International_Economics_Tenth_Edition (1)

Chapter 3

79

	much to be desired. For example, the Indonesia	enable impartial inspectors to visit each compa-
	wage increases by Reebok and Nike put total	ny for purposes of certification.
	minimum compensation at only 20 U.S. cents an	At the turn of the century, dozens of U.S. uni-
	hour, less than what is needed to support a fami-	versities jumped on the antisweatshop bandwag-
	ly and well below the 27 cents per hour that	on, reacting to a growing student protest move-
	Nike paid until Indonesia's economic crisis began	ment, and took stepsto bar labor abuses in the
	in 1997.	manufacture of clothes that bear college logos.
	Indeed, there simply is no excuse on humani-	This led to a new White House-sponsored
	tarian grounds for sweatshop conditions to	alliance, the Fair Labor Association (FLA), which
	prevail anywhere. But what is the best way of	consisted of 56 universities and corporations such
	preventing sweatshops? Unions and human rights	as Nike, Reebok, Liz Claiborne, and Phillips-Van
	activists in the United Statesadvocate imposing	Hausen. The alliance is intended to set up an
	boycotts on imports from countries where sweat-	elaborate, worldwide factory-monitoring system
	shopsexist, to encourage those countries to	to attempt to eliminate sweatshop abuses. Under
	improve working conditions. Although domestic	its provisions, participating companies can use the
	unions may have legitimate concerns over the	FLA logo on their labels and in their advertising,
	well-being of foreign workers, unions may bene-	helping portray the firms as ethical corporate citi-
	fit from a boycott of products produced by sweat-	zens. Ethics-minded consumers, in turn, can look
	shop workers. The demand for domestic union	for the FLA logo while shopping to guarantee
	workers will increaseand become more inelastic	that what they purchase is free of moral stigma.
	if the goods produced by low-wage sweatshop	Simply put, company executives hope that the
	workers are no longer perceived as being close	FLA logo will improve their products' image and
	substitutes to the goods produced by union work-	boost sales; critics of sweatshops hope that the
	ers.Thus a boycott will be expected to increase	logo will pressure nonparticipating companies
	the wage and employment for union workers.	into eliminating sweatshop abuses and join the
	Critics, however, contend that it makes no	FLA. The charter of the Fair Labor Association is
	sense to impose sanctions on a whole country	available on the Internet at http://www.dol.gov/
	for labor standards violations by a relative few	dol!esalpublidnosweatlpartnership/aip.htm.
	employers: That would punish the innocent
	along with the guilty. An alternative approach
	would be to boycott only the products of those	Source: Robert Collier. ·U.S. Finns Reducing Sweatshop Abuses: But
	companies that do not implement good labor	Wages Still at Poverty Level." SanFrancisco Chronicle, April 17, 1999,
	practices. Yet implementing such selective sanc-	and "Reebok Finds ills at Indonesian Factories," The Wall Street
		Journal, October 18, 1999. See also Edward Graham. Fighting the
	tions would be difficult because it would require
		Wrong Enemy, Institute for International Economics, Washington, DC,
	governments to devote sufficient resourcesto
		2000, Chapter 4.

Another reason for intraindustry trade in	plants operating close to full capacity, meaning that
homogeneous goods is seasonal. The seasons in the	it may be less costly to export electricity at off-peak
Southern Hemisphere are opposite those in the	times, when domestic demand is inadequate to
Northern Hemisphere. Brazil may export seasonal	ensure full-capacity utilization, and import electric-
items (such as agricultural products) to the United	ity at peak times.
States at one time of the year and import them	Although some intraindustry trade occurs in
from the United States at another time during the	homogeneous products, available evidence suggests
same year. Differentiation in time also affects elec-	that most intraindustry trade occurs in differentiat-
tricity suppliers. Because of heavy fixed costs in	ed products. Within manufacturing, the levels of
electricity production, utilities attempt to keep	intraindustry trade appear to be especially high in

80 Sources of Comparative Advantage

machinery, chemicals, and transportation equipment. A significant share of the output of modern economies consists of differentiated products within the same broad product group. Within the automobile industry, a Ford is not identical to a Honda, a Toyota, or a Chevrolet. Two-way trade flows can occur in differentiated products within the same broad product group.

