How does China compete with developed countries?

Peter K. Schott , 10 October 2007

a

A

Public discussion about the competitiveness of Chinese exports on world markets is often misleading. Since misconceptions are often at the root of bad policy, it’s worth reviewing what recent research tells us about the relative sophistication of Chinese products and the potential effects of China’s growth on firms and workers in developed economies.

Basic economics tells us that countries with very cheap labour like China ought to specialise in relatively unsophisticated goods like t-shirts and toys, while more developed economies like Germany or Japan should concentrate on more skill- and capital-intensive products like pharmaceuticals and supercomputers. As trade barriers and other trade costs fall, countries will cede production of goods at odds with their comparative advantage to free up resources that can be used to produce goods in which they are most competitive.

The extent to which countries at different levels of development specialise in different sets of goods has important implications for workers in developed economies. That is because specialisation influences how directly high-wage workers in developed countries compete with lower-wage workers in developed economies. If Germany and China produce and export the same mix of goods, then reductions in the world price of those goods driven by trade liberalisation and Chinese growth must reduce wages in the developed economies – the much-feared “race to the bottom”. On the other hand, if China produces toys but Germany does not, German workers gain from the growth of China’s toy industry: their wages remain high because they are determined by goods that China does not produce, while the decline in toy prices increases the amount of income they can devote to other goods and services.

A surprising fact that emerges from the analysis of detailed trade statistics is that developed economies tend to remain active in import product markets even as developing countries move in.1 In the US import market, for example, the share of all possible manufacturing products imported from the developed economies of the OECD over the last 35 years has remained constant at nearly 100%, even as the share imported from China jumped from 9% to an unprecedented 85%. These trends present a puzzle: if Chinese competition is so fierce, why didn’t it push the OECD countries out of more US import markets?

One potential explanation for the increasing overlap of developed and developing countries in export markets is trade barriers. Even in our era of relative trade liberalisation, many barriers to trade remain. Perhaps the best example of such barriers can be found in apparel and textile markets, where a global quota agreement known as the Agreement on Textiles and Clothing severely limited developing countries’ ability to dominate clothing markets until 2005. Because developing economies were not allowed to satisfy the demand for apparel in many developed-country markets, firms in developed countries could still find customers.

But another, more important reason for the increasing co-existence of developed and developing economies in export markets is a more subtle phenomenon – vertical differentiation. Analysis of export price variation across countries within product markets reveals that manufacturing exports from low-wage developing countries sell at a substantial discount compared to the exports of high-wage developed economies. In the US import market, the average price of China’s machinery and electronics products is just 25% of the average price received by OECD countries. Over time, this OECD “premium” has increased: in the late 1980s and early 1990s, the average Chinese machinery and electronics product was 35% of the average OECD price.

The fact that price differences between imports from China and the OECD exist, but that US consumers still purchase imports from both sources, suggests that developed-country exports possess attributes such as higher quality or added features for which US consumers are willing to pay extra. If that were not true, there would be no customers for developed country exports and the market share of developing countries would be 100%. Japan and China might both produce and export televisions, for example, but the Japanese televisions might employ more sophisticated technology, contain a richer set of amenities, or exhibit superior workmanship than the televisions exported by China. This superiority manifests in consumers’ willingness to pay a higher price.

Returning to the issue of how Chinese growth might affect workers in developed economies, it is important to recognise that vertical specialisation within product markets can also help insulate workers in developed countries from the low wages of workers in developing economies. Intuitively, the less substitutable goods of greater and less sophistication are, the weaker is the link between prices and wages and the more separated the workers in the two types of countries will be. Developed countries can move away from developing countries by climbing the quality ladder as well as by shifting the composition of their output.

Both of these forces appear to be at work. The widening price gap between Chinese and OECD varieties in some industries is consistent with quality upgrading: in reacting to China, firms in developed economies try to specialise in ever-more sophisticated versions of products to protect their sales. As a result, they drop their lowest price goods, raising their average price. Recent analyses of US manufacturing firms provide further evidence consistent with such a response. One study, for example, shows that even though US manufacturing firms are more likely to contract or fail as their industry’s exposure to imports from low-wage countries increases, this outcome is mitigated by the sophistication of the goods they produce within their industry.2 Firms that appear to be producing more sophisticated goods within industries have better outcomes. This study also suggests that firms move up as well as out in response to trade liberalisation by switching into industries that are more in line with US comparative advantage and that are therefore less exposed to low-wage country exports.

These behaviours provide intuition for why trade with developing countries will not lead to the elimination of manufacturing in the developed world, as some of the most extreme critics of globalisation contend. Even though increased trade with China may cause developed countries to abandon the production of their less-sophisticated goods, production of more-sophisticated goods, or the research and design services associated with them, is always waiting to take its place. Indeed, as is often pointed out, the creative destruction associated with these reallocations should be encouraged: allowing countries to produce according to their comparative advantage enhances the efficiency of production and encourages the availability of a wider variety of products at lower prices to consumers in all countries, thereby raising standards of living.

The problem, of course, is that all workers do not benefit equally from the adjustments associated with trade liberalisation.3 In developed countries, low-skill workers are disproportionately likely to be dislocated from their jobs as firms move up the quality ladder, and they may also have the hardest time finding matches with new employers. But it is precisely such losses to workers, and not a concern with jobs, that should be the focus of trade policy. Temporarily shielding certain jobs from import competition merely postpones an inevitable adjustment that only becomes more painful the longer it is delayed. Instead, trade policy, like Denmark’s flexicurity program, should facilitate the ability of workers to find new employment when existing occupations disappear.4

In many ways, speculation about China today mirrors the uncertainty created by Japan’s ascendance in the 1980s. Back then, it was the Japanese who were poised to take over the world’s manufacturing, and it was the Yen rather than the Yuan that was under-valued. Responding to that competition was also painful for US and European firms, but we have to remember that firms don’t stand still. Some fail, others adapt, and the best of them not only survive, but thrive.

 


 

Footnotes

1 Peter K. Schott, The Relative Sophistication of Chinese Exports, Economic Policy (forthcoming).
2 Andrew Bernard, Brad Jensen and Peter K. Schott, Survival of the Best Fit, Journal of International Economics (2006).
3 Lori Kletzer, What are the Costs of Job Loss from Import-Competing Industries?, Institute for International Economics (2001).
4 Lori Kletzer, Trade-related Job Loss and Wage Insurance, Review of International Economics (2004).

 

 

Topics: International trade
Tags: China, manufacturing, vertical differentiation

Professor of Economics at the Yale School of Management