What kind of policies support a dynamic comparative advantage?

As the contrasting examples of the trade liberalisation, infant industry protection and targeted industrial policy illustrate, policy implications of the comparative advantage theory are not always clear. Following the precepts of the theory, any interference with comparative advantage, even if it entails government support to sectors in which a country may have ‘natural’ comparative advantage, can reduce gains from trade or even render them negative (e.g. Chapter 1). However, as pointed out by Rodrik (2009) even broad policies, not focused on any particular sector (e.g. education or capital market policies), can influence conditions and bias the development of certain activities. What is then the “natural” comparative advantage? Is it possible for a government to influence its comparative advantage in a fashion that is sustainable and beneficial for the country and the world trading system?

Understanding the interaction between policies - both trade policy and complementary policies - has become more challenging as the factors driving world commerce have grown more complex. Inter-industry trade in final goods and services with complete specialisation was a relatively straightforward matter and patterns of trade tended to be long-lived. In today’s world, complex global supply chains have caused intra-industry trade to grow exponentially, with an estimated 70% of total trade now taking place in intermediate goods (Miroudot et al. 2009). The rapid pace of technological change means that comparative advantage is shifting rapidly. Trade theories have evolved quickly to keep pace with these changes, but the intricacies of these theories have turned effective policy-making into a non-trivial matter.³

To shed light on these dilemmas the second part of the book focuses on the role of broad policies in influencing comparative advantage. That is, Chapters 6 to 10 focus on the role of 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 favour some sectors. These broad policies are a potential source of comparative advantage and thus of welfare gains from trade. Given the lack of conclusive evidence on the viability of targeted industrial policies in sustainably influencing comparative advantage, we exclude the discussion of these policies as ones potentially hindering or reducing the gains from trade.

The comparative advantage theory emphasises the relative differences in productivity between countries as the reason for international trade and hence for gains from trade. The larger the differences in underlying sources of comparative advantage across countries, the larger the gains from trade. In Chapter 6, Kowalski presents empirical analysis that builds on recent generalisations of theory and empirics of comparative advantage (e.g. Costinot, 2009; and Chor, 2010). The chapter quantitatively assesses the relative importance for bilateral trade flows at the industry level, with particular focus on how policy and institutional factors affect resource markets, thus potentially influencing these productivity differentials. The chapter focuses on the interactions between country and industry characteristics that together form the basis for comparative advantage. The overall results highlight the importance of broad-based policies in explaining a country’s export flows.

Focusing on policies affecting resource markets, the chapter shows that comparative advantage remains an important determinant of trade. For example, capital-to-labour ratios are at least as important in explaining industry patterns of trade as is geographical distance. The cross-country differences in secondary and tertiary education provide approximately half of the explanatory power as distance, while the broader indicator of average years of schooling has twice the explanatory power as the distance variable. Other important sources of comparative advantage include the availability of credit and primary energy supply while regulatory quality and labour market rigidity tend to influence trade patterns less significantly. Comparing jointly across the OECD and SEM groupings Kowlaski finds that cross-country differences, and thus the potential for gains from comparative advantage-driven trade, decreased for such sources of comparative advantage as: physical capital, average years of schooling, tertiary education, primary energy supply, availability of credit; while they increased for secondary education and regulatory quality.

The OECD grouping has become more homogenous as far as many comparative advantage sources are concerned, implying that the potential for comparative advantage- driven North-North trade may be diminishing. The non-OECD grouping, in addition to being generally more heterogeneous, displayed no clear tendency for cross-country differences to diminish over time, indicating a persistently high potential for comparative advantage-driven South-South trade. The widening differences between OECD and non- OECD economies for physical capital, availability of credit or regulatory quality suggest an increasing potential for comparative advantage-driven North-South trade along these lines. However, differences between OECD and non-OECD have narrowed for human capital indicators. Overall, the author argues that these results suggest that comparative advantage has been—and is likely to be in the future—relatively more important for North-South and South-South trade than for North-North trade.