For industrial countries, intraindustry trade in differentiated manufactured goods often occurs when manufacturers in each country produce for the "majority" consumer tastes within their country while ignoring "minority" consumer tastes. This unmet need is fulfilled by imported products. For example, most Japanese consumers prefer Toyotas to General Motors vehicles; yet some Japanese consumers purchase vehicles from General Motors, while Toyotas are exported to the United States. Intraindustry trade increases the range of choices available to consumers in each country, as well as the degree of competition among manufacturers of the same class of product in each country.

Intraindustry trade in differentiated products can also be explained by overlapping demand segments in trading nations. When U.S. manufacturers look overseas for markets in which to sell, they often find them in countries having market segments that are similar to the market segments in which they sell in the United States, for example, luxury automobiles sold to high-income buyers. Nations with similar income levels can be expected to have similar tastes, and thus sizable overlapping market segments, as envisioned by Linder's theory of overlapping demand; they would be expected to engage heavily in intraindustry trade.

Besides marketing factors, economies of scale associated with differentiated products also explain intraindustry trade. A nation may enjoy a cost advantage over its foreign competitor by specializing in a few varieties and styles of a product (for example, subcompact autos with a standard transmission and optional equipment), while its foreign competitor enjoys a cost advantage by specializing in other variants of the same product (subcompact autos with automatic transmission, air-conditioning, cassette player, and other optional equipment). Such specialization permits longer production runs, economies of scale, and decreas-

ing unit costs. Each nation exports its particular type of auto to the other nation, resulting in twoway auto trade. In contrast to interindustry trade, which is explained by the principle of comparative advantage, intra industry trade can be explained by product differentiation and economies of scale.

With intraindustry specialization, fewer adjustment problems are likely to occur than with interindustry specialization, because intraindustry specialization requires a shift of resources within an industry instead of between industries. Interindustry specialization results in a transfer of resources from import-competing to export-expanding sectors of the economy. Adjustment difficulties can occur when resources, notably labor, are occupationally and geographically immobile in the short run; massive structural unemployment may result. In contrast, intraindustry specialization often occurs without requiring workers to exit from a particular region or industry (as when workers are shifted from the production of large-size automobiles to subcompacts); the probability of structural unemployment is thus lessened.

The Product Cycle:

A Technologically Based

Theory of Trade

The explanations of international trade presented so far are similar in that they presuppose a given and unchanging state of technology. The basis for trade was ultimately attributed to such factors as differing labor productivities, factor endowments, and national demand structures. In a dynamic world, however, technological changes occur in different nations at different rates of speed. Technological innovations commonly result in new methods of producing existing commodities, in the production of new commodities, or in commodity improvements. These factors can affect comparative advantage and the pattern of trade.

Recognition of the importance of dynamic changes has given rise to another explanation of international trade in manufactured goods: the product life cycle theory. This theory focuses on the role of technological innovation as a key

determinant of trade patterns in manufactured products.'

According to this theory, many manufactured goods such as electronicproducts and officemachinery undergo a predictable trade cycle. During this cycle, the home country initially is an exporter, then loses its competitive advantage vis-a-vis its trading partners, and eventuallymay become an importer of the commodity.The stages that many manufactured goods go through include the following:

1.Manufactured good is introduced to home market.

2.Domestic industry shows export strength.

3.Foreign production begins.

4.Domestic industry loses competitive advantage.

5.Import competition begins.

The introduction stage of the trade cycle begins when an innovator establishes a technological breakthrough in the production of a manufactured good. At the start, the relatively small local market for the product and technological uncertainties imply that mass production is not feasible. The manufacturer will likely operate close to the local market to gain quick feedback on the quality and overall appeal of the product.

During the trade cycle's next stage, the domestic manufacturer begins to export its product to foreign markets having similar tastes and income levels. The local manufacturer finds that, during this stage of growth and expansion, its market becomes large enough to support mass-produc- tion operations and the sorting out of inefficient production techniques. The home-country manufacturer is therefore able to supply increasing amounts to the world markets.

As time passes, the manufacturer realizes that it must locate production operations closer to the foreign markets to protect its export profits. The domestic industry enters its mature stage as innovating businesses establish branches abroad. A reason for locating production operations abroad is that the cost advantage initially enjoyed by an innovator is not likely to last indefinitely. Over time, the innovating nation may find its technology

'See Raymond Vernon, "International Investment and International Trade in the Product Life Cycle," Quarterly Journal of Economics 80,

1966, pp. 190-207.

Chapter 3

81

becoming more commonplace and transportation costs and tariffs playing an increasingly important role in influencing sellingcosts. The innovator may also find that the foreign market is large enough to permit mass-production operations.

