comparative advantage of vietnam’s textile and clothing industry

vii List of Acronyms and Abbreviations FDI Foreign direct investment GDP Gross Domestic Product R&D Research and development RCA Revealed Comparative Advantage RSCA Revealed symmetric co

i

Thai Nguyen University

Socialist Republic of Vietnam

Southern Luzon State University Republic of Philippines

Thesis Title:

Comparative Advantage of Vietnam’s Textile and

Clothing Industry

A Research Proposal Presented to the Faculty of Graduate School

Southern Luzon State University Lucan, Quezon, Philippines

Thai Nguyen University S.R Vietnam

In Partial Fulfillment of The Requirements

for The Degree Doctor in Business and Administration

SUPERVISOR: ASSOCIATE PRO, DR NGUYEN KHANH DOANH

STUDENT NAME: LE ANH TUAN

ENGLISH NAME: JOHN

THAI NGUYEN, 2013

I would like to faithfully acknowledge professors of SLSU & TNU at DBA Program

at University of Thai Nguyen for their insightful lectures in different subjects that provide me knowledge and technique to develop a good research

My sincere thanks are extended to my entire friends for their meaningful discussion, hospitality and friendships

Finally, I am profoundly grateful to my parents, my wife, my sisters and my brothers, who have been always with me in every situation They have been table source of encouragement and sharing during my work

iii

LIST OF CONTENTS

Chapter 1: INTRODUCTION 1

1.1 Problem Statement 1

1.2 Objectives 3

1.2.1 General Objective 3

1.2.2 Specific Objectives 4

1.3 Dissertation structure 4

Chapter 2: LITERATURE REVIEW 5

2.1 Theoretical Foundation 5

2.1.1 Definition of comparative advantage 5

2.1.2 Theories of comparative advantage 7

2.1.2.1 Ricardian model 7

2.1.2.2 Heckscher – Ohlin model (H-O) 10

2.1.3 Factors affecting comparative advantage 14

2.1.3.1 Technological Superiority 14

2.1.3.2 Resource endowments 14

2.1.3.3 Availability of credit 16

2.1.3.4 Economies of scale 16

2.1.3.5 Technological Gap (Benefits of an Early Start) and Product Cycle 17

2.1.3.6 Demand Patterns: Demand Considerations 17

2.1.3.7 National and International Policies 17

2.1.3.8 Factors affecting export performance 18

2.1.4 Comparative Advantage framework 21

2.1.5 Competitive advantage 21

2.1.6 Linking comparative advantage and competitive advantage 24

2.1.7 Measuring comparative advantage 27

2.1.7.1 Balassa’s Index of Revealed Comparative Advantage 27

2.1.7.2 The Donges and Riedel Measure 27

2.1.7.3 Wolter Index 28

2.1.7.4 Michaely Index 28

2.1.7.5 Export Share Ratio 29

Chapter 3: RESEARCH METHODOLOGY 30

3.1 Measuring comparative advantage 30

3.1.1 Revealed comparative advantage 30

3.1.2 Trade balance index 31

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3.1.3 Trade specialization 32

3.1.4 Market share 32

3.1.5 Alternative Specifications of Revealed Comparative Advantage 33

3.2 Analyzing the Structural Stability 34

3.2.1 Stability of Revealed Comparative Advantage 34

3.2.2 Intra-Distribution Dynamics 35

3.3 Indices of Mobility 36

3.3.1 Shorrocks Index (M1) 36

3.3.2 Shorrocks Index (M2) 37

3.3.3 Sommers and Conlisk Index (M4) 37

3.4 Measure of Export Concentration 37

3.5 Trade Compatibility 38

3.6 Modeling the determinants of comparative advantage 38

3.6.1 Model description 38

3.6.2 Model specification 40

3.6.3 Choosing between FEM and REM 41

3.7 Data sources 41

Chapter 4: EMPIRICAL FINDINGS 43

4.1 Vietnam’s Export Performance in Textile and Clothing 43

4.1.1 Overview of Vietnam’s Economy and Textile and Clothing Exports 43

4.1.2 Structure of Vietnam’s Textile and Clothing Exports 45

4.1.3 Direction of Vietnam’s textile and clothing exports 47

4.2 Patterns of Vietnam’s Comparative Advantage in Textile and Clothing 51

4.2.1 Patterns of Vietnam’s Comparative Advantage in Textile and Clothing 51

4.2.2 The Dynamics of Vietnam’s Comparative Advantage in Textile and Clothing53 4.2.3 Concentration of Vietnam Textile and Clothing Exports 56

4.3 Determinants of Vietnam’s Comparative Advantage and Competitiveness in Textile and Clothing 57

4.4 Trade Complementary and Forecasting Vietnam’s Potential Exports 63

Chapter 5: CONCLUSIONS AND POLICY IMPLICATIONS 65

APPENDICES 67

REFERENCES 69

The timeliness of the study is also reinforced by the fact that increased trade

integration of Vietnam over the past few years is likely to have contributed to a shift

in comparative advantage in Textlile and Clothing Industry in the world market

The Study identifies the pattern of comparative advantage using the

Balassa (1989) index for export data The index has been calculated at the sector and commodity level of the Harmonized System of classification The Dissertation also analyses comparative advantage according to factor intensity The analysis shows broad in the structure of comparative advantage of Vietnam’s Textile and Clothing Industry

I do hope that this Dissertation will serve as a useful source and provide valuable

reference material for researchers and policy makers associated with and interested in export promotion strategy in Vietnam

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LIST OF TABLES

Table 4.1: Basic Economic Indicators of Vietnam 43

Table 4.2: Contribution of Textile and Clothing to Vietnam’s Total Exports 44

Table 4.3: Annual Growth Rate of Vietnam’s Textile and Clothing Exports 44

Table 4.4: Structure of Vietnam’s Textile and Clothing Exports (in percent) 45

Table 4.5: Top 10 Textile and Clothing Export Markets of Vietnam (in percent) 47

Table 4.6: Importance of Vietnam in World Exports of Textile and Clothing Exports 49

Table 4.7: Summary of Statistics 51

Table 4.8: Measures of Trade Specialization 51

Table 4.9: Vietnam’s Revealed Comparative Advantage in Textile and Clothing 52

Table 4.10: Results of Galtonian Regression 54

Table 4.11: Transition Probability Matrix 2001-2011 55

Table 4.12: Mobility Indices 56

Table 4.13: Herfindahl Index 56

Table 4.14: Summary of Statistics 57

Table 4.15: Determinants of Vietnam’s Textile and Clothing Exports (REM) 58

Table 4.16A: Tariff rates applied by Vietnam on Imports of Textile (in percent) 61

Table 4.17: Trade Complementary 63

LIST OF FIGURES Figure 2.1: Comparative advantage framework 21

Figure 2.2: Determinants of National Competitive advantage 24

Figure 2.3: Linking Comparative Advantage and Competitive Advantage 25

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List of Acronyms and Abbreviations

FDI Foreign direct investment

GDP Gross Domestic Product

R&D Research and development

RCA Revealed Comparative Advantage

RSCA Revealed symmetric comparative advantage

RTA Relative trade advantage

SCA Sustainable competitive advantage

TBI Trade Balance Index

WTO World Trade Organization

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Chapter 1 INTRODUCTION

1.1 Problem Statement

The textile and clothing industry has been historically the core industrial sector in Vietnam’s economy due to its advantage in terms of factor endowments and market scale Many reasons explain why this has long been the key industry of Vietnam: it is a sector with requires light investment; the technology is simple; it mostly uses unskilled labor, etc During the past years, Vietnam’s textile industry has made remarkable efforts and become a main component in the textile industry in Southeast Asia and an important member in the global textile market With around 3,800 companies including state-owned enterprises, joint stock and limited companies, the textile and clothing industry is the leading export sector of Vietnam, making a considerable contribution to the country’s prosperity

