whle the ndustral revoluton took place over a century or so, the Globalsaton revoluton has taken place under our very eyes n one or two decades and s contnung unabated. We have globalsaton n tastes, whch s leadng to products becomng more and more global n nature, and we have globalsaton n producton and labour markets, whch s leadng to ncreasng outsourcng of parts, components and servces... Thrdly, servces are charactersed by mperfectly compettve market structure (monopolstc competton, olgopoly and monopoly). The actual market structure depends on the cost structure of a partcular market. Techncally nduced economes of scale and scope are relatvely unmportant n most servces except for transport, telecommuncatons, commerce and some ndependent servces such as entertanment and rental servces. Fourthly, markets n servce sector are charactersed by asymmetrc nformaton. Servces are knowledge and experence-ntensve. Many servces are experenced goods smlar to knowledge-based assets (Markusen et al., 1995: ) and once learned, a producer has an nformaton advantage over consumers wth respect to qualty of the servce and that of compettors. Imperfect nformaton causes problems for the market mechansm because of the tendency for moral hazard, n whch the qualty of servces change over tme, and adverse selecton n whch low qualty servces drve out hgh qualty servces.

4 Unversty of Pretora etd Sche, M M (2005) 26 Melvn (1985) argues that servces should be consdered as a separate class of commodtes wth characterstcs that dstngush them from what s generally thought of as a commodty. He suggests that servces lnked to goods and servces should be dsentangled Relatonshp between characterstcs and the modes of supply used n nternatonal trade n servces. Sampson and Snape (1985) argue that servces requre close proxmty between the producer and consumer. All servces need jont producton, but the mode of nteracton dffers substantally. Some servces requre physcal proxmty to acheve jont producton (transport, surgery, constructon etc.) whle others do not requre physcal presence for jont producton (consultancy servces, data management, telecommuncatons, fnancal servces etc.). Internatonal trade n servces can be classfed on the bass of the constrants on physcal locaton of the producer and consumer n realsng the transacton. Ths classfcaton was poneered by Sampson and Snape (1985) and adopted n Artcle I of GATS (World Trade Organsaton, 2002: ). Frstly, there are servce transactons, whch do not nvolve the movement of both the consumer and the producer of the servce. These servces, lke goods, are produced n one country and cross the borders of the mportng and exportng countres. Ths s crossborder trade (.e. mode 1 under GATS). Examples nclude consultng servces, archtectural desgns handled through correspondence and produced n the exportng country, lcensng, research and development, telecommuncatons and e-commerce. Sampson and Snape (1985:173) argue that ths category s also called separated servce snce they are dsemboded from both factors of producton and consumers. Snce they are separated, they may be ncorporated nto goods and dentfed unquely as goods nstead of servces (floppy dsks full of data, compact dsk full of musc, drawngs of archtectural plans of a brdge, etc.).

5 Unversty of Pretora etd Sche, M M (2005) 27 Secondly, there are servce transactons for whch the consumer travels across the borders to an mmoble provder. GATS refer to ths category as consumpton abroad (mode 2). Examples nclude Amercan patents temporarly movng to South Afrca to be treated by a surgeon n Cape Town, South Afrcan toursts travellng to the Rocky Mountans n the US, South Afrcan students enrollng n full-tme studes n an Amercan unversty, Amercan toursts move to South Afrca to see the Table Mountans or Robben Islands n Cape Town. Sampson and Snape (1985) pont out that, just as n separated servces, there are stll cases where the demarcaton between goods and servces s not clear. A case n pont s a product send overseas for processng, whch s then re-exported. Thrdly, servce transactons may ental permanent local establshment through a foregn afflate (e.g. branches of multnatonal corporatons n South Afrca) of a frm orgnatng from a dfferent country. Ths s referred to as commercal presence (.e. mode 3 under GATS). Ths s the domnant mode of nternatonal competton n servce markets such as bankng, nsurance, legal servces and consultances. Fourthly, servce transactons may be suppled through temporary movement of natural persons whle the consumer does not move. Ths s referred to as presence of natural persons (.e. mode 4 under GATS). Examples nclude certan busness servces that send out consultancy teams, audtng teams and constructon. Fnally, transactons may occur through movement of both factors of producton and the consumer to a thrd country. Examples nclude, a South Afrcan patent meets wth an Amercan surgeon n a London hosptal, an employee from Kenya Revenue Authorty moves to Southern Afrcan Tax Insttute (SATI) 6 to attend a course offered by a lecturer from Harvard Unversty. Three countres wll be transactng n ths case, wth the Unted Kngdom and South Afrca sellng the servces of hosptals and educaton respectvely. These servce transactons, descrbed n Sampson and Snape (1985:173), are not dealt wth by GATS (World Trade Organsaton, 2002: ). 6 Southern Afrcan Tax Insttute s a pan Afrcan nsttuton, based at the Unversty of Pretora, and offers tranng on varous aspects of tax to government offcals.