Although an innovating nation's monopoly position may be prolonged by legal patents, it will likely break down over time, because in the long run knowledge tends to be a free good. The benefits an innovating nation achieves from its technological gap are short-lived, as import competition from foreign producers begins. Once the innovative technology becomes fairly commonplace, foreign producers begin to imitate the production process. The innovating nation gradually loses its comparative advantage, and its export cycle enters a declining phase.

The trade cycle is complete when the production process becomes so standardized that it can be easily used by other nations. The technological breakthrough therefore no longer benefits only the innovating nation. In fact, the innovating nation may itself become a net importer of the product as its monopoly position is eliminated by foreign competition. Textiles and paper products are generally considered to have run the full course of the trade cycle. The spread of automobile production into many parts of the world implies that its production process is close to becoming standardized.

Radios, Pocket Calculators, and the International Product Cycle

The experience of u.s. and japanese radio manufacturers illustrates the product life cycle model. Following World War II, the radio was a wellestablished product. u.s. manufacturers dominated the international market for radios because vacuum tubes were initially developed in the United States. But as production technologies spread, japan used cheaper labor and captured a large share of the world radio market. The transistor was then developed by u.s. companies. For a number of years, u.s. radio manufacturers were able to compete with the japanese, who continued to use outdated technologies. Again, the japanese imitated the U.S. technologies and were able to sell radios at more competitive prices.

82	Sources of Comparative Advantage
	Pocket calculators provide another illustration
	of a product that has moved through the stages of
	the international product cycle. This product was
	invented in	1961	by	engineers	at	Sunlock
	Comptometer, Inc., and was marketed soon after
	at a price of approximately $1,000. Sunlock's
	pocket calculator was more accurate than slide
	rules (widely used by high school and college stu-
	dents at that time) and more portable than large
	mechanical calculators and computers that per-
	formed many of the same functions.
	By 1970, several u.s. and japanese companies
	had entered the market with competing pocket cal-
	culators; these firms included Texas Instruments,
	Hewlett-Packard, and Casio (of				japan). The
	increased competition forced the price down to
	about $400.	As the	1970s continued,			additional
	companies entered the market. Several began to
	assemble their pocket calculators in foreign coun-
	tries, such as Singapore and Taiwan, to take advan-
	tage of lower labor costs. These calculators were
	then shipped to the United States. Steadily improv-
	ing technologies resulted in product improvements
	and falling prices; by the mid-1970s, pocket calcu-
	lators sold routinely for $10 to $20, sometimes
	even less. It appears		that	pocket calculators had

reached the standardized-product stage of the product cycle by the late 1970s, with product technology available throughout the industry, price competition (and thus costs) of major significance, and product differentiation widely adopted. In a period of less than two decades, the international product cycle for pocket calculators was complete.

Dynamic Comparative

Advantage: Industrial Policy

David Ricardo's theory of comparative advantage has influenced international trade theory and policy for almost 200 years. It implies that nations are better off by promoting free trade and allowing competitive markets to determine what should be produced and how.

Ricardian theory emphasizes specialization and reallocation of existing resources found domestically. It is essentiallya statictheory that does not allow for a dynamic change in industries' comparative

advantage or disadvantage over the course of several decades. The theory overlooks the fact that additional resources can be made available to the trading nation because they can be created or imported.

The remarkable postwar economic growth of the East Asian countries appears to be based on a modification of the static concept of comparative advantage. The japanese were among the first to recognize that comparative advantage in a particular industry can be created through the mobilization of skilled labor, technology, and capital. They also realized that, in addition to the business sector, government can establish policies to promote opportunities for change through time. Such a process is known as dynamic comparative advantage. When government is actively involved in creating comparative advantage, the term industrial policy applies.

In its simplest form, industrial policy is a strategy to revitalize, improve, and develop an industry. Proponents maintain that government should enact policies that encourage the development of emerging, "sunrise" industries (such as high technology). This strategy requires that resources be directed to industries in which productivity is highest, linkages to the rest of the economy are strong (as with semiconductors), and future competitiveness is important. Presumably, the domestic economy will enjoy a higher average level of productivity and will be more competitive in world markets as a result of such policies.

A variety of government policies can be used to foster the development and revitalization of industries; examples are antitrust immunity, tax incentives, R&D subsidies, loan guarantees, low- interest-rate loans, and trade protection. Creating comparative advantage requires government to identify the "winners" and encourage resources to move into industries with the highest growth prospects.