Vietnam’s textile and clothing industry has developed rapidly in recent years and has become a main component of the country’s economy The export value of textile and clothing products has contributed the second largest share in the country’s total export value This sector has helped significantly to the increase in source of foreign exchange and Vietnam’s gross national product (GDP) In 2006, the export value of the textile and clothing products was 5.8 billion US dollars, making this industry the second most important export sector of Vietnam only after crude oil In 2007, Vietnam became an official member of the World Trade Organization (WTO) This has provided Vietnam great opportunities to develop, especially in terms of international trade as Vietnam receives equal treatment and benefits in trade like other members of WTO, and it was not be subjected to quotas anymore Moreover, joining the WTO helps Vietnam access to global market, expand export markets and increase value of goods exported The textile and clothing industry sector has seen an impressive period of development, with the trade volume increasing around 8% after ten years, from 2001 to 2011 Despite the global economic depression during the past years, the export value of this sector has continued to increase, exceeding 11 billion USD in 2010, an increase of 24% compared with 2009, and 14 billion USD in 2011, an increase of 38% compared with 2010 The production and exports of Vietnamese textile and clothing products contribute a considerable share in the world, accounting for 18.6% of the world’s total exports in textile industry in 2010 Currently, Vietnam ranks number five in the world in terms of textile and clothing exports, with over 2 million people working in this sector, accounting for nearly 5% of the country’s total labor force (VINATEX, 2012) The increase in export value of the sector in recent years results

2

from the expansion in export market Beside maintaining the traditional markets such as the

US, EU, Japan, the Vietnamese textile and clothing companies has expanded to new export markets such as Korea, Taiwan, the Middle East, and Singapore

Rapid development of Vietnam’s textile and clothing industry derives from many factors, including abundant low-cost labor force and a stable political environment Among them, the most important advantage is human capital The Vietnamese labor force has two main characteristics, the first is its low price as well as the higher quality compared with some other countries Vietnam has a young population with a high percentage of people at working age, an annual source supplementing the country’s labor force Vietnam has gained many economic benefits in the textile industry without a loss of the comparative advantage

in labor supply, and such an advantage is a driving force for the textile and clothing industry’s further development The second characteristic is its sustainability Expansion of urbanization and improvement in education in Vietnam has provided more high quality labor for the textile and clothing industry, guaranteeing the supply of workers for future development

Besides, trade and economic policies have also contributed to the development of the Vietnamese textile and clothing industry and helping Vietnam reach higher position in global market of textile and clothing products Textile and clothing industry has been declared as an key industry of the country’s economy Therefore, the Vietnamese government has adopted policies promoting an export-led growth strategy supported by strong foreign direct investment (FDI) inflows The state monopoly of foreign trade was abandoned The non tariff barriers were reduced Maximum import tariff rates were also decreased These measures have helped to reduce the anti-export bias resulting from the structure of trade protection, which tended to reduce the profitability of exporting compared

to producing for the domestic market (Athukorala, 2006 cited in Jean-Rafael and Jean Pierre, 2009) Tariff exemptions were also implemented for imported inputs used in the manufacturing export products as well as tax incentives and Export processing zones have multiplied (Jean-Rafael and Jean Pierre, 2009) Implementation of trade agreements have affected trade liberalization and increased market access After joining international economic organizations such as ASEAN (in 1997) and WTO (in 2007), and signing bilateral trade agreements (for example, with US in 2000), tariffs on imports and exports were significantly reduced or dropped, bringing various economic gains and especially increased market access

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It is obvious that Vietnam possesses a comparative advantage in textile and clothing manufacturing Nonetheless, Vietnam’s textile industry is facing various difficulties, such as excessive resource reliance, most enterprises are medium and small size, low technology and value added, indisposition in trade structure and highly concentrated export markets Another difficulty is the workers’ low level of skill, partly resulting in the low competitiveness of textile products Vietnamese textile workers are considered inferior in terms of professional skills compared with other textile export countries Among over 2 million people working in textile and clothing sector, percentage of skillful workers are relative low

Furthermore, supporting industries of textile and clothing manufacturing are still undeveloped and cannot meet the demand from this sector Domestic materials for this industry are seriously deficient and the textile company are unable to rely on domestic suppliers Despite Vietnam having a natural conditions suitable for growing cotton, the total cotton output is still not enough to provide for the textile industry In 2007, Vietnamese textile and clothing companies had to import around 90% of cotton material needed, and 70% of other materials for manufacturing such as fiber and fabric Shortage of local materials in one of main reasons resulting in decrease in business efficiency and in comparative advantage of Vietnamese textile and clothing enterprises

On the other hand, the textile and clothing industry is labor intensive Development of the Vietnam’s textile and clothing industry is still determined by labor costs Vietnam’s comparative advantage in textile industry mainly result from low labor costs However, this kind of advantage is tending to decrease as developed countries are persistently investing new technologies into their textile and clothing industries and the advantage of cheap labor

in developing countries tends to be weakened along with improvement in productivity in developed countries The developed countries can maintain higher profit in their textile and clothing industry while at the same time reduce production

It is therefore urgent for Vietnam have policies and measures to strengthen comparative advantage of textile industry and overcome serious domestic obstacles This dissertation aims at an in-depth investigation of comparative advantage of Vietnam’s textile and clothing industry and brings corresponding suggestions

1.2 Objectives

1.2.1 General Objective

 To investigate the patterns of Vietnam’s comparative advantage in textile and clothing industry

 To analyze the dynamics of Vietnam’s comparative advantage in textile and clothing industry

 To assess the determinants and factors affecting Vietnam’s comparative advantage in textile and clothing industry

 To derive policy implications based on the empirical findings Results of this research could be important in terms of helping to develop policies aiming at improving Vietnam’s comparative advantage

1.3 Dissertation structure

This dissertation consists of five chapters Chapter one describes the Statement of the problem and objectives of the Study Chapter Two provides an overview of the literature on comparative advantage and factors affecting comparative advantage of a country in a given industry Chapter Three describes indicators and index used to measure comparative advantage and then plus outlines the methods and models used in the study Chapter Four presents the results over three parts, these being Vietnam’s export performance in textile and clothing industry, patterns of Vietnam’s comparative advantage in textile and clothing industry and determinants of Vietnam’s comparative advantage in textile and clothing industry The discussion chapter reflects on the implications of the study’s findings and provides recommendations for policy makers The final chapter presents the conclusions, the limitations of the study and gives directions for further research

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Chapter 2

LITERATURE REVIEW 2.1 Theoretical Foundation

2.1.1 Definition of comparative advantage

In economics, comparative advantage is one of the oldest and most lasting concepts (Evans, 1989) Comparative advantage is commonly expressed as international differences in the opportunity costs of goods; that is, the quantity of other goods sacrificed to make one more unit of that good in one country as compared to another country In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies According to the law of comparative advantage, a country must specialize in those products that it can produce relatively more efficiently than other countries (Krugman and Obstfeld, 2003) This implies that despite absolute cost disadvantages in the production of goods and services, a country can still export those goods and services in which its absolute disadvantages are the smallest and import products with the largest absolute disadvantage It also implies that a country with absolute cost advantages in all its products will specialize and export those products where the absolute advantage is the largest, and will import products with the smallest absolute advantages Comparative advantage thus also leads to specialization, but differs from specialization based on absolute advantage, in that a country will always import, whether or not it is more or less efficient overall in the production of all goods and services relative to other countries