So if these broad-based policies tend to explain comparative advantage trade, what about more specific policies? Many countries have instituted a range of policies to encourage exports, attract FDI, and promote specific industries or sectors in pursuit of growth and development. While some policies, such as building roads and ports are relatively ‘neutral’, and thus not controversial, others are more problematic. Policy neutrality does not mean free trade or a common tax structure for all industries. Optimal tax theory and practical fiscal considerations imply that countries will often want to rely on tariffs as a source of revenue. Indeed, in his generalized rendition of comparative advantage, Deardorff (1980) shows that gains can still be made in the presence of tariffs and export taxes. But are policy interventions beyond those associated with optimal taxes or revenue constraints justifiable? Especially for poor developing economies?

The hundreds of studies on trade policies, trade shares, productivity and growth reviewed in Harrison and Rodriguez-Clare (2009) show a strong correlation between increasing trade shares and country performance but no significant correlation between tariffs on final goods and country outcomes. Instead, interventions that increase exposure to trade are likely to lead to higher welfare gains than other types of intervention (tariffs or import substitution for example).

Stone and Shepherd, in Chapter 7, present evidence that dynamic gains from trade derive from the importation of intermediate and capital goods. The chapter establishes that dynamic gains from trade can be an important conduit for increased firm-level innovation and productivity, both key components of economic growth. The chapter builds on previous research on the dynamic gains by moving beyond a single country basis to examine impacts on firm-level productivity for a cross-section of countries. It also explores the specific impacts of broad, or complementary, policies on firms’ ability to realise dynamic gains. Imports of intermediate and capital goods are associated with increased productivity in firms, while results for innovation are not as pervasive. Importantly, it finds that a range of complementary policies affects a firm‘s ability to generate productivity gains from intermediate and capital goods imports. Access to skilled labour is a particularly important policy variable with respect to the productivity gains of the import of intermediate goods, followed by access to finance, while macroeconomic stability slightly outranks access to finance for capital goods importers. The importance of access to finance has particular policy significance given the widespread financial reforms being discussed or underway.

In order to gain some insight into a country’s capacity to target specific industries to help “promote” comparative advantage, Stone and Shepherd examine the ability of policies to affect productivity gains by sector. The general finding is that sector-level response varied widely and is best understood only after-the-fact. That is, those industries which one would expect to gain the most from policy support did not always show the strongest gains. For example, light manufacturing showed the strongest productivity gains from imported intermediate goods, but nothing for capital goods imports. While textiles and leather were strongly affected by equipment imports, they were unaffected by intermediate goods. Not all sectors experienced the same innovation from imports. For example, electronics had a strong positive relationship while light manufacturing showed no statistically significant relationship at all. The results illustrate the complications involved in successfully implementing so-called targeted policies.

However, there has been evidence put forth of the success of targeted policies. Rodrik

• (2006) argues that government policies helped China to acquire domestic capabilities in consumer electronics that would most likely not have been developed in their absence. That is, static inefficiency costs were overcome by policy, favourably affecting Chinese growth. The idea behind this ‘special industries’ argument is that what matters most for future growth and development is not volume, but quality. However, Rodriguez-Clare
• (2007) showed that externalities are not necessarily intrinsic to sectors themselves, but rather to the way they are organised. For example, import substitution may expand the manufacturing sector but if production takes place in unsophisticated ways and no clustering benefits materialize, there is no justification for policy to alleviate so-called externalities and thus lead to welfare gains.

Chapter 8 addresses the “special industries” argument by examining the patterns of trade in advanced technology products (ATP). Deason and Ferrantino argue that even those industries which are touted as promising to have the ‘right’ technology - i.e. their adoption would allow economies to move up the production ladder or “leap frog” development stages - are themselves anomalies and thus cannot provide a means of importing ready-made comparative advantage. In addition, many of the technologies developed in ATPs are not easily adopted across economies. So the strategy of acquiring technological capacity through industrial policy is not always pragmatic. Indeed, successful diffusion (distribution of the location of a given export over a wider group of economies) and downstreaming (shifting of the location of a given export to lower- income economies) through product cycle suggests the movement of nation-specific technology is an indication of the pre-existence, rather than acquisition, of comparative advantage.

