Tài liệu Comparative advantage of vietnam’s textile and clothing industry

Thai Nguyen University Southern Luzon State University Socialist Republic of Vietnam Republic of Philippines Thesis Title: Comparative Advantage of Vietnam’s Textile and Clothing Industry A Research Proposal Presented to the Faculty of Graduate School Southern Luzon State University Lucan, Quezon, Philippines Thai Nguyen University S.R Vietnam In Partial Fulfillment of The Requirements for The Degree Doctor in Business and Administration SUPERVISOR: ASSOCIATE. PRO, DR NGUYEN KHANH DOANH STUDENT NAME: LE ANH TUAN ENGLISH NAME: JOHN THAI NGUYEN, 2013 i ACKNOWLEDGEMENTS Throughout the course of research leading to the completion of this thesis, I have gratitude to many people, who have provided me with tremendous help and support in one way or another, which I think I cannot possibly acknowledge in full measures. First and foremost, I would like to express my sincere thanks to Vice Associate Pro. Dr.Nguyen Khanh Doanh, my advisor, for his invaluable thoughts, insightful suggestions and useful guidance throughout the thesis works. Sincere appreciations were also to the committee members for their propositions, valuable comments, and constructive suggestions which were of substantial value to this study. I would like to faithfully acknowledge professors of SLSU & TNU at DBA Program at University of Thai Nguyen for their insightful lectures in different subjects that provide me knowledge and technique to develop a good research. My sincere thanks are extended to my entire friends for their meaningful discussion, hospitality and friendships. Finally, I am profoundly grateful to my parents, my wife, my sisters and my brothers, who have been always with me in every situation. They have been table source of encouragement and sharing during my work. ii LIST OF CONTENTS LIST OF CONTENTS Chapter 1: INTRODUCTION............................................................................................... 1 1.1. Problem Statement ............................................................................................ 1 1.2. Objectives ......................................................................................................... 3 1.2.1. General Objective ............................................................................................. 3 1.2.2. Specific Objectives ........................................................................................... 4 1.3. Dissertation structure ........................................................................................ 4 Chapter 2: LITERATURE REVIEW .................................................................................. 5 2.1. Theoretical Foundation ..................................................................................... 5 2.1.1. Definition of comparative advantage ............................................................... 5 2.1.2. Theories of comparative advantage .................................................................. 7 2.1.2.1. Ricardian model .......................................................................................... 7 2.1.2.2. Heckscher – Ohlin model (H-O) ............................................................... 10 2.1.3. Factors affecting comparative advantage ....................................................... 14 2.1.3.1. Technological Superiority ......................................................................... 14 2.1.3.2. Resource endowments ............................................................................... 14 2.1.3.3. Availability of credit ................................................................................. 16 2.1.3.4. Economies of scale .................................................................................... 16 2.1.3.5. Technological Gap (Benefits of an Early Start) and Product Cycle ......... 17 2.1.3.6. Demand Patterns: Demand Considerations ............................................... 17 2.1.3.7. National and International Policies ........................................................... 17 2.1.3.8. Factors affecting export performance ....................................................... 18 2.1.4. Comparative Advantage framework ............................................................... 21 2.1.5. Competitive advantage ................................................................................... 21 2.1.6. Linking comparative advantage and competitive advantage .......................... 24 2.1.7. Measuring comparative advantage ................................................................. 27 2.1.7.1. Balassa’s Index of Revealed Comparative Advantage ............................. 27 2.1.7.2. The Donges and Riedel Measure .............................................................. 27 2.1.7.3. Wolter Index .............................................................................................. 28 2.1.7.4. Michaely Index .......................................................................................... 28 2.1.7.5. Export Share Ratio .................................................................................... 29 Chapter 3: RESEARCH METHODOLOGY .................................................................... 30 3.1. Measuring comparative advantage ................................................................. 30 3.1.1. Revealed comparative advantage ................................................................... 30 3.1.2. Trade balance index ........................................................................................ 31 iii LIST OF CONTENTS 3.1.3. Trade specialization ........................................................................................ 32 3.1.4. Market share ................................................................................................... 32 3.1.5. Alternative Specifications of Revealed Comparative Advantage .................. 33 3.2. Analyzing the Structural Stability................................................................... 34 3.2.1. Stability of Revealed Comparative Advantage .............................................. 34 3.2.2. Intra-Distribution Dynamics ........................................................................... 35 3.3. Indices of Mobility.......................................................................................... 36 3.3.1. Shorrocks Index (M1) ..................................................................................... 36 3.3.2. Shorrocks Index (M2) ..................................................................................... 37 3.3.3. Sommers and Conlisk Index (M4) .................................................................. 37 3.4. Measure of Export Concentration ................................................................... 