Relating the law of comparative advantage, the question that frequently arises is how is it possible for a country that is less efficient in the production of all products to export any of these products to another country that is more efficient in the production of all these products? (Smit, 2010) The answer lies in the self-equilibrating nature of the trade balance between countries (Krugman, 1993) This means that in equilibrium, if the input cost is sufficiently lower in one country than another country, the price of the product will be lower

in the low input cost country, even if that country is less efficient in the production of the product (Salvatore, 2002) Any deviations from equilibrium will automatically realign the exchange rate between the two countries to ensure new trade equilibrium

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According to Baumol and Binder (2009), comparative advantage underlies the economics analysis of international trade patterns A country that is particularly adept at producing certain items – such as aircraft in the United States, coffee in Brazil, oil in Saudi Arabica - should specialize in those activities, producing than it wants for its own use The country can take the money it earns from its exports and purchase from other nations items that it does not make for itself And this is still true if one of the trading nations is the most efficient producer of almost everything The United States might, for example, be better than South Korea at manufacturing both computers and television sets But if the United State is vastly more efficient at producing computers, but only slightly more efficient at making television sets, it pays for the United States to specialize in computer manufacture, for South Korea to specialize in television production, and for the two countries to trade The idea of comparative advantage has been first mentioned in Adam Smith's Book The Wealth of Nations: "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage." But the law of comparative advantages has been formulated by David Ricardo who investigated in detail advantages and alternative or relative opportunity in his 1817 book On the Principles of Political Economy and Taxation Ricardo established the result that countries can mutually benefit from trade if pre-trade relative prices of commodities in those countries are different (Caves and Jones 1977)

Recent comparative advantage analyses are frequently based on the Heckscher - Ohlin O) model of international trade or its extensions The basic version of the H-0 model was developed in a context of two inputs and two outputs The two central hypotheses of this model, as described by Leamer (1984), are: (1) immobility of some production factors between countries, and (2) factors can be used in different combinations to produce different goods The model also assumes that all countries have access to the same technology and free trade The main implication of this model is that, given the restrictive set of assumptions, a country will export commodities whose production makes intensive use of factors locally abundant, and will import commodities that are produced with factors relatively scarce (Caves and Jones 1981), that is, a country will have comparative advantage

(H-in the production of the good which (H-intensively uses factors abundant (H-in that country Thus, trade flows are dictated exclusively by factor endowments The resulting main difference between the Ricardian and Heckscher-Ohlin implications is that the Ricardian theory explains international trade on the basis of differences in technology (or productivity)

is least inefficient

2.1.2 Theories of comparative advantage

The theory of comparative advantage is likely one of the most important concepts in international trade theory Leamer (1984) suggested that the main purpose of trade theory is

to describe and predict the responsiveness of outputs and factor prices to changes in output prices and factor supplies and also identify which commodities are exported and which are imported Two basic models were initially developed to address these issues: the Ricardian model and the Heckscher-Ohlin model

2.1.2.1 Ricardian model

Caves and Jones (1977) describe the Ricardian model as the oldest and simplest trade model

in which the details of production are fully incorporated According to the classical Ricardian theory of comparative advantage, relative labor productivities determine trade patterns The Ricardian model plays an important pedagogical role in international economics (Golub and Hsiehh, 2000)

Ricardo’s theory of comparative advantage is based on the labor theory of value (Salvatore, 2002) The Ricardian model assumes that i) labor is the only factor of production that is remunerated, ii) all labor is homogeneous and all occupations pay the same wage, iii) in any occupation the number of man-hours required per unit of output is constant and independent

of the output level, that is, real cost per unit is constant and, iv) labor is mobile among industries but immobile between countries (Caves and Jones 1977) These unrealistic assumptions led to the incorporation of opportunity cost into the explanation of the theory of comparative advantage If the Ricardian theory of comparative advantage is redefined in terms of opportunity cost, then a country will have a comparative advantage in the production of goods and services if such goods and services can be produced at a lower opportunity cost This implies that a country will have a comparative cost advantage in the

8

production of those goods and services that can be produced at a lower opportunity cost than

in other countries (Salvatore, 2002)

The Ricardian model can be easily understood in the context of a country, commodity model Adapting Caves and Jones (1977), imagine a simplified closed economy

two-in which only two commodities, X and Y, can be produced Let a LX and aLY each represent

the constant real labor costs per unit of output in the production of X and Y, respectively If output levels are given by Zx and Zy, the total level of labor allocated to X and Y would be

aLX Zx and aLY Zy, respectively Assume labor is fully employed,

The assumption of fixed labor requirements per unit of output implies that equation (1) describes a straight line transformation schedule (see Caves and Jones 1977, p 76) This implies that in the Ricardian model, relative prices are fixed and determined by the real

labor costs per unit of output a LX and aLY To see this, we ask how much extra Y could be

produced if X output is reduced by one unit This reduction would release a LX units of labor

Since a LY units of labor are required to produce one unit of Y, aLX /a LY extra Y units could be

produced Since a LX /a LY represents the relative price of X, and this ratio is constant, relative prices are constant In this case, the straight line transformation curve would also imply that

the relative supply function (Zx/ZY) is horizontal This implies that demand has no role in

determining pre-trade relative prices

Now suppose that this country engages in trade with another country that also produces only

X and Y In the Ricardian model, patterns of trade are completely determined by technological differences between countries, or put in another way, trade flows are

determined by the countries' pre-trade relative prices Let a LX* and aLY* each represent the

constant real labor costs per unit of output in the production of X and Y in the foreign country, respectively In a general form, the foreign country has comparative advantage in X only if

<

Equation (2) makes evident the counterintuitive nature of the Ricardian model Following the example offered by Ricardo and later replicated by Caves and Jones (1977), suppose the home country has higher labor costs per unit of production than the foreign country in both commodities Why should the foreign country import anything from the home country? Because, although the home country labor was at an absolute disadvantage in both

9

commodities X and Y, its disadvantage is relatively less in one of the goods The foreign country has an incentive to focus on the production of the good it produces the cheapest, and import the good the home country produces the cheapest Higher wages accompany higher productive labor in the foreign country The assumption of immobile factors of production between countries guarantees that wages will not be equated

Strengths and weakness of the Ricardian model

Major difficulties with the Ricardian model are: 1) labor is the only input considered - this implies, for example, that differences in factor endowments between countries play no role

in explaining trade patterns, 2) the demand side of the model has no role in determining patterns of trade since pre-trade prices are determined exclusively by relative supply, and 3) differences in technology between countries is overemphasized, without explaining why methods of production should differ

Incomplete specialization: Perhaps the most problematic feature of the simple Ricardian model, from an empirical point of view, is the implication that countries specialize completely in tradable-goods production, except in case when a small country cannot satisfy demand of a large country In practice, import-competing sectors rarely disappear in the face

of foreign competition There are two possible routes to reconciling incomplete specialization with differences in labor productivity: product differentiation and disequilibrium effects

A disequilibrium interpretation of the Ricardian model is that price and quantity arbitrage is incomplete, resulting in incomplete specialization in the short run In long run equilibrium, either complete specialization or equality of unit labor costs would be attained, but the process of adjustment may be very slow