Deason and Ferrantino present and analyse patterns of trade for a number of technology-intensive products, including ATP, for a group of 15 economies in Asia, Europe, and the United States. The chapter finds that the degree of downstreaming is highly sector-specific and product-specific; e.g. there has been more downstreaming of electronics than chemicals, of consumer electronics than electronic components, and of certain basic chemicals than specialized products such as photographic film and cosmetics. The exports of many products not normally considered to be ATP continue to be concentrated in high-income economies. The authors argue that China’s export of ATP can be traced to three types of policy initiatives: the encouragement of FDI; the encouragement of processing trade (including importing intermediates goods); and the development of special economic zones. In other words, they implemented broader and not industry or sector specific, policies. The chapter concludes that it would not be possible, a priori, to predict which goods would be subject to rapid adoption and exploitation on comparative advantage grounds.

Thus, the results of Kowalski in Chapter 6 and Deason and Ferrantino in Chapter 8 suggest that maintaining or developing competitiveness in a certain area—for instance capital-intensive sectors—is best achieved developing effective broad policies that facilitate resource flexibility and accumulation. For example, in the case where a country succeeds in increasing its endowment of capital, relative to other countries and other factors of production, this is likely to result in the re-orientation of its exports toward capital-intensive sectors. Importantly, a broad-based approach involves a lower risk of reducing welfare gains from such specialisation, compared to policies involving direct support to capital-intensive sectors, though we certainly cannot exclude the possibility that the overall costs of such an approach exceed the benefits.

Acquiring comparative advantage in technological goods implies an ability to ascertain all of the advantages of this acquired technology, which depends on things like the size of adjustment costs and ability to absorb technologies. Policies, and government resources, shouldn’t be used to acquire advanced technologies with perhaps limited spillover benefits - limited due either to the nature of the technology or the ability of the local economy to benefit from it. Rather, emphasis should be on the importance of protecting innovation (e.g. through patents) through supporting basic research at universities and underwriting risk and coordination of pioneer firms. Cavazos Cepeda and Lippoldt show in Chapter 9, how a strong IPR regime is beneficial to the accumulation of capital and technological progress.

Chapter 9 considers empirically the relationship between change in the protection of intellectual property rights (IPR) between 1990 and 2000 and the evolution of technological achievement for a broad sample of OECD countries. In order to understand how it may impact on a sector’s ability to acquire a comparative advantage they also examine the relationship of such achievement to changes in labour productivity. By looking at the potential influence of IPRs on the ability of innovators (and subsequent rights holders) to appropriate benefits from their innovations, the authors argue, they can say something about the economic incentives for the application of improved technologies in the economy (e.g. from domestic innovation and technology transfer from abroad, including via trade and foreign direct investment), with potential implications for productivity and, ultimately, comparative advantage. The results point to a positive and statistically significant relationship between indicators for protection of patent and trademark rights and technological achievement. The relationship between such technological achievement and labour productivity was positive and significant in certain specifications.

Policies protecting IPR have the potential to spur innovation and productivity and can lead to the development of comparative advantage. This is a dynamic view of policy in which creating the right economic atmosphere (creating the right incentives) spurs firms to innovate without regard to a specific industry or output. Instituting such policies can instigate a dynamic process of comparative advantage. Whether comparative advantage is driven by technology or factor endowments does not change the fact that these forces change over time. Basic factors such as capital can become advanced technology; simply labour can become human capital. These more productive resources promise higher income and thus growth for economies. Cavazos Cepeda and Lippoldt show how changes in IPR protection are associated with change in indicators for innovation, technology transfer, trade and foreign direct investment. As such, these policies can facilitate the gradual accumulation of knowledge capital in firms, sectors and economies. Thus, reform of inadequate IPR protection may be cited as one part of a general strategy for promoting certain comparative advantage without resorting to a “special industries” type approach.