37 3.5. Trade Compatibility ........................................................................................ 38 3.6. Modeling the determinants of comparative advantage ................................... 38 3.6.1. Model description ........................................................................................... 38 3.6.2. Model specification ........................................................................................ 40 3.6.3. Choosing between FEM and REM ................................................................. 41 3.7. Data sources .................................................................................................... 41 Chapter 4: EMPIRICAL FINDINGS ................................................................................. 43 4.1. Vietnam’s Export Performance in Textile and Clothing ................................ 43 4.1.1. Overview of Vietnam’s Economy and Textile and Clothing Exports ............ 43 4.1.2. Structure of Vietnam’s Textile and Clothing Exports .................................... 45 4.1.3. Direction of Vietnam’s textile and clothing exports ...................................... 47 4.2. 4.2.1. 4.2.2. 4.2.3. 4.3. Patterns of Vietnam’s Comparative Advantage in Textile and Clothing ....... 51 Patterns of Vietnam’s Comparative Advantage in Textile and Clothing ....... 51 The Dynamics of Vietnam’s Comparative Advantage in Textile and Clothing53 Concentration of Vietnam Textile and Clothing Exports ............................... 56 Determinants of Vietnam’s Comparative Advantage and Competitiveness in Textile and Clothing ........................................................................................................... 57 4.4. Trade Complementary and Forecasting Vietnam’s Potential Exports ............ 63 Chapter 5: CONCLUSIONS AND POLICY IMPLICATIONS ...................................... 65 APPENDICES....................................................................................................................... 67 REFERENCES ..................................................................................................................... 69 iv LIST OF TABLES ABSTRACT This Study is the first to attempt a systematic evaluation of the comparative advantage for Vietnam’s Textile and Clothing Industry in the global market. The study is timely as Vietnam has made an extensive effort to change its international trade for some years and the consequent increase in competitive pressures and technology transfers, is expected to have led to a restructuring of the economy such that the composition of Textile and Clothing exports Volumne reflects Vietnam’s comparative advantage in the global economy. The timeliness of the study is also reinforced by the fact that increased trade integration of Vietnam over the past few years is likely to have contributed to a shift in comparative advantage in Textlile and Clothing Industry in the world market. The Study identifies the pattern of comparative advantage using the Balassa (1989) index for export data. The index has been calculated at the sector and commodity level of the Harmonized System of classification. The Dissertation also analyses comparative advantage according to factor intensity. The analysis shows broad in the structure of comparative advantage of Vietnam’s Textile and Clothing Industry. I do hope that this Dissertation will serve as a useful source and provide valuable reference material for researchers and policy makers associated with and interested in export promotion strategy in Vietnam. v LIST OF TABLES LIST OF TABLES Table 4.1: Basic Economic Indicators of Vietnam ................................................................ 43 Table 4.2: Contribution of Textile and Clothing to Vietnam’s Total Exports ...................... 44 Table 4.3: Annual Growth Rate of Vietnam’s Textile and Clothing Exports ....................... 44 Table 4.4: Structure of Vietnam’s Textile and Clothing Exports (in percent) ...................... 45 Table 4.5: Top 10 Textile and Clothing Export Markets of Vietnam (in percent) ................ 47 Table 4.6: Importance of Vietnam in World Exports of Textile and Clothing Exports ........ 49 Table 4.7: Summary of Statistics ........................................................................................... 51 Table 4.8: Measures of Trade Specialization ........................................................................ 51 Table 4.9: Vietnam’s Revealed Comparative Advantage in Textile and Clothing ............... 52 Table 4.10: Results of Galtonian Regression ........................................................................ 54 Table 4.11: Transition Probability Matrix 2001-2011........................................................... 55 Table 4.12: Mobility Indices ................................................................................................. 56 Table 4.13: Herfindahl Index................................................................................................. 56 Table 4.14: Summary of Statistics......................................................................................... 57 Table 4.15: Determinants of Vietnam’s Textile and Clothing Exports (REM)..................... 58 Table 4.16A: Tariff rates applied by Vietnam on Imports of Textile (in percent) ................ 61 Table 4.17: Trade Complementary ........................................................................................ 63 LIST OF FIGURES Figure 2.1: Comparative advantage framework .................................................................... 21 Figure 2.2: Determinants of National Competitive advantage .............................................. 24 Figure 2.3: Linking Comparative Advantage and Competitive Advantage .......................... 25 vi LIST OF ABBREVIATIONS List of Acronyms and Abbreviations FDI Foreign direct investment GDP Gross Domestic Product H-O Heckscher-Ohlin R&D Research and development RCA Revealed Comparative Advantage RSCA Revealed symmetric comparative advantage RTA Relative trade advantage SCA Sustainable competitive advantage TBI Trade Balance Index WB The World Bank WTO World Trade Organization vii CHAPTER 1: INTRODUCTION Chapter 1 INTRODUCTION 1.1. Problem Statement The textile and clothing industry has been historically the core industrial sector in Vietnam’s economy due to its advantage in terms of factor endowments and market scale. Many reasons explain why this has long been the key industry of Vietnam: it is a sector with requires light investment; the technology is simple; it mostly uses unskilled labor, etc. During the past years, Vietnam’s textile industry has made remarkable efforts and become a main component in the textile industry in Southeast Asia and an important member in the global textile market. With around 3,800 companies including state-owned enterprises, joint stock and limited