Alternatively, incomplete specialization (and intra-industry trade) can coexist with productivity differences, owing to product differentiation With product differentiation, differences in technology can drive inter-industry trade, while intra-industry trade occurs because of product differentiation, as in Krugman (1981) Allowing for product differentiation also help address Bhagwati’s (1964) objection to test of Ricardian theory Bhagwati argued that if the tests of Ricardians model are based on incomplete price arbitrage, then one should examine the link between trade prices and trade flows instead of going directly from labor costs to trade flows With product differentiation, productivity differences, incomplete specialization, and commodity price equalization could be consistent For example, in variant of Krugman’s (1981) model of Dixit – Stiglitz

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monopolistic competition, if country X is relatively productive in industry A relative to industry B compared with country Y, X will produce more varieties and be a net exporter of good A, yet the price of each variety of good A will be equalized across countries by trade

In such a framework, there is no link between observed post-trade relative product prices and trade patterns, but there is a link between relative labor productivity and trade

Although the theory of comparative cost advantage is based on a set of strict assumptions, this does not invalidate the general acceptance of the theory in explaining gains from trade (Krugman 1990; Culbertson, 1986; Keesing, 1966) This is furthermore underscored by the fact that most of the principles of the World Trade Organization (WTO) are based on the belief in the validity of the law of comparative advantage (Root, 2001) Even the relaxation

of most of the assumptions does not affect the general validity of the theory in any significant way (Harkness, 1983), and enough empirical evidence exists to support the theory of comparative advantage (Bernhofen and Brown, 2004; Schott, 2004; Uchida and Cook, 2005)

The superiority of the theory of comparative advantage lies in the remarkable amount of useful information that it summarizes clearly and concisely According to Salvatore (2002):

“It shows the conditions of production, the autarky point of production and consumption, the equilibrium relative commodity prices in the absence of trade, the comparative advantage of each nation it also shows the degree of specialization in production with trade, the volume of trade, the terms of trade, the gains from trade, and the share of these gains to each of the trading nations” It is this power of the theory that provides a convincing explanation why trade is a positive sum game (Krugman, 1994a, 1994b, 1998)

2.1.2.2 Heckscher – Ohlin model (H-O)

Whereas the Ricardian model of trade conveys the essential idea of comparative advantage,

it does not explain the direction of trade Economists thus needed an alternative model of comparative advantage to explain the direction of trade An important theory to explain the reasons, or causes, of comparative advantage differences between countries is the Heckscher-Ohlin (H-O) theory (Salvatore, 2002)

According to this theory, countries differ with respect to their factor intensities, namely the labor and capital that are used in the production of goods and services While there are many different resource explanations of comparative advantage, the H-O theory isolates factor abundance or endowments as the basic determinant of comparative advantage Although the

In the H-0 model, trade is driven mainly by differences in factor endowments, leading to the main conclusion that a country with balanced trade will export the commodity that uses intensively its relatively abundant factor and will import the commodity that uses intensively its relative scarce factor (Heckscher-Ohlin theorem) Leamer (1984) offers a

straightforward proof to this theorem Consider two commodities Xi andX2 In equilibrium,

factor supply equals to factor demand

K = aK1X1 + aK2X2

L = aL1X1 + aL2 + X2

(3)

Let V represent the vector of endowments (K, L) and X the vector of outputs (X 1, X2).Then

these equations can be written as

prices of output and consumers maximize identical homothetic utility function, each country

consumes commodities in the same proportions, C = sX w , where s is the country's

1

The complete set of assumptions, as described by Leamer (1984), under which the main conclusions of the model can be reached, are: (1) the number of goods and factors are equal to two; (2) production factors are completely immobile between countries but move costlessly between industries within a country and (b) commodities are traded freely at zero transportation cost; (3) input and output markets clear competitively, (4) countries have costless access to the same technology; (5) the variability of factor endowment ratios among countries is less than the variability of factor input intensities across industries (see pages 4 through 6 for a precise definition of variability) This condition is necessary to ensure factor price equalization across countries; (6) all consumers maximize an identical homothetic utility function.

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consumption share of world output and C is its consumption vector Trade balance requires

that p'X = p'C - sp'X w (value of production equals value of consumption), where p is the

price vector (p 1, p2) Thus, balanced trade implies

that is, the consumption share is the ratio of own GNP to world GNP

In the context of the H-0 model, net exports is defined as the difference between production and consumption:

To conclude the argument, Leamer (1984) demonstrates that if a given country is relatively

capital abundant (K / K w > L / Lw), than the excess factor supply vector has signs (+,-) This

is assured by the fact that the consumption share is a weighted average of capital share and the labor share

s =

=

= = [ ( ) ( )]

where w is the factor reward vector: w = (A') -1 p This implies that s is bounded by K/K w

and L/L w , and consequently K/K w > s is equivalent to K/K w > L/L w The last step in

determining the sign of the net export vector of a capital abundant country is defining the effect of pre-multiplying a vector with signs (+,-) by the inverse of the matrix A:

A-1 = [

] = [

]/| |, where | | = ( ) = [

If X 1 is the capital intensive industry, then | | > 0, and A-1

has the sign pattern [ ] Thus, if the country is abundant in capital, the vector of excess factor supplies has sign pattern (+,-), and trade therefore has sign pattern T = [ ] [ ] = [ ] This implies

13

that the capital abundant country exports the capital intensive commodity X 1 and imports the

labor intensive commodity X 2 (Leamer 1984)

A number of empirical studies have been conducted to verify the H-O theory One of the first such studies was conducted by Leontief (1953), who found that, irrespective of the general believe that the United States was expected to be an exporter of capital-intensive products and an importer of labor-intensive products, the results confirmed just the opposite The paradox was later confirmed by Baldwin (1971) Similar results were reported in studies based on data for Japan, Germany, India and Canada (Baldwin, 1979)

The Leontief paradox has led economists to look for alternative explanations for the H-O theory The most important of these was the introduction of differences in human capital (Keesing 1966; Baldwin 1971) as an explanation of the paradox Others were the product

cycle theory (Vernon 1966) and the technology gap theories (Gurber et al., 1967; Gold

1981) that incorporate time as a dynamic extension to the basic H-O theory Most of these theories were mere modifications and extensions of the basic H-O theory and did not reduce the validity of the theory in explaining the direction of trade between countries

The Ricardian and the H-O models are important to make clear the definition of comparative advantage, a term frequently misused These models are also used as guidelines

in the construction of the empirical model

The connection between the theoretical models and the problem at hand stems from the fact that the theory allows one to form expectations on what determines the configuration of international supply of textile products, what causes this configuration to change and how countries move toward a new equilibrium when economic conditions change Moreover, theoretical models allow us to contrast results from empirical models with expectations The importance of having a solid theoretical reference cannot be overstressed For instance, several studies have tried to explain and forecast patterns of production and trade based on differences in absolute production costs For instance, these studies tend to conclude that textile and clothing production will increase in areas where it can be produced cheaper in absolute terms

Although this idea may seem intuitive, it is misleading The Ricardian model suggests that relative costs (and not absolute costs) are important in determining patterns of production

In theory, it is possible to manufacture textile products in regions where absolute costs are not the lowest Thus, in order to form a correct expectation of the allocation of world supply