6 Unversty of Pretora etd Sche, M M (2005) THE SPECIFIC HORIZONTAL AND VERTICALLY DIFFERENTIATED IIT MODELS The tradtonal trade theory (HOS orthodoxy) takes t as a trusm that countres trade n order to take advantage of ther dfferences. The new trade theory admts that dfferences between countres s one reason for trade but dffers wth HOS n argung that trade may result because of ntrnsc advantages to specalsaton (Krugman 1994:2). Thus, much trade (manly for smlar countres) represents specalzaton to take advantage of ncreasng returns than to captalse on nherent dfferences between the countres. The new trade theory models, based on ndustral organsaton, were developed towards the end of 1970s and n the early 1980s. The lterature that ncorporates ndustral organsaton has two man strands. The frst branch s bascally concerned wth modellng the role of economes of scale as a source of trade. The ntroducton of economes of scale nto the model requres that the mpact of the ncreasng returns to scale on market structure be taken nto account. However, as Krugman (1994) ponts out, n ths lterature, the approach has been to get the ssue of market structure out of the way as soon as possble. Ths s done by assumng that markets are charactersed by Chamberlnan monopolstc competton (the CHO model). The second strand of lterature vews mperfect competton as the core of the story rather than an unavodable nusance. Thus models based on mperfect competton are constructed Horzontal dfferentaton In horzontal product dfferentaton, there are two man approaches. The frst s love-of-varety approach (Krugman, 1979 and Helpman, 1981) where all varetes of a product enter an ndvdual s utlty functon symmetrcally n a Dxt-Stgltz (1977) framework. The second s deal-varety approach attrbuted to Lancaster (1966, 1980),

7 Unversty of Pretora etd Sche, M M (2005) 29 whch assumes that consumers do have preferences for an deal varety and they demand goods not for ther own sake but for the characterstcs they possess Love-of-varety Under ths approach, t s assumed that there are commodtes that ndvduals lke to consume n many varetes, so that varety s valued n ts own rght. Helpman and Krugman (1985:116) argue that the love-of-varety may arse when for some products, an ndvdual lkes to have n many varetes. Thus a consumer may lke to eat n a South Afrcan, Chnese, Amercan and French restaurants, each tme gong to a dfferent restaurant. The man features of ths approach can be llustrated by reference to Krugman (1979). The model borrows from the semnal works of Spence (1976), Dxt and Stgltz (1977) where t s assumed that each country has only one ndustry, whch produces a range of goods under ncreasng returns to scale. On the demand sde, the model assumes that all consumers share the same utlty functon nto whch all goods enter symmetrcally; n U = v( c ), v > 0 and v < 0 (2.1) Where c s the ndvdual s consumpton of varety. Ths utlty ensures that the ndvdual s demand for varety determnes all the trade between smlar countres. It s assumed that the number of varetes, n, s very large, so that the cross-prce elastcty s zero. The elastcty of demand facng an ndvdual producer s; v ( c ) ε = (2.2) v ( c ) c

8 Unversty of Pretora etd Sche, M M (2005) 30 ε θ Where < 0. Krugman (1980) ntroduced a dfferent case where v ( c ) = ( c ). In ths c 1 case as n tends to nfnty, the elastcty of demand s constant and equal to ε = 1 θ. Ths mples that a consumer s ndfferent between any two varetes and also that there s no sgnfcant nteracton between any two frms. Dxt and Norman (1980), usng a model ncorporatng two sectors, reached the same constant elastcty of substtuton usng a dfferent utlty functon. On the supply sde, Krugman (1979) assumed that there s only one factor of producton (labour). He further assumed that the foregn country s dentcal to the domestc economy. Each consumer maxmses; n * n+ n U = v( c ) + v( c ) (2.3) = n+ 1 Where * denotes foregn country, wth goods 1,2 n, beng produced n the home country and goods n+1,,n+n* beng produced n the foregn country. Snce every good enters the utlty functon symmetrcally, welfare n both countres wll ncrease because the number of varetes avalable to consumers ncreases to n+n*. Addtonally, snce the ncrease n market sze mples larger economes of scale, there wll be welfare gans n terms of lower unt costs. In vew of the fact that there are no ncentves for frms to produce the same varety, each good wll be produced n only one country. The model does not, however, determne whch country produces whch varetes. When countres dffer n sze as n the case of US and South Afrca, the larger country wll produce more varetes. Thus South Afrca wll realze the larger gans from trade because the ncrease n the number of varetes avalable to her consumers wll be larger than for the US.

9 Unversty of Pretora etd Sche, M M (2005) The deal-varety model Ths model, based on the work of Lancaster (1966,1979, 1980), assumes that there s an deal varety that consumers prefer 7. The man dfference between ths approach and the love-of-varety approach s that, whle n the latter all dfferentated products enter the utlty functon symmetrcally, the deal-varety approach assumes asymmetry. Consumers perceve each product/servce as havng ts own set of characterstcs. A graduate program represents a bundle of characterstcs such as nstructon mode, type of specalsaton, status n terms of rankng of unverstes etc., whch wll defne ts specfcaton. Graduate programs that have the same characterstcs (although n dfferent proportons) wll form a group of academc programs. Product specfcatons are assumed to vary n a contnuous manner. Ths can be presented ether as a lne (Lancaster 1979) or a crcle (Helpman, 1981). The representaton by Helpman (1981) assumes that there s a contnuum of types of products and that there s a one-to-one correspondence between these types and ponts on a crcumference of a varety specfcaton crcle. A pont on the crcle represents a product of a partcular type. Indvduals are perceved to have preferences (whch are assumed unform among consumers) over a certan specfcaton rather than over a collecton of goods. These characterstcs are non-combnable, that s, consumers cannot obtan a certan specfcaton by combnng two or more goods. Each ndvdual wll have a most-preferred good or deal-product n the crcle. Ths means that n a gven economy, dfferent consumers wll have dfferent most-preferred varetes or deal varety specfcatons. It s assumed for smplcty that there s unform densty of consumers over the spectrum so that the same aggregate demand exsts for every varety. When the number of varetes produced s less than the number demanded, some consumers wll be able to consume ther deal varetes whle others wll be forced ether to consume a varety whch s not deal or not to consume the product at all. If the consumer has to settle for a varety, whch s not hs/her deal, the prce he/she s wllng 7 A good example s a consumer who prefers a harcut from a specfc salon.