To better understand the significance of dynamic comparative advantage, we might think of it in terms of the classic example of Ricardo's theory of comparative advantage. His example showed that, in the eighteenth century, Portugal and England would each have gained by specializing respectively in the production of wine and

cloth, even though Portugal might produce both cloth and wine more cheaply than England. According to static comparative-advantage theory, both nations would be better off by specializing in the product in which they had an existing comparative advantage.

By adhering to this prescription, however, Portugal would sacrifice long-run growth for short-run gains. Instead, if Portugal adopted a dynamic theory of comparative advantage, it would specialize in the growth industry of that time (cloth). The Portuguese government (or Portuguese textile manufacturers) would thus initiate policies to foster the development of its cloth industry. This strategy would require Portugal to think in terms of acquiring or creating strength in a "sunrise" sector instead of simply accepting the existing supply of resources and using that endowment as productively as possible.

Today, every industrialized country and many less-developed countries use industrial policies that encourage the development or revitalization of basic industries, including steel, autos, chemicals, transportation, and other important manufactures. Each of these industrial policiesdiffers in character and approach; common to all is an active role for government in the economy. Usually, industrial policy is a strategy developed collectively by government, business, and labor through some sort of tripartite consultation process.

Advocates of industrial policy typically cite japan as a nation that has been highly successful in penetrating foreign markets and achieving rapid economic growth. Following World War II, the japanese were the high-cost producers in many basic industries (such as steel). In this situation, a static notion of comparative advantage would require the japanese to look to areas of lesser disadvantage that were more labor intensive (such as textiles). Such a strategy would have forced japan into low-productivity industries that would eventually compete with other East Asian nations having abundant labor and modest living standards.

Instead, the japanese invested in basic industries (steel, autos, and later electronics, including computers) that required intensive employment of capital and labor. From a short-run, static perspective, japan appeared to pick the wrong

Chapter 3

83

industries. But from a long-run perspective, those were the industries in which technological progress was rapid, labor productivity rose fast, and unit costs decreased with the expansion of output. They were also industries in which one would expect rapid growth in demand as national income increased.

These industries combined the potential to expand rapidly, thus adding new capacity, with the opportunity to use the latest technology and thus promote a strategy of cost reduction founded on increasing productivity. japan, placed in a position similar to that of Portugal in Ricardo's famous example, refused to specialize in "wine" and chose "cloth" instead. Within three decades, japan became the world's premier low-cost producer of many of the products for which it initially started in a high-cost position.

Critics of industrial policy, however, contend that the causal factor in japanese industrial success is unclear. They admit that some of the japanese government's targeted industries-such as semiconductors, steel, shipbuilding, and machine tools-are probably more competitive than they would have been in the absence of government assistance. But they assert that japan also targeted some losers, such as petrochemicals and aluminum, for which the returns on investment were disappointing and capacity had to be reduced. Moreover, there are examples of successful japanese industries that did not receive government assistance-motorcycles, bicycles, paper, glass, and cement.

Industrial-policy critics contend that if all trading nations took the route of using a combination of trade restrictions on imports and subsidies on exports, a "beggar-thy-neighbor" process of trade-inhibiting protectionism would result. They also point out that the implementation of industrial policies can result in pork-barrel politics, in which politically powerful industries receive government assistance. Finally, it is argued that in a free market, profit-maximizing businesses have the incentive to develop new resources and technologies that change a country's comparative advantage. This raises the question of whether the government does a better job than the private sector in creating comparative advantage.

84	Sources of Comparative Advantage

Industrial Policies Support

Boeing and Airbus

Industrial policy applies to the commercial jetliner industry, as seen in Boeing and Airbus. The world's manufacturers of commercial jetliners operate in an oligopolistic market that has been dominated by Boeing of the United States and the Airbus Company of Europe. During the1970s, Airbus sold less than 5 percent of the world's jetliners; today, it accounts for more than half of the world market.