2.1.3 Factors affecting comparative advantage

2.1.3.1 Technological Superiority

Adam Smith’s principle of “absolute advantage” and David Ricardo’s principle of

“comparative advantage”, in general, are based on the technological superiority of one country over another country in producing a commodity The Ricardian model assumes constant productivity, as there is only one factor of production (labor), and therefore constant (opportunity) costs that leads to complete specialization However, increasing opportunity costs that often arise in multi-factor situations (law of diminishing returns) due

to limited quantity of some factors specific to an industry can easily be accommodated to allow for incomplete specialization Thus, in the Ricardian model, technological differences

in two countries are the major source of movement of commodities across national boundaries

While the principle of comparative advantage as expounded by David Ricardo was couched

in terms of technological superiority, the principle, when phrased in terms of comparing opportunity cost or relative prices of goods and services between countries is sufficiently general to encompass a variety of circumstances Furthermore, although Ricardo’s explanation of comparative advantage was in static terms, comparative advantage is a dynamic concept A country’s comparative advantage in a product can change over time due

to changes in any of the determinants of comparative advantage including resource endowments, technology, demand patterns, specialization, business practices, and government policies

2.1.3.2 Resource endowments

Availability of resources in a country provides another source of comparative advantage for countries that do not necessarily possess a superior technology Under certain restrictive assumptions, comparative advantage can be obtained due to differences in relative factor endowments As propounded by Heckscher and Ohlin, a country has a comparative

15

advantage in the production of that commodity which uses the relatively abundant resource

in that country more intensively For example, newsprint uses natural resources (forest products) more intensively compared to textiles Textiles use labor (L) more intensively compared to newsprint Canada is relatively abundant in natural resources (R) compared to India (R/L) Canada > (R/L) India This implies R will be relatively cheaper in Canada as compared to India Thus, Canada has a comparative advantage in newsprint and will therefore specialize and export newsprint to India Likewise, India has a comparative advantage in textiles and will therefore specialize and export textiles to Canada

a Traditional endowments

Land, labor, and capital are the traditional factors considered by the textbook models of international trade They are also the most commonly used factors in empirical studies of patterns of trade across countries and across industries within countries The treatment of land and unskilled labor as endowments is less controversial than capital

In addition to physical capital, human capital is also a source of comparative advantage The importance of human capital accumulation in economic performance has been studied by many economists Lucas (1988) argued that human capital accumulation is the ―engine of growth citing the notable differences in productivity of human capital relative to the smaller differences in productivity of physical capital across countries Romer (1990) and Barro (1991) carried out cross-sectional studies and found empirical support for the positive relationship between human capital accumulation and economic growth Recently, Barro and Lee (2010) created a new dataset of stocks of human capital based on educational attainment and found that length of schooling has a significant effect on output as well as income at the country level, particularly for secondary and tertiary levels of education Some recent studies dealing with the impact of human capital accumulation on trade

performance include Spiros and Riezman (2007), Manova (2008) and Spiros et al (2009)

Human skills can also be considered a resource Countries with relatively abundant human skills will have a comparative advantage in products that use human skills more intensively Certain products such as electronics require a highly skilled labor force (such as engineers, programmers, designers, and other professional personnel) Such products may gain comparative advantage in countries (such as Taiwan, Singapore, Hong Kong) that are relatively better endowed with such skilled labor (Keesing, 1966) Government policies aimed at better education and training can create such an endowment

b Knowledge and schooling

16

These factors are country-specific only to the extent that efforts towards knowledge creation and schooling actually stay within national borders In the case of expenditures in research and development (R&D), either private or public, patent rights embody the institutions that secure the property rights on the created knowledge In the case of education, international limits on the migration of people make the educational attainment of the adult population a country-specific feature

c Domestic transport infrastructure

Internationally immobile factors of production should also include the extent and quality of domestic infrastructure Since industries have different transport-intensities for delivering their products to the main export markets, these factors have the potential of affecting the composition of net exports and comparative advantage

2.1.3.3 Availability of credit

Financial development has been established as a pre-condition for economic development

A study by Rajan and Zingales (1998) established that industrial sectors that are relatively more in need of external finance develop faster in countries with more developed financial markets Beck (2003) and Manova (2008) built on this idea and demonstrated that financial development translates into a comparative advantage in industries that use more external finance Beck (2003) demonstrated this effect using data for 36 industries and 56 countries Manova (2008) showed how such an effect may arise in a theoretical trade model with heterogeneous firms where larger, more productive firms have an advantage in obtaining external finance She also found empirical evidence for this effect using data on bilateral exports for 107 countries and 27 industries during the period 1985-1995 More recently Chor (2010) confirmed the importance of credit constraints as determinant of international trade patterns using a sample of 83 countries and 20 industries and data for 1990

2.1.3.4 Economies of scale

Economies of scale can provide comparative advantage by lowering production costs External economies that operate by shifting the average cost of firms downward can in fact occur due to an industrial policy or a proactive role of the government in providing better infrastructure and/or a better educated or trained labor force Such economies of scale are consistent with Ricardian model Economies of scale (internal) achieved through the existence of a large home market and/or some policy-induced accessibility to a larger market outside the nation (say due to a customs union) also imply lower production costs

17

This may boost or create a comparative advantage for the industry experiencing such economies of scale

2.1.3.5 Technological Gap (Benefits of an Early Start) and Product Cycle

Industrially advanced nations in general had an early start in most manufactured products and services, which allowed them to enjoy large national and international markets Industrially advanced nations were thus able to export new products until such time that the products were produced by other low factor cost countries Vernon’s (1966) Product Cycle hypothesis emphasizes the importance of the nature and size of home demand for new products in highly industrialized countries Since, initially, the new product involves experimentation of the features of the product as well as the production process, the countries that have sufficient home demand for such products produce and export them As the specific nature of demand becomes more universal and the technology more easily available to others, the nation loses comparative advantage in that product Meanwhile, the firms are likely to have developed another product that enables the nation to gain comparative advantage in that product

2.1.3.6 Demand Patterns: Demand Considerations

The role of demand and the size of the home market for products are already evident in (1) establishing the equilibrium terms of trade and therefore the division of gains from trade; (2) economies of scale; and (3) product cycle hypothesis In addition, Linder (1961) emphasized the role of demand in the home market as a stepping stone towards success in international markets According to Linder, manufacturers initiate the production of a new product to satisfy the local market In this step, they learn the necessary skills for making the product by more efficient techniques, which in turn, give these nations comparative advantage in the product vis-à-vis other countries Linder’s study postulates exporting the product to countries with similar tastes/demand patterns The theory, coupled with market imperfections and product differentiation can explain a large portion of intra-industry trade among the industrialized nations

2.1.3.7 National and International Policies

National policies towards infrastructure, export promotion, education and training, R&D policy related to export industries can go a long way in creating and sustaining comparative advantage The policies that do not target any particular sectors but rather reflect broad public choices or seek to enhance general resource endowments, even though they may indirectly favor some of the sectors, are a potential source of comparative advantage and

of comparative advantage to these industries The 1965 Auto-Pact between Canada and the USA is a good example of targeting individual industries to influence production and trade through national policies Chang in Lin and Chang (2009) described the four decades long protection of the Japanese car industry by high tariffs, direct and indirect subsidies and restrictions on foreign direct investment before it became competitive in the world markets Nokia group was cross-subsidized by its sister companies before it started making profits (Lin and Chang, 2009) Korean state owned firm POSCO benefited from import substitution-type of policies and the Brazilian aircraft company Embraer was established and developed into a global competitor through state ownership and export subsidies (Rodrik, 2009)

The trade creation and trade diversion effects of customs unions/free trade areas are well known in the literature Further, the policies pursued by international organizations such as the World Bank, the IMF and the WTO can also become a source of comparative advantage/disadvantage to some industries in countries affected by such policies