10 Unversty of Pretora etd Sche, M M (2005) 32 to pay for that varety (for a gven ncome) s negatvely related to the dstance of ths varety from the deal. Ths means that the further away s the varety avalable from hs/her deal, the lower the prce. On the supply sde, Lancaster (1980) assumed ncreasng returns to scale n the producton specfcaton so that there s decreasng costs for some range of output. Ths model shows that IIT occurs as a consequence of preference varety and economes of scale, as n the love-of-varety approach. However, the gans from trade are dfferent. In the love-of-varety approach, snce all goods/servces enter the utlty functon symmetrcally, an ncrease n the number of varetes avalable ncreases welfare for all ndvdual consumers. In the deal-varety model, the fact that goods/servces enter the utlty functon asymmetrcally mples that an ncrease n varety wll be benefcal for some consumers but harmful to others. Ths asserton s predcated on the fact that some consumers wll, after trade, be able to consume products/servces close to ther deal specfcatons than n autarky snce the average dstance between varetes on the spectrum s smaller wth trade than wthout trade. However, for some consumers that were consumng ther deal varety before trade, openng trade may not ncrease ther welfare. It s mportant to note that ths model mples that preference varety s the only reason for the exstence of IIT. If preferences were equal for all ndvduals n each country, all consumers would have the same most-preferred good/servce and thus, the output for ths group of products/servces would be homogeneously made for ths specfcaton. The orgnal model s flawed snce t assumes that countres have equal szes, whch may not be approprate for the South Afrca-US IIT n servces. Lancaster (1980) and Helpman (1981) extended the basc model by allowng countres to vary n sze (measured by the number of consumers). Thus the larger country wll, n autarky, produce a large number of varetes due to the exstence of larger economes of scale. The upshot of the extenson s that the smaller country (South Afrca) wll reap larger gans from trade (n terms of consumer welfare), snce the ncrease n the number of

11 Unversty of Pretora etd Sche, M M (2005) 33 varetes avalable to consumers wll be bgger for the smaller country than for the larger country (the US). Furthermore, the basc model was extended by Lancaster (1980) and Helpman (1981) nto the HOS framework where dfferences n factor endowments between the two countres exst. Ths leads to the concluson that IIT wll be hgher the more smlar (n terms of factor endowments and market sze) are the tradng economes. Also, as n the love-of-varety approach, ths model does not predct the drecton of trade (unless extended to nclude dfferences n ntal factor endowments). Ths model s useful for IIT n servces. Frstly, servces are hghly dfferentated and there are certan servces that consumers have deal varetes. A good example s educaton, where some people for nstance prefer US unverstes whle others prefer South Afrcan unverstes. Secondly, the extenson to nclude dfferences n country szes and factor endowments drectly nforms the modellng process whereby a varable for market sze s ncluded n the emprcal South Afrca-US IIT n servces model Vertcal dfferentaton: Dfferentaton by qualty The new classcal vew/cho of nternatonal trade popularsed n the md-1980s gnored a vtal ssue: that products are not only dfferentated horzontally but also vertcally (Fontagnè and Freudenberg 2002:135). Vertcal dfferentaton means dfferentaton along the qualty spectrum and generates dfferent determnants and consequences of IIT from those of horzontal dfferentaton. In horzontal dfferentaton, products/servces sold at the same prces are perfect substtutes, whle n vertcal dfferentaton, a common rankng of consumer preferences can be assocated wth dfferences n qualty, based on factor endowments (Falvey, 1981), on fxed costs n R & D (Gabszewcz, Shaked, Sutton and Thsse, 1981) or on the qualfcatons of the labour force (Gabszewcz and Turrn, 1997).

12 Unversty of Pretora etd Sche, M M (2005) 34 Falvey (1981) used a partal general equlbrum model based on two countres and two factors of producton. As n the HOS framework, each country has dfferent ntal endowments of factors of producton, whch results n dfferent factor prces n the two countres. There are, however, two dfferences wth the HOS. Frstly, although there are two factors of producton, captal s assumed to be ndustry-specfc. Captal s assumed to be mmoble between sectors but completely moble wthn a gven ndustry. Secondly, each ndustry wll produce vertcally dfferentated goods (.e. wth dfferent captal-labour ratos or dfferent qualtes). Ths model predcts the drecton of trade where each country wll export the qualtes n whch t has comparatve advantage (product qualtes that use the relatve abundant factor more ntensvely). Ths model predcts the pattern of trade n a way that s consstent wth the tradtonal HOS theory wth each country exportng the qualtes n whch t has comparatve advantage. Thus home country exports those qualtes below the margnal qualty and the foregn country exportng those qualtes above the margnal qualty. The model further predcts that n the presence of tarffs, some qualtes wll be produced n both countres, wth no trade occurrng n those qualtes. In ths model, there s no gan from trade va economes of scale or va ncrease n product varetes. The benefts arse manly from the usual reasons of comparatve advantage; wth free trade, consumers are able to buy the qualty they want at cheaper prces. In ths sense, the Falvey (1981) model as well as the Falvey and Kerzkowsk (1987) s a natural extenson of the HOS framework, takng nto account product dfferentaton wthout completely dscardng the fundamental premses of the HOS theory. Ths model has mplcatons on trade lberalsaton and concomtant factor adjustments. On one hand, the model argues that trade restrctons are nmcal to trade based on exchange of qualtes. On the other hand, the model dsmsses the approach advocated by CHO model of assocatng nter-ndustry trade wth panful trade-nduced factor market adjustment costs and IIT wth less costly adjustments (as n Helpman and Krugman, 1985). The model argues that the CHO approach s at odds wth the development of vertcally dfferentated IIT (VIIT). Gabszewcz and Turrn (1997)

