The Comparative Advantage of Nations: Shifting Trends and Policy Implications

The Nobel Prize-winning economist Paul Samuelson once famously argued that
comparative advantage was the clearest example of a proposition in the social
sciences which was both true and not obvious. Need not, before this audience, go
back to the foundations of the theory, which Samuelson thought many important
people failed to understand. Will be arguing, however:
o that trade based on comparative advantage in the Asia Pacific has been the
source of very substantial gains, even though it has taken a form quite
different from the exchange of cloth for wine in Ricardo’s well known
example
o changes in relative costs in the region will create quite new patterns of
trade over the next decade and in the longer term
o that there remains a need for adjustment by both the US and China to
manage tensions arising from the pattern of trade which has developed.
The New Form of Comparative Advantage

For most of the period since the Second World War, world trade has grown faster
than world GDP
o there are many explanations for this, but a significant factor has been the
development of global production chains and intra-firm trade, which can
see intermediate products cross national borders several times before final
assembly
o a recent OECD study found that 56 per cent of goods trade is in
intermediates
o the formation of global chains has been facilitated by a number of
developments, including sharp declines in tariffs; a decline in transport
costs; intense competition among firms to source products and services
from the cheapest locations; and advances in telecommunications which
have made it easier to control complex production processes.

As a consequence, comparative advantage increasingly takes the form of a relative
advantage in performing a particular task in the production chain, rather than in
the production of a final good from a few inputs
o in other words, as one of the OECD presentations for this session has
noted, we need to think increasingly of trade in terms of tasks required to
produce output.

Paradoxically, the task of final assembly may be the most labour-intensive task of
all, and may be performed in developing rather than developed countries.

The electronics industry provides a good case study of the new form of
comparative advantage.

As a recent paper by Ganges and Van Assche on the industry notes, “Labourabundant China is heavily specialized in the assembly of final products, which are
exported to the U.S. and the E.U. ASEAN countries are also significant final
goods exporters. The production of intermediate goods – which ... is typically a
more sophisticated activity than assembly – is dominated by the NIEs, economies
which have considerable physical and human capital.” The high-income
economies also focus on intermediate products, as well as product design,
innovation and marketing.

The value added by China may be small. For example, it is said to add only about
US$12 of value to the production of parts for Apple’s iPad, and a little over US$5
to the value of the fifth generation Apple video IPod which was assembled in
China.

The pattern of trade which has developed has delivered enormous gains to
countries both in the East Asian region and outside it
o in the decade to 2005, electronics production in 9 developing East Asian
economies grew at a compound annual rate of 10 per cent, lifting their
share of world electronics production from 22 to 43 per cent
o developing economies engaged in these networks have benefited from the
transfer of technology and skills, and from new and better jobs
o high-income economies importing these products have also benefited from
an improved range and cheaper products than would otherwise have been
possible

including, for example, cheaper computers and innovative
consumer electronic products such as iPods and LCD TVs.
Emerging Trends in Comparative Costs in the Region

The development of East Asian economies is bringing about important changes in
relative costs.

Perhaps the key here is China, where there has been a significant scholarly debate
on the question of whether the economy has reached a turning point in its
development, characterised by a shift to rising labour costs.

Many of those in this audience will no doubt have views on this issue, but I can
perhaps cite the most eminent of Australia’s China analysts, Professor Ross
Garnaut, who has looked carefully at this issue over a number of years. In a paper
written earlier this year, Professor Garnaut, suggests that “There is now
compelling evidence that the period of labour surplus and reasonably steady
wages for unskilled workers – supported by continuing large-scale movement of
people from agriculture to industry and from the countryside to the cities – has
come to an end.”
o Garnaut cites evidence that real hourly wages for migrant workers
increased by 90 per cent from 2001 to 2009, after two decades of relative
stagnation
o with the momentum of real wage growth quickly re-established after the
shock of the Global Financial Crisis.

There are, of course, complexities associated with the geographically segmented
nature of the Chinese labour market which Garnaut acknowledges. In particular,
the continuing differences between rural and urban wages and the possibilities for
industry to move to lower cost western/interior provinces could play a role in
moderating wage growth.
o In terms of the more developed eastern provinces, it is interesting to note
that the provinces of Zhejiang and Jiangsu, with a combined population of
over 120 million people, have a per capita income that is roughly that of
the ROK in the late 1980s to early 1990s and an industrial structure that
also closely mirrors that of the ROK at that time.