2.1.3.8 Factors affecting export performance

As comparative advantage is normalized by dividing the export-import ratio of a country for

a given industry by that for the world, factors affecting export performance also affect comparative advantage of a country in a given industry Determinants of export performance can be divided into internal and external components External components include market access/entry conditions and a country’s location regarding international markets Internal components are related to supply-side conditions (Fugazza, 2004)

19

Supply conditions are fundamental in defining the export potential of an economy and, for a given level of access to international markets, countries with better supply conditions are expected to export more (Fugazza, 2004) Main determinants of supply-side conditions include: domestic transport infrastructure, macroeconomic environment/real exchange rate, foreign direct investment and institutional quality (UNCTAD, 2005)

a Domestic transport infrastructure

Many studies have shown that domestic transport infrastructure is one of the main factors affecting export supply capacity of a country, especially at the early stages of development (UNCTAD, 2005) It is obvious that infrastructure influence trade though affecting transport

costs and delivery time for goods Bougheas et al (1999) found a positive relationship

between the quality of infrastructure and the volume of trade Mbekeani (2007) and Bacchetta (2007) show that for most African countries poor transport infrastructure is one of the main constraints of international trade, and isolates countries face many difficulties participating in global production networks (Limão and Venables, 2000) Poor domestic transport infrastructure result in high transport costs which make the exports of African

countries expensive and uncompetitive and reduce export value (Matthee et al., 2007)

Therefore, improvement in transportation conditions and infrastructure in general can lead

to improvements in export performance

b Foreign direct investment (FDI)

FDI is also an important factor affecting export performance of a country Through increasing financial capital, FDI can help the country use their resources more efficiently and decrease unemployment, and thus increase a country’s output and productivity (Seetanah and Khadaroo, 2007) However, whether FDI contributes to export growth or not depends on the nature of the policy regime and motive for such investment According to the World Bank (1993) if the purpose of FDI is to capture the domestic market (tariff-jumping type of investment), it may not contribute to export growth; but if the motive is to tap export markets by taking advantage of a country's comparative advantage, then FDI may contribute to export growth Some studies indicate that there exists a negative relationship

between FDI and export performance (Gu et al., 2008; Jeon, 1992) However, others found

that FDI encourage export performance of receive countries (Fugazza, 2004; UNCTAD, 2005)

c Quality of institutions

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Quality of institutions have been also found to be highly correlated with trade and affect export performance According to UNCTAD (2008) the institutional quality and government policies is one of factors determining whether countries can benefit from globalization Levchenko (2004) concludes that differences in quality of institutions can be

a source of comparative advantage In low-income countries, weak and missing institutions can exert a resistance effect on enterprises in taking advantage of new trading opportunities (Biggs, 2007) A decrease in quality of a country’s institutions is supposed to result in a reduction of its exports (Anderson and Marcouiller, 2002)

d Economic scale

Many studies have shown that economic scale which is generally measured by GDP of export and import country is an important determinant of export performance Antonucci and Manzocchi (2006) state that the larger the economies of the export and import countries, the larger trade exchanges among them

e Distance between export and import country

The greater is the distance between the two countries, the higher are the costs related to transporting goods, thereby reducing the gains from trade and trade itself (Fugazza, 2004) Glick and Rose (2002) state that more distant countries trade less and vice versa Distance bring about resistance impact on trade flow, mainly because of transport costs and time of delivery (Antonucci and Manzocchi, 2006)

f Land –locked countries

Geography of a country is also a factor affecting its export performance by altering international transport costs Landlocked countries have limited access to ports, resulting in increase in transport costs (Redding and Venables, 2003) Therefore, landlocked countries meet more difficulties in improving their international trade volumes than coastal countries

(Matthee et al., 2007)

g Common border

Previous studies have shown that the impact of distance on trade between countries is linear This means that the trade between countries sharing border is greater than countries with similar distance but not sharing border (Fugazza, 2004) The study of Glick and Rose (2002) also show land border encourage trade between two countries

non-h Colonial ties

21

Glick and Rose (2002) explore the impact of colony relationship on trade of countries They show that trade between the two countries is encouraged if the two countries were ever colonies with the same colonizer, or currently are colonies, or one country ever colonized the other country

2.1.4 Comparative Advantage framework

All the above considerations yielding comparative advantage to the nation may be seen as a framework of a number of forces that can be portrayed in the form of a diamond shown in Figure 1 Obviously, the firms specializing within the industries that have comparative advantage are on a much stronger footing to derive competitive advantage in producing standardized or differentiated products within that industry In this framework, technology, resources, demand and the trade-enhancing policies are depicted as four forces influencing the comparative advantage of a nation in a commodity/service vis-à-vis other countries Dynamic elements influencing comparative advantage are also included in these forces

“Despite all discussions on competitiveness however, no clear definition or model has yet been developed There is even ongoing debate about the “entity” of competitiveness.” Hoffman (2000) developed a definition of sustainable competitive advantage (SCA) based

Trade Enhancing National Policies/ International Policies (WTO, IMF, World Bank…)

Technology/ Scale Economies/Supporting Industries

Quantity and Quality of

Physical and Human

Resources

Demand /Market Size

INDUSTRY

22

on Barney (1991) together with dictionary meanings of each term as “An SCA is a prolonged benefit of implementing some unique value-creating strategy not simultaneously implemented by any current or potential competitors along with the inability to duplicate the benefits of this strategy.” Obviously, this definition emphasizes competitive advantage of a firm based on firm-specific factors and thus ignores macro aspects of comparative advantage

A number of researchers on competitive advantage have focused on the determinants/sources of competitive advantage such as important attributes of the firm: rareness, value, inability to be imitated, and inability to be substituted (Barney, 1991); important potential resources classified as financial, physical, legal, human, organizational, informational, and rational (Hunt and Morgan, 1995); ability in developing superior core competencies in combining their skills and resources (Prahalad and Hamel, 1990); a set of dynamic capabilities—capabilities of possessing and allocating and upgrading distinctive resources Luo (2000) A number of studies have also analyzed the role of individual factors such as intellectual property rights, trade secrets, data bases, the culture of organization, etc (Hall, 1993), ethics capability (Buller and McEvoy, 1999), corporate reputation (Ljubojevic, 2003), diversity in workplace (Lattimer, 2003) and corporate philanthropy (Porter and Kramer, 2002) The central focus of these contributions is still on firm-specific factors of competitive advantage

Porter (1990) developed a framework of competitive advantage “A Diamond of National Advantage” based on detailed case studies of firms in 100 industries in 10 industrially advanced nations (USA, Japan, Germany, UK, Switzerland, Italy, Sweden, Denmark, Sweden, Korea and Singapore) that constituted 50% of world exports in 1985 A nation is deemed to have competitive advantage in the industry “if it possessed competitive advantage relative to the best worldwide competitors” in terms of indicators such as “the presence of substantial exports to a wide array of other nations and/or significant outbound foreign investment based on skills assets created in the home country” (Porter, 1990) The central thesis is that “National prosperity is created, not inherited It does not grow out of a country’s natural endowments, its labor pool, its interest rates, or its currency’s value as classical economics insists A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade Companies gain advantage against the world’s best competitors because of pressure and challenge …having strong domestic rivals, aggressive home-based suppliers, and demanding local customers.” (Porter, 1990) Innovation in every sphere of a firm’s activities plays the central role in awarding competitive advantage to a