13 Unversty of Pretora etd Sche, M M (2005) 35 suggest that specalzng n top-qualty varetes wll be assocated wth adjustment costs f the qualfcaton of labour employed ntensvely to produce low-qualty varetes s specfc. Thus t s possble that the portablty of qualfcatons s lmted across the qualty range of products even wthn sectors. The mplcaton of ths s that the adjustment costs assocated wth VIIT (exchange of qualtes) mght be szeable, as t may not be equvalent to specalze n hgh-or low-qualty products/servces n the same ndustry. Costly dsplacement of resources may take place as a result of specalzng along the qualty spectrum sustaned by R&D expenses, endowments n human captal, or smply advertsng Strategc IIT models Homogeneous products/servces The basc model of IIT n the presence of strategc nteracton goes back to Brander (1981). However, Brander and Krugman (1983) made generalsatons and reformulatons and the model s orgnal focus on IIT was redrected to the phenomenon of recprocal dumpng. The corollary of ths s that the model has had a much greater nfluence on the dumpng lterature than on IIT lterature. The basc characterstc of the Brander s model s ts emphass on market power. In ths model, IIT n homogeneous products/servces s the result of frms ncentves to penetrate nto each other s market n a recprocal manner. Unlke the CHO models, where the ssue of market structure s a nusance and got rd of by assumng monopolstc competton, Brander bulds hs story usng mperfect competton. He demonstrates that, n an ndustry characterzed by Cournot competton, frms exports are the results of ther proft motves and consequently, trade ncreases competton.

14 Unversty of Pretora etd Sche, M M (2005) Strategc IIT n vertcally dfferentated products/servces The role of vertcal product dfferentaton has been neglected n the strategc trade polcy lterature. VIIT can explan the pattern of trade between the developed and developng countres (Clark and Stanley, 1999, Kunn and Zgc, 2003). Zhou, Spence and Vertsky (2002) presented the frst theoretcal paper lnkng vertcal product dfferentaton and strategc trade. The paper deals wth endogenous qualty choce by frms and strategc competton takes place n a thrd country market as opposed to the domestc market. Kunn and Zgc (2003) attempt to construct a smple strategc trade duopoly model wth product dfferentaton where the acton takes place n the domestc market. The decson varable n the model s the selecton of product qualtes and duopoly as a market structure emerges endogenously from the nature of the competton and the sze of the market. The model assumes that the dfferent abltes of the frms from the developng world compared wth ther developed country counterparts leads to dfferences n qualty cost effcency. The generaton of hgh qualty varetes depends on R & D nvestment, learnng by dong and the level of human captal. Kunn and Zgc argue that at the margn an ncrease n qualty would requre hgh effort and hgher costs on the part of developng country frm than on the part of developed country frm. They show that the ncdence of qualty reversal depends on the relatve cost effcency n producng qualty and f the dfference n the effcences s large enough, there s no swtch n qualty ladder. Overall, strategc trade lterature n the context of ndustral organsaton offers some nsght nto the case for protecton of ndustres. Frstly, trade polcy can be used to extract foregn monopoly rents. Secondly, there could be a possble use of protectonst polces as a way to get frms lower ther average costs curves. Lastly, protectonst polces can be used to promote addtonal entry, when ths s desrable.

15 Unversty of Pretora etd Sche, M M (2005) 37 Fgure 2.3 s a schematc representaton of IIT theores. The fgure shows the dfferent theores that explan IIT for homogenous products, HIIT and VIIT. These theores encapsulate both the causes and the consequences of dfferent types of IIT n merchandse trade. Although servces are dfferent from goods, the powerful logc of these theores transcends these dfferences. The lterature survey so far provdes a bass for the next secton, whch focuses on how to translate IIT trade theores (based on ndustres) to servce trade data Applcablty of goods-based IIT theores to servces The general vew about applcablty of comparatve advantage theory to servces s summed up n Hndley and Smth (1984:389) as follows servces are dfferent from goods n ways that are sgnfcant and that deserve careful attenton, but the powerful logc of comparatve advantage transcends these dfferences. Ths vew made sense pror to the onset of the GATS and the defnton of servces based on the four modes of delvery. Lee and Lloyd (2002: 162) pont out there s currently no model/models of IIT n servces. They attrbute ths to the fact that servces have dfferent modes of delvery and technologcal requrements, whch makes t very dffcult to develop a sngle theory for all the modes of supply. In the case of mode 1, standard IIT trade theores, whch assume nternatonal mmoblty of factors of producton, apply. Hndley and Smth (1984) analyse whether theores of comparatve advantage, amed at explanng nter-ndustry trade n goods, can be appled to servces or not. They contend that Rcardo s proof nvolvng wne and cloth would stll be vald even f he consdered wne and nsurance polces.