The United States has repeatedly complained that Airbus receives unfair subsidies from governments of Europe, as seen in Table 3.9. U.S. officials argue that these subsidies place their company at a competitive disadvantage. Airbus allegedlyreceivesloans for the development of new aircraft; these loans are made at below-market interest rates and can amount to 70 to 90 percent of an aircraft's development cost. Rather than repaying the loans according to a prescribed timetable as typically would occur in a competitive market, Airbus is allowed to repay them as it delivers an aircraft. Airbus is also alleged to benefit from debt forgiveness when it suffers losses. The United States maintains that these subsidies allow Airbus to set unrealistically low prices, offer

liABLE 3.9

Does Airbus Have an Unfair Advantage?

concessions and attractive financing terms to airlines, and write off development costs.

Airbus has defended its subsidieson the grounds that they prevent the United States from holding a worldwide monopoly in commercial jetliners. In the absence of Airbus, European airlines would have to rely exclusively on Boeing as a supplier. Fears of dependence and the loss of autonomy in an area on the cutting edge of technology motivate European governments to subsidize Airbus.

Airbus also argues that Boeing benefits from government assistance. Rather than receiving direct subsidies like Airbus, Boeing receives indirect subsidies. For example, governmental research organizations support aeronautics and propulsion research that is shared with Boeing. Support for commercial jetliner innovation also comes from military-sponsored research and military procurement. Research financed by the armed services yields indirect but important technological spillovers to the commercial jetliner industry, most notably in aircraft engines and aircraft design. Also, Boeing subcontracts part of the production of its jetliners to nations such as Japan and China, whose producers receive substantial governmental subsidies. Boeing is thus able to purchase components from these producers at rel-

Government support of Airbus has long been a sore point for Boeing. Most of the support comes in the form of low-interest loans to develop new planes, and repayment does not begin until deliveries start. All figures in millions of dollars.

Airbus Aircraft Program	Government	Total Cost to Airbus		Outstanding
	Loans	with Interest		Repayments
A300/31 0	$ 888	$	0	$	0
A320	1,480		2,101		140
A330/340	2,671		3,306		0
A340-500	2,548		3,637	3,637
A380	2,450		3,351	3,351
Total	10,037	12,395		7,128

Source: European Aeronautic Defence and Space Company, Bloomberg News, Airbus, Boeing, Morgan Stanley.

atively low prices because of governmental subsidies, thus enhancing Boeing's competitiveness.

As a result of the subsidy conflict between Boeing and Airbus, the United States and Europe negotiated an agreement to curb subsidies for the two manufacturers. The principal element of the accord was a 33 percent cap on the amount of government subsidies that these manufacturers could receive for product development. In addition, the indirect subsidies were limited to 4 percent of a firm's commercial-jetliner revenue.

Although the subsidy agreement calmed trade tensions between the United States and Europe, by the early 2000s the subsidy dispute was heating up. The United States criticized the European Union for granting subsidies to Airbus and called for the European Union to renegotiate the 1992 subsidy deal.

What inspired the United States to renew its efforts to force European compliance with its interpretation of the subsidy pact was severe price discounting by Airbus. In 2003, for example, Airbus offered discounts of 40 to 45 percent off list price to win the contract to supply jetliners to airlines. Boeing contended that such discounts could not possibly occur without subsidies. Moreover, Airbus developed a new super-jumbo jetliner, the A380, capable of carrying 555 passengers. The Airbus jetliner would challenge the market supremacy of the Boeing 747 (with about 400 seats), the only other jumbo jet available for sale. To pay for the development costs of the A380, which could reach $15 billion, Airbus will get 40 percent of its funding from parts suppliers, 30 percent from government loans arranged by its partners, and the final chunk from its own resources. It remains to be seen how renewed tensions between Boeing and Airbus will be resolved.

Government Regulatory

Policies and Comparative

Advantage

Besides providing industrial policies to enhance competitiveness, governments impose regulations on business to pursue goals such as workplace safety, product safety, and a clean environment. In the