Demographic trends in the East Asian economies are likely to have an even more
profound impact on relative costs over the coming years. Many of the East Asian
economies are aging rapidly. Analysis carried out by the Japanese Government
suggests that the dependency ratio in Japan began to increase from around 1995,
while for China, Singapore and Thailand, it will begin to increase from around
2015. In contrast, the dependency ratio will continue to fall in India and the
Philippines until around 2045.

In terms of raw numbers, in China, the working age population is expected to
grow by only 3.1 million per annum over 2011-15, after which it will begin to
decline
o India, in contrast, is projected to add at least 80 million to its labour force
over the next decade; indeed, Goldman Sachs recently released a report
which suggested that the increase over the next decade would be 110
million.
Implications for the Pattern of Trade

These trends will ultimately have important implications for trade patterns. In the
first instance, the location of manufacturing production in China will undergo
some changes, with the central and western regions increasingly emerging as lowcost assembly centres
o assisted by efforts by the Chinese Government to reduce inequalities and
to open up the inland provinces.

Beyond this, the ageing of the Chinese population will encourage the transition to
less labour-intensive patterns of production in the long term. The role of low-cost
manufacturing and assembly may then increasingly fall to other emerging
economies, possibly India, Indonesia and Vietnam.

Anecdotal evidence already suggests that some operations are being relocated to
other low-wage regional economies, thought this may be more to diversify supply
rather than to adjust to higher costs.

The impact on trade patterns over the long term will depend on how different
economies position themselves, on their overall competitiveness and on their links
with global supply chains.

Australia, for its part, stands to benefit from closer engagement with the dynamic
Asia Pacific region
o have already benefited massively from China’s rapid industrialisation,
which has seen China’s steel demand rise from around 44 kilograms per
capita in 1980 to around 375 kilograms per capita in 2008 (i.e. growth at a
compound annual rate of around 8 per cent)
o this has massively boosted demand for Australian iron ore and coal,
pushing our terms of trade to the highest levels for many decades
o our capacity to adjust and to participate in global supply chains in goods
and services in which we have expertise (for example, raw materials,
engineering services, mining technology and services) has been facilitated
by ongoing reforms to the Australian economy

including floating the Australian dollar, tariff liberalisation,
deregulation of the financial sector, taxation reform and reforms
encouraging competition
o our engagement will also be assisted by the network of free trade
agreements that Australia has negotiated or is negotiating with regional
economies, as well as by our involvement in APEC and other regional
forums.
The Impact on Trade Tensions

Changes in trade patterns will in turn have implications for trade tensions between
the developed economies (particularly the US) and developing economies
(especially China).

It is difficult to be precise here, but:
o as China begins to move toward less reliance on labour-intensive products,
at least some parts of the Western economies may experience slightly
lower levels of competition from that source than before
o on the other hand, other economies are likely to move to take on a greater
role in labour intensive production than before
o and China is likely to take on a somewhat broader role in manufacturing,
moving beyond simple assembly operations to the production of more
sophisticated and technology-intensive goods, which will compete with a
wider range of goods in OECD economies
o Australia is one of the world’s largest markets for mining
machinery and in the current mining boom has begun increasingly
to turn to China to supply that sort of heavy machinery
o as Garnaut has suggested, China’s savings rates may also change as wages
increase as a share of GDP, leading to a reduction in its external trade
surplus.

None of these changes will work quickly, however. For the short and medium
term, the US will face a sizeable trade deficit, with the attendant risk of trade
conflict with countries such as China which appear to contribute heavily to the
deficit
o (as an aside, “appear” is the right word because China’s contribution, as
the examples of the iPad and iPod suggest, is likely to be overstated by the
way in which we measure trade flows).

Key to managing trade tensions will be changes on both sides
o with the US moving to lift its domestic savings rate and improve
competitiveness
o and China allowing its exchange rate to appreciate and encouraging more
rapid growth in domestic demand
o important that we maintain the relatively open markets which have
delivered very substantial gains to all economies in the region.

There is clearly a fear in some quarters in developed economies that China will at
some point develop to the point where it produces everything
o but this at least is one concern (resting on a confusion of the role of
absolute and relative cost advantages) that can be laid to rest using the
theory of comparative advantage.