16 Unversty of Pretora etd Sche, M M (2005) 38 Fgure 2.1: Schematc representaton of IIT theores Intra-Industry Trade Homogenous products/ servces Horzontal dfferentaton (Dversty) Vertcal dfferentaton (Qualty) Comparatve advantage HOS Strategc (Game-theoretc) Monopolstc competton Perfect competton Olgopoly Technologcal dfferences Olgopoly Spence-Dxt-Stgltz Approach (Demand for varety) (dfferentaton n utlty functon) Hotellng-Lancaster Approach (Dversty of tastes) Comparatve advantage Factor Endowments Fxed costs n R &D Davs(1995) Davs and Wensten(2000) Recprocal dumpng Krugman(1979,1980,1981) Dxt and Norman(1980) Ether(1982) Lancaster(1980) Helpman(1981) Falvey(1981) Falvey and Kerzkowsk(1987) Flam and Helpman(1987) Gabszewcs-Shaked- Sutton-Thsse(1981) Motta-Thsse-Cabrales(1995) Brander(1981) Brander and Krugman(1983) Tang(1999) Bernhofen and Hafeez(2001) Source: Adapted from Fontagné and Freudenberg (1997:17,2002:136)

17 Unversty of Pretora etd Sche, M M (2005) 39 Exstng models of IIT (e.g. n Markusen and Maskus, 2002), whch ncorporate FDI mght be applcable to servces suppled under commercal presence (mode 3). However, as noted by Lee and Lloyd (2002: 162), the other theores of vertcally and horzontally dfferentated products cannot be appled to servces suppled under modes 2,3 and 4 snce the servce products are dfferentated on the bass of locaton of the producer and or consumer. However, statstcs used for analyss s based on BMP5, whch tends to capture crossborder (mode 1) and mode INCORPORATING IIT INTO THE NET FACTOR CONTENT OF BALANCED TRADE Orgnally, the emprcal evdence of smultaneous exports and mports of smlar products was perceved as an nvaldaton of the HOS model and ts varants based on Rcardo s comparatve advantage (Fontagné and Freudenberg, 1997). The HOS model argues that trade reflects an nteracton between the characterstcs of countres and producton technology of dfferent goods/servces. Specfcally, t argues that a country wll export goods/servces whose producton s ntensve n the factors, whch t s abundantly endowed wth. Ths model predcts three thngs. Frstly, trade should typcally be between complementary countres-labour abundant countres should trade wth captal-abundant countres. Secondly, the sources of the comparatve advantage should be seen n the composton of trade. Fnally, trade should have a strong effect on ncome dstrbuton snce t s an ndrect way of countres tradng factors of producton (factor content of trade). In the late 1970s and early 1980s, new theores of nternatonal trade were constructed usng the models of monopolstc competton desgned by Spence-Dxt and Stgltz and Lancaster and ndustral organsaton theory (small number market structures).

18 Unversty of Pretora etd Sche, M M (2005) 40 Consequently, a new orthodoxy emerged referred to as the new classcal vew or Chamberln-Heckscher-Ohln (CHO) model. Ths vew underscores gans n varety, ncreasng returns to scale and compettve pressures that are related wth nternatonal trade. Helpman and Krugman (1985) provded a synthess of the vast lterature usng two concepts; ntegrated equlbrum used to clarfy the condtons for the factor prce equalsaton, and net factor content, whch s a central feature of hgher dmensonalty models. At the same tme there were models of vertcal dfferentaton ntroduced by Falvey (1981) and Falvey and Kerzkowsk (1987), n whch specalsaton takes place along the qualty spectrum Net factor content of balanced trade: Mathematcal presentaton The factor content of trade, propounded by Vanek (1968), s the amount of factor nputs emboded n the trade of a country. Feenstra (2004), Feenstra and Hanson (2000) provde an exposton of the structure of the Heckscher-Ohln-Vanek (HOV) model. The standard HOV model rests on a number of assumptons. Frstly, there are n ndustres and m prmary nputs. Secondly, each ndustry produces a sngle output and the prmary nputs are moble wthn countres but mmoble between countres. Thrdly, there s free trade n all goods j=1,2 J. Fourthly, all fnal goods/servces prces are equalsed among the tradng countres. Ffthly, there are dentcal technologes across countres =1,2 I. Sxthly, consumer tastes are dentcal and homothetc across countres. Seventhly, trade leads to factor prze equalzaton (FPE) across countres for all factors of producton, k=1,2 K. Fnally, there s no factor ntensty reversal. The quantty of prmary factor k used per unt output n ndustry j s denoted by matrx A = [ a kj ]. Accordng to Feenstra and Hanson (2000:155), ths matrx represents drect plus ndrect factor requrement. Ths can be decomposed nto a ( K J ) D matrx

19 Unversty of Pretora etd Sche, M M (2005) 41 contanng drect factor requrements and a ( J J ) B nput-output matrx. The matrx B descrbes how a gven servce s used n the producton of tself and other servces. The total factor requrements matrx, A, s computed as; 1 A = D( I B) (2.4) Where I s an dentty matrx. Owng to dentcal technologes and FPE n HOS model, ths matrx s dentcal n all the tradng partners. The net output vector for country s denoted by a ( J 1) matrx Y and the consumpton vector C. The net exports (trade) vector s gven by T Y C. The T can also be calculated as = T = X M. Ths s pre-multpled by A to obtan the factor content of trade (.e. the amount of labour, captal, land, etc.) emboded n the trade of country. The HOV theorem then relates the factor content of trade ( F = AT = AX AM ) to the ( K 1) vector of endowments for country, E, as compared to world endowments E ; w AT = E α E (2.5) w p C Where α s the total consumpton of country relatve to the world consumpton. p C w The Equaton 2.5 states that the factor content of trade s equal to the net factor endowments of a country 8. 8 Ths equaton provdes the bass for the rank and sgn test of HOV due to Bowen, Leamer and Svekauskas (1987). The rank test states that the rankng of the net factor endowments (rght hand sde) equals the rankng of factor content (left hand sde). In other words f South Afrca has more labour (rght hand sde), she should export products/servces that embody more labour n the producton process.

