Strategies for Global Value Added: Gains Comparative advantage © Professor Daniel F. Spulber

2 Midea: Leading Chinese appliance manufacturer Every major manufacturer is producing air conditioners in China for customers there. Many of the major manufacturers are exporting from their facilities in China. These developments suggest that China has a comparative advantage in the production of air conditions and related appliances relative to its trading partners. How does this fit into the overall pattern of exports and imports and the product mix?

3 International product mix How do you explain the mix of traded goods? How do you explain the location of production in a particular country for a specific product or service? How do you explain the types of goods that are imported to a particular country? What products should the international business provide?

4 A key task of the manager of the international business is to identify gains from trade Coordinate serving and sourcing to maximize net gains from trade -- these decisions are connected! Identify supplier countries and the products that they can provide Identify customer countries and the products they need Profit by capturing some of the gains from trade

5 Specialization and division of labor Adam Smith The Wealth of Nations 1776 The division of labor generates the greatest improvement in the productive powers of labor the division of labor is limited by the extent of the market So, greater trade means more opportunities for greater productivity

6 This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth. David Ricardo Principles of Political Economy and Taxation 1817 To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth.

7 Differences in productivity and technology: The theory of comparative advantage Absolute advantage of one industry over the same industry in another country is not the issue Comparative advantage means that there are returns to each country specializing in certain activities Even if a country is better at both producing clothing and computers than another country, it is still better for each to specialize a bit more in one or the other activity

8 What to produce – computers or clothing? Comparative Advantage asks which country is relatively better at computers than clothing in comparison with the other country A country should focus more on computers than clothing if transferring resources at the margin from clothing to computers will yield greater returns than doing so in the other country Correspondingly, the other country should focus more on clothing (transferring some resources from computers to clothing) There are some costs of transferring resources and adjusting production

9 Comparative advantage So, England would export sweaters to France and import bicycles from France England has a comparative advantage in sweaters and France has a comparative advantage in bicycles These are the productivities of one unit of labor in each country

10 Comparative advantage Find the productivity ratios for each good England compared to France for each good: Sweaters24/6 = 4 Bicycles:18/12 = 3/2 The productivity ratio for sweaters is greater than for bicycles England compared to France is relatively more productive in sweaters than bicycles England has a comparative advantage in sweaters France has a comparative advantage in bicycles

11 Comparative advantage and gains from trade Suppose that England exports 54 sweaters and imports 72 bicycles For 72 bicycles, England can shift four units of labor to sweaters since 72/18 = 4 Shifting 4 units of labor to sweaters produces 4 x 24 = 96 sweaters, therefore Englands net gain in sweaters: = 42

12 Comparative advantage and gains from trade France imports 54 sweaters. France can shift 9 units of labor to bicycles because 54/6 = 9 Then France can produce 108 more bicycles since 12 x 9 = 108 Frances net gain in bicycles: = 36

13 Each country has a labor force of 20 Suppose that labor is evenly divided by sector. Table showing total output and consumption before trade takes place

14 Each country has a labor force of Total output rises England shifts workers 4 from bicycles to sweaters France shifts 9 workers from sweaters to bicycles Table showing total outputs -- total outputs increase

15 Table showing total consumption after trade England gets to consume more sweaters and France gets to consume more bicycles

16 Trade and the product mix Productivity of a unit of labor in each country for each good.

17 Trade and the product mix Production function: Zero profit condition: Q A1 = g A1 L A1 P A1 Q A1 = W A L A1 P A1 = W A /g A1 Price of each good equals the unit cost of labor This shows the tradeoff between the cost and productivity of labor

18 Trade and the product mix General rule: The low-price country exports and the high-price country imports. Country A supplies the good if P A1 < P B1. Recall that prices equal unit labor costs: P A1 = W A /g A1 P B1 = W B /g B1 So, Country A supplies the good if lower unit costs: W A /g A1 < W B /g B1

19 Trade and the product mix Country A supplies the good if W A /g A1 < W B /g B1 which is the same as W A / W B < g A1 /g B1 Conclusion: Country with productivity ratio above wage ratio is the exporting country.

20 Trade and the product mix Example:Which country exports which good?

21 Trade and the product mix Example:Which country exports which good? Wages:W A = 18 W B = 6 Wage ratio: W A / W B = 3. Productivity ratio greater than wage ratio: Country A exports Good 2 and Good 3 to Country B. Country A imports Good 1 from Country B.

22 Trade and the product mix X W A /W B X* TECHNOLOGY CURVE: List the goods in decreasing order: Country A supplies goods below X* Country B supplies goods above X* Country ACountry B g A /g B Good 2 Good 3 Good 1

23 Effect of wage changes on the product mix X W A /W B X* Relative wages increase Relatively higher wages in Country A Shift in product mix Country ACountry B W 1 A /W 1 B X1X1 g A /g B

24 Trade and the product mix Table showing prices based on unit costs of labor Helps explain inter-country price differences

25 Managers should understand constant change in opportunities for sourcing and serving Comparative advantage keeps changing: GDP per capita in some Asian countries

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

27 Effect of technological change on product mix X W A /W B X* Lower labor requirements in Country A cause shift in product mix – even assortment of products changes within in each country Country ACountry B X1X1 g A /g B

28 Effect of costs of trade on product mix X X* Country A exports Country B exports Nontraded X** Country A produces goods from 0 to X** Country Bs produces goods above X* g A /g B W A */W B W A /W B * g A /g B Country B sees trade costs as if wages rise in Country A Country A sees trade costs as if wages rise in Country B

29 Effect of lowering costs of trade Increases specialization of countries – for given technology Reduces the range of nontraded goods Increases the range of traded goods Improves national incomes and increases total production These effects define globalization!

30 Summary and take-away points Managers should understand how gains from trade create value in international business The product mix is as much about demand patterns as it is about production patterns Managers should consider costs of trade in determining the product mix