23

firm and therefore the industry Why some firms are more capable of successful innovations depends on four attributes of a nation: factor conditions, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry

Factor conditions do not refer to the conventional pool of resources, such as land, labor, capital, raw materials, but rather those “created” and continually upgraded such as highly specialized skilled labor, and world-class scientific institutions most suited to the industry’s needs The Demand conditions refer to, not the size, but the character of home market demand the sophisticated and demanding buyers who can signal the future pattern of demand and can pressure the companies to innovate faster compared to competitors elsewhere Related and supporting industries that are internationally competitive, and in particular, actively engaged in innovation and upgrading are more promising in creating competitive advantage rather than the mere existence of raw material and/or component producing industries Firm strategies, structure and rivalry refer to managerial, organizational as well as the existence of competitive forces/challenges from other firms within the industry While the managerial/organizational modes must be compatible with other sources of competitive advantage, existence of domestic rivalry is considered sine-qua-non as well as an integrating force in the “diamond” It forces companies to a continual challenge for innovation and upgrading in all forces in the “diamond” and makes the working of the diamond as a system in gaining and sustaining competitive advantage Porter presents these forces in the form of a “diamond” depicted in Figure 2 (adapted from Porter,1990a)

Competencies/Resources to benefit from Comparative Advantage and convert it in

to Competitive Advantage

Innovation Strategies related to Demand Factors

& Product Differentiation

24

Figure 2.2: Determinants of National Competitive advantage

As is obvious from the description and operation of the forces in the “diamond”, the competitive advantage of an industry is driven by firm-specific factors, the competitive environment, and the push towards innovation and up-grading The basic differences in the framework of competitive advantage vis-à-vis factors influencing comparative advantage are (1) an emphasis on “created” factors of production and innovation by the firms in competitive advantage versus the “inherited” factors of production and technology with dynamic elements at the national level; (2) an emphasis on demand side, particularly firm’s success in creating a differentiated product with some unique characteristics within the same industry in competitive advantage versus market size for products of each industry in comparative advantage; (3) an emphasis on gaining monopoly or niche by successful firms

in markets for their products in competitive advantage versus emphasis on traditional models of competition in comparative advantage; and (4) an emphasis on explaining intra-industry trade in advanced industrialized economies in competitive advantage versus inter-industry trade in comparative advantage Thus, in general, the competitive advantage framework relies on the “bottom-up” approach to competitive advantage of a nation as compared to the “top-down” approach in the models of comparative advantage What needed is a synthesis of the two frameworks for a better explanation of international trade in all goods and services

2.1.6 Linking comparative advantage and competitive advantage

As is evident from the two approaches, competitive advantage relies heavily on the specific factors such “created” factors, “created” demand for the product, and internal economies achieved through innovation Comparative advantage, on the other hand emphasizes nationally “endowed” factors, differences in international technology/productivity, external economies, and international policies It is noted that forces underlying both competitive advantage and comparative advantage are important in deriving a nation’s advantage in trade In fact, the forces under competitive and comparative advantage can be seen to reinforce each other in explaining a nation’s advantage in international trade

firm-A pragmatic approach would therefore entail linking forces under both competitive and comparative advantage, as shown in Figure 3 For trade among the developed countries, particularly the intra-industry trade, firm level forces (competitive advantage diamond) are stronger compared to the country level forces For trade between the developed and the

25

developing countries (or the resource-rich countries), particularly the inter-industry trade, country level forces (comparative advantage diamond) are stronger compared to the firm level forces Further, the same country may gain advantage in intra-industry trade with some countries as well as inter-industry trade with some other countries

Figure 2.3: Linking Comparative Advantage and Competitive Advantage

Competencies/Resources to benefit from Comparative Advantage and convert it in

to Competitive Advantage

Innovation Strategies related to Demand Factors

& Product Differentiation

Technology/ Scale Economies/Supporting Industries

Quantity and Quality of

Physical and Human

Resources

Demand /Market Size

INDUSTRY

26

Strength of the feedback from the firm level forces to the country level forces depends on the strength of research & development and innovation strategies (relating to both demand and supply sides) carried out by the firms and national competition policy The strength of the feedback from the country level forces to the firm level forces depends on the differences in factor endowments and technology between countries, the degree of national involvement in infrastructure, skill training, and the macro policies suitable for international trade and investment In general, it is believed, in a static world, a country and the firms in that country will enjoy competitive advantage if firms in that country specialize in the products in which a country has a comparative advantage In a dynamic world, firms will find it to their benefit to enhance comparative advantage of their nations through forces of competitive advantage, where created factors and cutting-edge technology and innovation assume greater importance The competitiveness of nations measured by organizations such

as the World Economic Forum and the International Institute of Management Development, though not suitable for our purpose, use both micro and macro variables

The principles of comparative and competitive advantage can be illustrated by Canada’s international trade Canada enjoys a relative abundance (relative to labor and semi-skilled labor) of capital and a number of natural resources such as minerals, forest and agricultural land as compared to a number of developing countries such as Brazil, China, India and Indonesia Canada’s exports to these countries are predominated by transport equipment, heavy machinery, newsprint, wood pulp, wheat, minerals, mineral and chemical fertilizers; whereas commodities such as clothing, footwear, toys, light electronic items predominate imports from these countries Diamonds from India and natural rubber and rubber products from Indonesia are also important in Canadian imports from these countries Natural resource intensive goods also predominate in Canada’s exports to countries such UK and Japan Canada’s trade, both imports and exports, with USA, its largest trading partner, is still predominated by transport vehicles, a result of the Auto-Pct since 1965—a good example of the influence of national policies on international trade

However, the competitive advantage developed by the Canadian auto industry is also responsible for Canadian exports of automotive parts and vehicles to nearly 50 other countries in the world Canada is also engaged in intra-industry trade with several countries (with similar endowments of labor and capital and technology) in a number of industries such as aircraft and aircraft parts, electronic computing and peripheral equipment, telecommunications equipment, medicaments, etc This trade is more easily explained by the “bottom-up” approach of the competitive advantage framework

27

2.1.7 Measuring comparative advantage

The concept of comparative advantage is widely accepted, but at the same time comparative advantage in a particular commodity by a country is difficult to measure Therefore, attempts have been made to approximate the concept in an indirect way These indirect methods use information “revealed” from post-trade situations and assumptions about the relationship between observable and unobservable variables (Greenaway and Milner, 1993) Therefore these indexes of Revealed Comparative Advantage (RCA), are in fact, useful as one of the few formal ways of measuring the sector identity and intensity of a country’s comparative advantage and disadvantage

2.1.7.1 Balassa’s Index of Revealed Comparative Advantage

Among the measures of RCA that use only trade data, several versions have been adopted in the literature One of the most widely applied is developed by Balassa (1989) In fact, he used two different indices: the export-import ratio and an export performance index

The export-import ratio has been normalized by dividing the export-import ratio of a country for a given industry by that for the world:

Where Xij and Mij refer respectively to exports and imports of industry i and country j; Xiw

and Miw refer respectively to world exports and world imports of industry i

On the other hand the second measure is based on export data only and is calculated by dividing a country’s share in the exports of a given commodity category by the share in the world exports of manufactured goods:

RCA2 = (Xij / Xiw) / (Σ Xij / Σ Xiw) * 100 (11)

Where Xiw and Xij are the world’s and country j’s export of industry i, and Σ Xij , Σ Xiw are

the total exports of manufactures for country j and the world w respectively

If the latter index, as the basic index of RCA, takes a value of greater than 100, then the

share of industry i in country j’s exports is larger than the corresponding world share, and therefore country j has a revealed comparative advantage in industry i