20 Unversty of Pretora etd Sche, M M (2005) 42 Although ths standard HOV model s general n terms of the number of prmary nputs and goods, most of the underlyng assumptons are qute restrctve when appled to trade n servces. Frstly, the assumpton of free dentcal technology does not make a lot of sense for most servces snce technology s the centrepece of trade. Mode 3 (commercal presence) and mode 4 (movement of natural persons) ental trade of ntellectual assets such as patents, copyrghts, blueprnts, trademarks etc. The assumpton of dentcal technology mples that ntra-ndustry trade has zero factor content by constructon (Davs and Wensten, 2000, Trefler and Zhu, 2000). Accordng to Feenstra (2004), there are two ways to ncorporated dfferences n technology nto the HOV. The frst approach models productvty of factors n dfferent countres whle the second method models dfferences n the factor requrements matrx, A. Wth dfferences n producton technology, the factor content of trade could be respecfed as; F mod * * [ A A ] [ X M ] = AX A M = o (2.6) * Where s modfed factor content of trade, A and A are the domestc and foregn F mod country technology matrces respectvely, and o s a Hadamard product operator (element-by-element product). These are parttoned matrces so that the rght hand sde s conformable for nner product. The technology matrces A and depend on technologes and the equlbrum factor prces n the home and foregn countres, respectvely (Lloyd, 2002). Trefler and Zhu (2000) tred to ncorporate dfferences n technologcal matrx n emprcal testng of the factor content of trade. * A

21 Unversty of Pretora etd Sche, M M (2005) 43 Davs and Wensten (2000:154), n ther quest to explan the mystery of mssng trade, argue that errors n the measurement of factor content arse, among others, from the fact that the tradtonal tests usng the standard HOV model assumed mplctly that the factor content of matched IIT has zero factor content. Lloyd (2002) succnctly explans ths by rewrtng the exports and mports as; X = G + x M = G + m (2.7) Where G s the vector of matchng trade (IIT) n the ndustres. In the above specfcatons, x and m are non-negatve. The value of x (or m ) s strctly postve f the country s a net exporter (or mporter) of ndustry s products/servces, and zero f t s a net mporter (exporter). Substtutng the above equatons nto the modfed HOV model yelds; F mod * * ( A A ) G+ ( Ax A m) = (2.8) The frst component on the rght hand sde of Equaton 2.8 s the factor content of matchng IIT. Its contrbuton depends on the value of matchng trade (G) and the dfferences n technology between the two tradng partners. The second component s the contrbuton of net exports and mports (nter-ndustry trade). It s clear that wth the assumptons of ntegrated equlbrum and dentcal technologes (.e. modfed HOV reduces to the standard HOV; * A = A ), the F mod ( A AG ) + Ax Am= 0+ A( x m) = F = (2.9) Secondly, the standard HOV does not take nto consderaton trade n ntermedate nputs. Producer and co-ordnaton servces such as nsurance, bankng, transport etc. are an mportant condut of nternatonal exchange of factor servces. Indeed, globalsaton has been charactersed by wdespread trade n fragmentaton of the producton process. Ths entals an entre value chan beng located n dfferent countres on the bass of ts

22 Unversty of Pretora etd Sche, M M (2005) 44 comparatve advantage. Producer and co-ordnaton servces play a sgnfcant role n facltatng ths process 9. Intermedate trade dlutes nternatonal dfferences n the combnaton of factors used n producton. Imported ntermedate servces drve a wedge between a country s total factor usage profle and ts endowments and thus dampenng the net factor servce trade. Indeed, Salvatore (2004b: 544) argues, Globalsaton n producton has proceeded so far that t s now dffcult to determne the natonalty of many products/servces [emphass added]. There have been attempts to ncorporate ntermedate nputs n the HOV model. Davs and Wensten (2000) model, that ncorporate dfferences n technology, mpute the factor content of mported ntermedate nputs usng domestc factor ntenstes. They observe that some error arses from ths assumpton but t s not sgnfcant. Trefler and Zhu (2000) exclude the mported ntermedate nputs by constructon. Lloyd (2002) questons these approaches gven the fact that more than half of total world trade s n ntermedate nputs. Remer (2004) developed a framework, whch reconcles global ntermedate trade wth general-equlbrum features of trade, producton and factor endowments n the presence of technologcal dfferences across tradng partners. The framework shows that global producton sharng tends to separate the factor content of fnal goods/servces from the country s factor endowment profle. A case n pont s South Afrca s exports of educaton servces to the US, produced usng expatrate lecturers from Europe, Australa, North Amerca and other Afrcan countres. In ths case South Afrca s exports of educaton servces to the US has very lmted relatonshp wth her endowments of sklled manpower (unversty lecturers) lmtng the standard HOV model as a gude to ndustral and servces trade polcy. 9 A case n pont s the Just-n-Tme management of nventory as well as value-for-money, whereby nventory s sourced from the most compettve suppler when requred thus savng huge sums of money n storage costs. Ths s facltated by producer servces such as communcaton and transportaton.