		Chapter 3		85
United States, these regulations are imposed by the
Occupational Safety and Health Administration,
Consumer Product Safety Commission, and
Environmental Protection Agency. Although gov-
ernment regulations may improve the well-being of
the public, they can result in higher costs for
domestic firms. According to the American Iron
and Steel Institute, U.S. steel producers are today
technologically advanced, low cost, environmental-
ly responsible, and customer focused. Yet they con-
tinue to face regulatory burdens of the U.S. govern-
ment that impair their competitiveness and trade
prospects, as seen in Table 3.10 on page 86.
Strict government regulations applied to the
production of goods and services tend to increase
costs and erode an industry's competitiveness. This
is relevant for both exportand import-competing
firms. Even if government regulations are justified
on social welfare grounds, the adverse impact on
trade competitiveness and the associated job loss
have long been a cause for policy concern. Let us
examine how governmental regulations on busi-
ness can affect comparative advantage.
Figure 3.4 on page 87 illustrates the trade
effects of pollution regulations imposed on the
production process. Assume a world of two steel
producers, South Korea and the United States.
The supply and demand schedules of South Korea
and those of the United States are indicated by
5s.K.o and	Ds.K.o, and by 5u.s.o and	D u.s.o. In the
absence of trade, South Korean producers sell 5
tons of steel at $400 per ton, while 12 tons of steel
are sold in the United States at $600 per ton.
South Korea thus enjoys a comparative advantage
in steel production.
With free trade, South Korea moves toward
greater specialization in steel production, and			the
United States produces less steel. Under increasing-
cost conditions, South Korea's costs and prices rise,
while prices and costs fall in the United States. The
basis for further growth of trade is eliminated when
prices in the two countries are equal at $500 per
ton. At this price, South Korea produces 7 tons,
consumes 3 tons, and exports 4 tons, and the
United States produces 10 tons, consumes 14 tons,
and imports 4 tons.
Suppose that the production of steel results in
discharges	into U.S. waterways,	leading	the

86 Sources of Comparative Advantage

TABLE 3.'10

U.S. Steelmakers Complain About Regulatory Burdens

Here are some examples of U.S. regulations affecting domestic steel producers:

•Alternative Minimum Tax. The corporate alternative minimum tax (AM1) maintains slower depreciation methods than under the regular corporate tax. The AMT increases the cost of capital for steel by about 3.6 percent, acts as a disincentive to capital investment in steel, and harms the competitiveness of domestic steel companies.

•Health Care. U.S. steel companies spent more than $1.5 billion for health care in 2003-for workers, retirees, and dependents. This adversely affects the competitiveness of U.S. steel companies vis-a-vis foreign competitors, many of whose health-care costs are borne by government through general tax revenues.

•OSHA. The complexity and cost of compliance with Occupational Safety and Health Administration (OSHA) regulations continue to increase. Many OSHA rules do not have a sound

scientific or medical basis and thus are impractical and cost ineffective.

•	Electricity Policy. Electricity is a major component of steel-manufacturing costs, but it cannot be
	purchased on a competitive basis as are other commodities.
•	Global Climate Change. Efforts by the United States to achieve a 7 percent decrease in green-
	house gas emissions from 1990 levels by the year 2012, as dictated by the Kyoto Protocol, could
	result in $5 billion in extra annual energy costs for U.S. steel companies.
•	Clean Air. Proposed tighter standards for pollutants could place much of the United States-
	including many steel industry sites-in nonattainment areas. The result would be enormous new
	costs for steel, with no comparable requirements for U.S. trading partners.

•Cleanup Standards. Cleanup standards of manufacturing sites, as mandated by the Resource Conservation and Recovery Act, are cost ineffective. No comparable program exists in other nations. Likewise, U.S. steel companies are often stymied in their efforts to return former industrial properties to productive, job-creating use.

Source: Domestic Policies that Impact American Steel's International Competitiveness, American Iron and Steel Institute, Washington, DC, 2001, pp. 1-2,

Environmental Protection Agency to impose pollution regulations on domestic steel producers. Meeting these regulations adds to production costs, resulting in the u.s. supply schedule of steel shifting to SU.S.l' The environmental regulations thus provide an additional cost advantage for South Korean steel companies. As South Korean companies expand steel production, say, to 9 tons, higher production costs result in a rise in price to $600. At this price, South Korean consumers demand only 1 ton. The excess supply of 8 tons is earmarked for sale to the United States. As for the United States, 12 tons of steel are demanded at the price of $600, as determined by

South Korea. Given supply schedule SU.S.b u.s. firms now produce only 4 tons of steel at the $600 price. The excess demand, 8 tons, is met by imports from South Korea. For U.S. steel companies, the costs imposed by pollution regulations lead to further comparative disadvantage and a smaller share of the U.S. market.

Environmental regulation thus results in a policy trade-off for the United States. By adding to the costs of domestic steel companies, environmental regulations make the United States more dependent on foreign-produced steel. However, regulations provide American households with cleaner water and air, and thus a higher quality of life.