2.1.7.2 The Donges and Riedel Measure

Another measure of comparative advantage calculated by Donges and Riedel (1977),

defines the RCA index as the ratio between the share of country j’s net exports of industry i

28

in its total trade of industry i, divided by corresponding share of net exports for all

manufacturing industries, and adjusted for the surplus or deficit in total manufacturing: RCA3 = { [ (Xij-Mij) / (Xij+Mij) ] / [ (Σ Xij-Σ Mij ) / (Σ Xij+Σ Mij ) ] –1}*100

+1 for (Σ Xij-Σ Mij ) > 0

With the expression within brackets times

- 1 for (Σ Xij-Σ Mij ) < 0

(12)

where X and M refers the value of country j’s exports and imports of industry i,

respectively If the value greater zero, it indicates that the country has a comparative advantage, and vice versa

The numerator of this measure is called as the revealed net exports ratio (RNEX) and is used as an index of RCA:

RCA4 = [ (Xij-Mij) / (Xij+Mij) ] *100 (13) The value ranges between the two extreme values of –100 (for industries that were imported but not exported) and +100 (for industries that were exported but not imported)

2.1.7.3 Wolter Index

Wolter (1977) suggested another but more simple measure with the same variables:

RCA5 = (Xij / Mij) / (Σ Xij / Σ Mij ) (14) where Xij , Mij denote the total value of exports and imports of industry i of country j, and

denote total value of exports and imports of the country In fact, the RCA index employed here, provides information about the relative export performance of a certain industry with respect to other industry groups in the country

2.1.7.4 Michaely Index

RCA6 = ( Xij / ΣXij ) – ( Mij / ΣMij ) (15)

where Xij , Mij denote the total value of exports and imports of industry i of country j The

first part of the formula represents the percentage share of a given sector in country’s exports, while the latter part represents the percentage share of a given sector in country’s imports The measure ranges between –1 and +1, with a neutral value of zero If the value of

country j, Xjw is the total world trade in industry, while ΣXw is total world trade This formula analyses a country’s world export share of an industry with the country’s total

export share of total world exports If a country j’s share of world exports of industry i is greater than country j’s share of world exports of all goods, the RCA will be greater than 1

which suggests the same as the other formulas do

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Chapter 3

RESEARCH METHODOLOGY 3.1 Measuring comparative advantage

3.1.1 Revealed comparative advantage

Comparative advantage underlies economists’ explanations for the observed pattern of industry trade According to Balassa (1965), comparative advantage could be “revealed” by observed trade patterns that reflect differences in factor endowments across nations In theoretical models, comparative advantage is expressed in terms of relative prices evaluated

inter-in the absence of trade Sinter-ince these are not observed, inter-in practice scholars measure comparative advantage indirectly

To measure the comparative advantage, Balassa constructed an index that measures a country’s revealed comparative advantage (RCA), which has been applied in a number of studies (Balassa, 1989; Huey, 1998; Kalirajan and Shand, 1998) The RCA uses the trade pattern to identify the sectors in which an economy has a comparative advantage, by comparing the country of interests’ trade profile with the world average Specifically, the RCA index is defined as the ratio of two shares The numerator is the share of a country’s total exports of the commodity of interest in its total exports The denominator is share of world exports of the same commodity in total world exports Formally the RCA is presented as:

n i ij ij

ij

X X X X

RCA

1 1

where Xij is exports by country j of commodity i, Xiw is world exports of commodity i The

RCA takes a value between 0 and +∞ This index has a relatively simple interpretation A

country is said to have a revealed comparative advantage in the product i if the value

exceeds unity If the value is less than unity, the country is said to have a comparative

disadvantage in the product i If RCA ij equals to unity, the share of that sector is identical

with the set of countries

The advantage of using the comparative advantage index is that it considers the intrinsic advantage of a particular export commodity and is consistent with changes in an economy’s

Hillman (1980) developed a condition that has to be fulfilled to obtain a correspondence between the B index and pre-trade relative prices in cross-country comparisons for a given product He showed that comparative advantage according to pre-trade relative prices for

country j in commodity i requires the following necessary and sufficient condition:

ij iw

ij

X

X X

X X

X

1

where Xij is exports of commodity i by country j, Xj is total exports of country j, Xiw is

world exports of commodity i, and Xw is the world’s total exports Assuming identical homothetic preferences across countries, the condition in the above equation is necessary and sufficient to guarantee that changes in the RCA are consistent with changes in countries’ relative factor endowments This condition guarantees that growth in the level of

a country’s exports of a commodity results in an increase in the RCA For an empirical test, Marchese and de Simone (1989) transformed Hillman’s condition into the following form:

ij iw

ij

X

X X

X X

X

If HI is larger than unity, the B index used in cross country comparison will be a good indicator of comparative advantage

3.1.2 Trade balance index

Trade Balance Index (TBI) is employed to analyze whether a country has specialization in export (as net-exporter) or in import (as net-importer) for a specific group of products (Lafay, 1992) This index is simply formulated as follows:

ij ij

ij ij

M X

M X TBI







where TBIij denotes trade balance index of country j for commodity i; Xij are imports by

country j of commodity i and Mij are imports by country j of commodity i The net to total

trade ratio evaluates trade performance and considers simultaneous exports and imports of a

32

particular product category Values of the index range from -1 to +1 Extremely, the TBI equals -1 if a country only imports, which reveals comparative disadvantage In contrast, the TBI equals +1 if a country only exports, which reveals comparative advantage

Indeed, the index is not defined when a country neither exports nor imports In this case, I put zero since the group of products shows either potentially to be exported or imported Any value within -1 and +1 implies that the country exports and imports a commodity simultaneously A country is referred to as “net-importer” in a specific group of product where the value of TBI is negative, and as “net-exporter” where the value of TBI is positive One problem with this measure is that net exports may change as a result of fluctuations in the overall trade balance, a macroeconomic issue not indicative of comparative advantage (Wolff, 1997)

ij n

i ij

ij

M

M X

X MI

1 1

where Xij are exports of sector i from country j, and M ij are imports for sector i to country

j The first part represents the share of a given sector in exports and the second part the share

of a sector in imports The Michaely index ranges from -1 to1 with a neutral value of zero

If it is positive (negative) the country is specialized (under-specialized) in that sector

33

Swann and Taghavi (1992) point out that market shares alone give no indication of how competitiveness will change with price, product redesign, change in price or design of substitute, or the exchange rate

3.1.5 Alternative Specifications of Revealed Comparative Advantage

Vollrath (1991) offers three specifications of revealed comparative advantage The first is

relative trade advantage (RTA) which takes exports and imports into account The index is

calculated using the following formula:

ij ij

n i ij ij

ij

M M M M

RMA

1 1

Where Mij is imports by country j of commodity i, Miw is world imports of commodity i

Therefore, relative trade advantage equals to:

n i ij ij

n i iw iw

n i ij ij

ij

M M M M

X X X X

RTA

1 1

1 1

Vollrath’s second measure is the logarithm of the relative export advantage (lnRXA) His third measure is revealed competitiveness (RC), which is calculated as follows:

RC = lnRXA - lnRMA

The advantage of these last two indices in log form is that they are symmetric through the

origin Positive values of RTA, lnRXA, and RC reveal comparative or competitive

advantage A problem with these and similar indices, noted by Vollrath (1989), is that observed trade patterns are likely to be distorted by government policies and may misrepresent underlying comparative advantage