23 Unversty of Pretora etd Sche, M M (2005) 45 Fnally, the assumpton of FPE n the standard HOV model does not hold n most servces suppled under modes 2, 3 and 4. Ths s because n these servces, factors of producton are moble across countres. In ths case countres specalse n dstnct sets of traded servces. A number of studes have shown that dscardng the assumpton of FPE s central to understandng Trefler s (1995) mssng trade 10 and for developng factor proportons-based models of the world economy (Davs and Wensten, 2000, Helpman, 1999:132) The net factor content of balanced trade: ntegrated equlbrum approach The ntegrated equlbrum under horzontal dfferentaton (HIIT) The ntegrated equlbrum (IE) s a paradgm that has been used n nternatonal trade for a long tme. The concept orgnated from Samuelson s (1949) work on FPE and was further refned by Dxt and Norman (1980). Helpman and Krugman (1985), n ther quest to synthesse the burgeonng lterature on IIT, placed IE at the centre of nternatonal trade analyss. The essence of IE s that there s a resource allocaton the world would have f goods and factors of producton were both perfectly moble. The analyss then poses a queston as to whether t s possble to acheve the same resource allocaton f factors of producton are nstead dvded up among countres and there s no nternatonal factor moblty. The approach shows that n general, there s a set of allocaton of factors of producton to countres n whch ths s possble. In ths case, factor endowments le wthn ths set (cone of dversfcaton), factor prces are equalsed through trade. Ths s the bass of Helpman and Krugman (1985) analyss that led to the new classcal vew/chamberln- Heckscher-Ohln (CHO) model based on a horzontal dfferentaton framework n the context of monopolstc competton. 10 The mssng trade phenomenon refers to Trefler s (1995) fndng that measured factor content of trade understates Vanek s (1968) predcton.

24 Unversty of Pretora etd Sche, M M (2005) 46 Accordng to the IE, the net factor content of nter-ndustry trade s postvely related to the dfference n relatve factor endowments between tradng partners. The converse s that IIT s negatvely related to the dfference n relatve factor endowments between tradng partners. Helpman and Krugman (1985) provde an exposton of the IE usng F prmary factors under perfect competton n all markets; a set V of m nput vectors; v j correspondng to the general producer equlbrum exst for each vector ω of factor prces. The IE s replcated by free trade between countres f V s compatble wth the set V && of endowments n the perspectve of unqueness of ω. Assumng a case of two ndustres (j=1,2), the two vectors defne a cone of dversfcaton and f the endowment vector belongs to t for all countres a soluton can be found assocatng postve outputs to a unque ω k (where k refers to countres). Wth hgher dmensonalty (l countres, m fnal goods and 3 prmary factors of producton) the prevous result only hold n the same trangle of dversfcaton as explaned n Leamer (1987). Fontagné and Freudenberg (1997) argue that nternal economes of scale can be ntroduced nto ths theoretcal framework wthout changng the basc prncple of the factor content of net trade flows. Usng ths theoretcal framework, the zero proft condton s met at equlbrum and horzontally dfferentated products/servces that belong to the same ndustry use the same producton functon (factor ntensty). Fgure 2.2 llustrates a one perod model of IE where ncome s used for consumpton only. Ths s a two-country world (k=1,2), two products/servces (j=1,2) wth the more captal ntensve good (1) beng horzontally dfferentated whle good 2 s homogenous. IE reproduces stuatons n whch trade of goods s only assocated wth a full

25 Unversty of Pretora etd Sche, M M (2005) 47 employment equlbrum where ω s dentcal n both countres. In ths model, both ncome and consumpton are gven by Equaton Y = rk + wl (2.10) k k k Fgure 2.2: Economc dstance and IIT under horzontal dfferentaton L* 0 * K * b V1 D Economc dstance C g w ω = r V2 K 0 L a f Source: Fontagné and Freudenberg (1997:14) The length of the horzontal axs s the world labour endowment and the length of the vertcal axs s the world captal endowment. The orgn for country 1 s the lower left corner and for country 2 s the upper rght corner. Any ponts on the world endowment box measures the endowments of the two countres. Pont C dvdes the world ncome/consumpton gven by lne OO * nto the natonal share (OC) and foregn share (CO * ). The world-ie s based on the fact that the endowment pont D les wthn the FPE set defned by the vectors v j ;