Chapter 3

87

.: FIGURE B.4

Trade Effects of Governmental Regulations

	~\
cY~0			South Korea			United States
#'0-~D						Sus I'"vr			<-c.~.
									~~~\l. ~Y
\~' ,IX				s		<, \S'> ~'\..J-.			0~~'
							\( Suso
/ '\D~					SKo
t,,\~	600				600
~					~
-2	500				-2 500
o					o
o	400				o
	oL...-C~-~-'------=----_
	3	5	7	9	4	10	12	14
		Steel (Tens)				Steel (Tens)

The imposition of government regulations (clean environment, workplace safety, product safety) on U.S. steel companies leads to higher costs and a decrease in market supply. This detracts from the competitiveness of U.S. steel companies and reduces their share of the U.S.steel market.

Also, the competitiveness of other American industries, such as forestry products, may benefit from cleaner air and water. These effects must be considered when forming an optimal environmental regulatory policy. The same principle applies to the regulation of workplace safety by the Occupational Safety and Health Administra-tion and the regulation of product safety by the Consumer Product Safety Commission.

Business Services and

Comparative Advantage

The trading of products among countries is not confined to the exporting and importing of manufactured goods, but also includes a group of activities known as business services. In many cases, business services are nonstorable, in that they must be consumed as they are produced (for example, management consulting); unlike manufactured goods, business services cannot be maintained in inventories by producers. Examples of internation-

ally traded business services include items such as tourism, freight transportation, construction, banking, finance, insurance, information management, and medical and legal services. Table 3.11 on page 88 shows the world's leading exporters and importers of services.

Does the theory of comparative advantage apply to trade in business services? The theory suggests that trade between two countries creates mutual economic gains, provided that such trade is based on a competitive market. As a theoretical statement, the theory of comparative advantage should be equally valid whether the products involved are tradable merchandise (such as aircraft) or tradable services (such as accounting services). The wine and cloth in Ricardo's classic example of comparative advantage could easily have been replaced by wine and insurance policies without altering the validity of the comparativeadvantage doctrine.

Similar to manufactured goods, business services are produced by combining resources to create something of value that can be bought or sold in the

88	Sources of Comparative Advantage

TABLE 3.11

Top 10 Exporters and Importers of Business Services. 2002 (in Billions of Dollars)

Exporters	Value	Share'	Importers	Value	Share'
United States	$273.6	17.4%	United States	$205.6	13.3%
United Kingdom	123.1	7.8	Germany	149.1	9.6
Germany	99.6	6.3	Japan	106.6	6.9
France	85.9	5.5	United Kingdom	101.4	6.6
Japan	64.9	4.1	France	68.2	4.4
Spain	62.1	4.0	Italy	61.5	4.0
Italy	59.4	3.8	Netherlands	55.7	3.6
Netherlands	54.1	3.4	China	46.1	3.0
Hong Kong	45.2	2.9	Canada	41.9	2.7
China	39.4	2.5	Ireland	40.4	2.6
			I I		nil

'Share of world exports or imports.

Source: World Trade Organization, World Trade Statistics, 2003 at http://www.wto.org.

market. One would expect that the production and sale of services would follow a pattern of economic behavior similar to the production and sale of manufactured goods. The majority of researchers who have examined the applicability of the comparativeadvantage principle to services have indicated that there is nothing in the theory that intrinsically makes it less applicable to services than to goods.

However, applying the comparative-advan- tage principle to services is difficult because they are such a heterogeneous group, The clear differences that exist among, say, banking services, air freight, and architecture services have led many to question whether the theory of comparative advantage can be a useful empirical guide for all service sectors. The heterogeneous nature of services makes it impossible to think of them as a single entity or for a nation to think of itself as having a competitive advantage in all services, any more than it can have a cost advantage in all manufactured goods.

It is unlikely that a single theory can encompass all the characteristics of international trade in services. However, researchers have identified a number of determinants underlying a nation's competitiveness in various services:

•Skills and capabilities of employees and employee wages

•A business's ability to organize a cooperative effort among workers with the right complementary skills

•Abundance of equipment, including communications facilities, data processing, and computers

•The institutional support provided by the legal system, practices, and traditions found in each nation

•The potential economies of scale afforded by a market's size

The export advantage in many services, as revealed by existing patterns of trade in services, appear to lie with the developed countries. Many traded services are intensive in the use of both technology and capital, whether human or physical. This seems to give the developed countries a competitive edge. The United States, for example, has often been characterized as having a comparative advantage in business services; this advantage reflects the long-standing position of the United States as a net exporter of technology and know-how.