From a different vantage point, in Chapter 10 van Tongeren takes up the question of export restrictions in the context of special industries. The chapter examines the recent resurgence of export restrictions and their impact on trade. This resurgence has alerted policy makers to the challenges of rapid industrialization and population growth and its increasing pressure on raw material supplies. Restrictions can take a variety of forms including export taxes and quotas, licensing requirements, dual pricing schemes, local processing requirements, state trading enterprises and outright prohibition. Restrictions divert raw material supplies to domestic markets, providing downstream industries with a cost advantage and limiting supply to world markets. However, it is often not the access to raw materials (often a relatively small input cost) which holds back production in downstream industries but domestic market failures. Thus, this chapter argues, these restrictions are inefficient because they are put in place to overcome domestic market failures which are better addressed through non-trade instruments. Attempts to use export restrictions to undo the effects of tariff escalation are counter-productive. That is because the economic impact of export restrictions usually manifests itself in the form of higher import prices as well as leading to counter-productive bandwagon effects. Export restrictions thus more regularly harm the trade position of these same economies imposing them. Restrictions also divert more supply to domestic market, depressing domestic prices. There develops a gap between domestic and world prices that can encourage fraud or illegal shipments. The chapter shows how restrictions at best, do not meet their stated objective and at worst, do actual harm to the imposing economy.

As noted throughout this volume, specializing in comparative advantage industries leads to gains from trade by effecting a more efficient division of labour. Trade liberalization - whether done in the multilateral framework of the WTO or unilaterally - acts through a variety of channels to improve the competitiveness of the economy and the aggregate wealth of its citizens. This competitiveness in turn derives in large part from the reallocation of factors of production from less efficient to more efficient sectors. This process of structural change is not a simple one; the longer it takes, the greater the economic cost of short-term unemployment of resources. Importantly from a political economy perspective, it leads to “job churn” with workers moving within and across sectors, leading to short-term and potentially structural (long-term) unemployment. Often the most vulnerable workers bear a disproportionate burden of the associated costs. Hence, while economists see trade-induced structural change as being a necessary and salutary process of evolution, many social actors lament it and work to resist it. This is particularly true in the context of an economic downturn. As the 2008-09 crisis has been the worst since the Great Depression, protectionist forces - allied against this process of structural change - have arguably been at their strongest in over seven decades. It took a great deal of political will to eschew this pressure. Note, however, that while there was technically no great protectionist backlash in terms of deeds, there has been in words, and we have not yet reverted back to the liberalization trend of earlier years.

Hence, focusing on structural change is important for economic, political-economy, and social considerations. In the final chapter, Chapter 11, Petri and Plummer offer a forward-looking policy chapter on a two-fold approach to welfare maximization. The first is for governments to pursue wide-ranging liberalisation of international trade and investment flows that allow a country to realise its comparative advantage. The second is to put in place a mix of structural policies that will allow a country to efficiently adjust to the changes that accompany this liberalisation. The chapter discusses various approaches to liberalisation, arguing that a multilateral approach on a most-favoured-nation basis is best, but that significant advancement could be made through regional agreements or concerted liberalisation. Policies needed to support structural change fall into two broad categories. The first includes policies that facilitate shifting resources from old to new areas of comparative advantage. The second are policies that raise productivity or improve factors of production in areas favoured by comparative advantage. The inevitable costs that come with trade liberalization can be reduced if governments embrace policies that speed the adjustment process and support efficient change. By focusing on policies that support structural adjustment, governments can avoid some of the pitfalls experienced in the past where policy was seen as an anecdote to markets. However, this chapter cautions policy makers against going to the other extreme and relying too heavily on markets. Governments need to use a balanced approach between policy and markets to facilitate these structural changes.