26 [ a ( r), a ( w) ] Unversty of Pretora etd Sche, M M (2005) 48 v j = Kj Lj (2.11) The factor contents of producton and consumpton can be defned for each country (k=1,2) and products (j=1,2) and then the net factor content of balanced trade. For the home country Og and Of are the factor contents of natonal consumpton n horzontally dfferentated and homogenous goods/servces respectvely. Smlarly, Ob and Oa are the factor contents of natonal producton n horzontally dfferentated and homogenous goods/servces respectvely. The net factor content of balanced trade s gven by the lne DC (producton less consumpton). The home country exports the servces of ts abundant factor and mports the ones of ts scarce factor along the lnes of the HOV theorem. The lne segment gb measures the net factor content of exports of the horzontally dfferentated product for the domestc economy. Ths country s engaged n IIT of good 1, whch s not balanced. The lne segment fa shows the net factor content of one-way flow of the homogenous good 2 (mports of the domestc economy). The lne DC also shows the economc dstance that s the dfference n natonal endowments between domestc and foregn country. The greater the economc dstance, the greater the net factor content of balanced trade. Ths shows that nter-ndustry trade s related postvely to the economc dstance (comparatve advantage of countres). In other words, IIT s negatvely related to economc dstance. At the extreme, nternatonal trade between countres havng dentcal relatve endowments n factors would be charactersed by a net factor content of balanced trade equal to zero, wth trade beng exclusvely of IIT. The upshot s that the new classcal vew or CHO model assocates nter-ndustry trade wth comparatve advantage (economc dstance) and IIT wth the monopolstc competton. The benefts and costs assocated wth trade are based on two postulatons. Frstly, nter-ndustry trade leads to reallocaton of resources between ndustres leadng to effcency and consumers react to a new set of relatve commodty prces. These

27 Unversty of Pretora etd Sche, M M (2005) 49 benefts are assocated wth nternal redstrbutve mechansm, whch harms the factor largely engaged n ndustres that face competton from mports (Stolper-Samuelson theorem). Secondly, IIT leads to gans n varety of goods due to economes of scale, lower factor market adjustment costs snce dsplaced factors of producton move wthn ndustres nstead of between ndustres, as s the case wth nter-ndustry trade. The central feature of the IE under horzontal dfferentaton makes sense for servces traded under mode 1 (cross-border) The ntegrated equlbrum under vertcal dfferentaton (VIIT) Under vertcal dfferentaton, the factor content of a good/servce descrbed by trade data dffers across countres. In ths type of dfferentaton, a good/servce s a contnuum of goods/servces dstngushed n terms of factor content and f the endowments of countres are dfferent, FPE does not hold for any par of countres. A country may specalse n a unque secton of ths contnuum for whch t has comparatve advantage. Vertcal dfferentaton, proposed by Falvey (1981), Falvey and Kerzkowsk (1987) and Flam and Helpman (1987) suggests that dfferences n prces and qualty are found n dfferences n the producton functon. They argue that a hgher qualty manfests n a hgher captal-ntensty mplyng that each varety s assocated wth a gven vector of nput. Fgure 2.3 shows the economc dstance under vertcal dfferentaton wth two qualtes (low and hgh). IIT n vertcally dfferentated products/servces (VIIT) s a specalsaton wthn ndustres along the qualty spectrum. The HOV model ascertans that the lne segment DC represents the net factor content of balanced trade. However, unlke the HIIT, IIT s assocated wth net factor content of balanced trade, whch s not zero. In ths stuaton, comparatve advantage, whch s captured wthn ndustres along ranges of qualty explan IIT and nduce a net factor content of balanced trade whch s

28 Unversty of Pretora etd Sche, M M (2005) 50 dfferent from the CHO model. In ths case VIIT has nternal redstrbutve pressures due to dfferng qualtes exported and mported. Fgure 2.3: Economc dstance and IIT under vertcal dfferentaton Lower qualty (V2) Hgher qualty (V1) D Homogenous (V3) Economc dstance C w ω = r L* 0 * K * K 0 L Source: Fontagné and Freudenberg (1997:16) 2.5 ECONOMICALLY MEANINGFUL DEFINITION OF AN INDUSTRY Ths controversy relates to the aggregaton of nternatonal trade statstcs nto exports and mports of ndustres defned n an economcally meanngful manner. Lloyd (2002) ponts out that categorcal aggregaton mpacts on the level of measured IIT, the emprcal explanaton of the trade flows and ther polcy mplcatons. The defnton s two-pronged; relatve factor ntensty defnton and ndustral organsaton defnton.

29 Unversty of Pretora etd Sche, M M (2005) Relatve factor ntensty defnton of an ndustry (HOS) Any model for IIT must adopt a defnton of an ndustry n an economcally meanngful way. Accordng to Bernhofen (2002), the HOS/HOV model emphaszes the boundares between two ndustres and uses relatve factor ntensty. Thus only goods/servces produced wth the same factor ntensty comprse an ndustry. Consequently, as long as the HOS assumptons hold, nternatonal trade s always nter-ndustry trade and IIT s precluded by defnton. However, as ponted out n Secton 2.4.1, the modfed verson of HOS model by Trefler and Zhu (2000) ncorporates IIT n the factor content of trade The ndustral organsaton (I-O) defnton of an ndustry The IIT models of the new trade theory are one-sector I-O models where the concept of an ndustry flows drectly from the market structure assumed. Hstorcally, the I-O dea of an ndustry (or market) goes back to Robnson (1933) (n Bernhofen, 2002:65). Although the sngle-sector nature of these models precludes any dscusson about the boundary of the ndustry, t s assumed mplctly that the goods/servces n the ndustry are confned by substtutablty n consumpton. In ths way IIT s defned as a two-way trade n goods/servces that are smlar n consumpton Implcatons of categorcal aggregaton to modellng of IIT The basc ssue s how well the statstcal classfcatons map on to ndustres. Lloyd (1994), usng formal aggregaton theory, hghlghts a number of mplcatons of the theory of categorcal aggregaton. Frstly, the explanatons of IIT vary among models. In the Dxt and Grossman model, factor proportons determne the patterns of nter-ndustry and IIT. Ths also holds true for models nvolvng jontness n producton due to a common ndustry nput.