companies, the textile and clothing industry is the leading export sector of Vietnam, making a considerable contribution to the country’s prosperity. Vietnam’s textile and clothing industry has developed rapidly in recent years and has become a main component of the country’s economy. The export value of textile and clothing products has contributed the second largest share in the country’s total export value. This sector has helped significantly to the increase in source of foreign exchange and Vietnam’s gross national product (GDP). In 2006, the export value of the textile and clothing products was 5.8 billion US dollars, making this industry the second most important export sector of Vietnam only after crude oil. In 2007, Vietnam became an official member of the World Trade Organization (WTO). This has provided Vietnam great opportunities to develop, especially in terms of international trade as Vietnam receives equal treatment and benefits in trade like other members of WTO, and it was not be subjected to quotas anymore. Moreover, joining the WTO helps Vietnam access to global market, expand export markets and increase value of goods exported. The textile and clothing industry sector has seen an impressive period of development, with the trade volume increasing around 8% after ten years, from 2001 to 2011. Despite the global economic depression during the past years, the export value of this sector has continued to increase, exceeding 11 billion USD in 2010, an increase of 24% compared with 2009, and 14 billion USD in 2011, an increase of 38% compared with 2010. The production and exports of Vietnamese textile and clothing products contribute a considerable share in the world, accounting for 18.6% of the world’s total exports in textile industry in 2010. Currently, Vietnam ranks number five in the world in terms of textile and clothing exports, with over 2 million people working in this sector, accounting for nearly 5% of the country’s total labor force (VINATEX, 2012). The increase in export value of the sector in recent years results 1 CHAPTER 1: INTRODUCTION from the expansion in export market. Beside maintaining the traditional markets such as the US, EU, Japan, the Vietnamese textile and clothing companies has expanded to new export markets such as Korea, Taiwan, the Middle East, and Singapore. Rapid development of Vietnam’s textile and clothing industry derives from many factors, including abundant low-cost labor force and a stable political environment. Among them, the most important advantage is human capital. The Vietnamese labor force has two main characteristics, the first is its low price as well as the higher quality compared with some other countries. Vietnam has a young population with a high percentage of people at working age, an annual source supplementing the country’s labor force. Vietnam has gained many economic benefits in the textile industry without a loss of the comparative advantage in labor supply, and such an advantage is a driving force for the textile and clothing industry’s further development. The second characteristic is its sustainability. Expansion of urbanization and improvement in education in Vietnam has provided more high quality labor for the textile and clothing industry, guaranteeing the supply of workers for future development. Besides, trade and economic policies have also contributed to the development of the Vietnamese textile and clothing industry and helping Vietnam reach higher position in global market of textile and clothing products. Textile and clothing industry has been declared as an key industry of the country’s economy. Therefore, the Vietnamese government has adopted policies promoting an export-led growth strategy supported by strong foreign direct investment (FDI) inflows. The state monopoly of foreign trade was abandoned. The non tariff barriers were reduced. Maximum import tariff rates were also decreased. These measures have helped to reduce the anti-export bias resulting from the structure of trade protection, which tended to reduce the profitability of exporting compared to producing for the domestic market (Athukorala, 2006 cited in Jean-Rafael and Jean Pierre, 2009). Tariff exemptions were also implemented for imported inputs used in the manufacturing export products as well as tax incentives and Export processing zones have multiplied (Jean-Rafael and Jean Pierre, 2009). Implementation of trade agreements have affected trade liberalization and increased market access. After joining international economic organizations such as ASEAN (in 1997) and WTO (in 2007), and signing bilateral trade agreements (for example, with US in 2000), tariffs on imports and exports were significantly reduced or dropped, bringing various economic gains and especially increased market access. 2 CHAPTER 1: INTRODUCTION It is obvious that Vietnam possesses a comparative advantage in textile and clothing manufacturing. Nonetheless, Vietnam’s textile industry is facing various difficulties, such as excessive resource reliance, most enterprises are medium and small size, low technology and value added, indisposition in trade structure and highly concentrated export markets. Another difficulty is the workers’ low level of skill, partly resulting in the low competitiveness of textile products. Vietnamese textile workers are considered inferior in terms of professional skills compared with other textile export countries. Among over 2 million people working in textile and clothing sector, percentage of skillful workers are relative low. Furthermore, supporting industries of textile and clothing manufacturing are still undeveloped and cannot meet the demand from this sector. Domestic materials for this industry are seriously deficient and the textile company are unable to rely on domestic suppliers. Despite Vietnam having a natural conditions suitable for growing cotton, the total cotton output is still not enough to provide for the textile industry. In 2007, Vietnamese textile and clothing companies had to import around 90% of cotton material needed, and 70% of other materials for manufacturing such as fiber and fabric. Shortage of local materials in one of main reasons resulting in decrease in business efficiency and in comparative advantage of Vietnamese textile and clothing enterprises. On the other hand, the textile and clothing industry is labor intensive. Development of the Vietnam’s textile and clothing industry is still determined by labor costs. Vietnam’s comparative advantage in textile industry mainly result from low labor costs. However, this kind of advantage is tending to decrease as developed countries are persistently investing new technologies into their textile and clothing industries and the advantage of cheap labor in developing countries tends to be weakened along with improvement in productivity in developed countries. The developed countries can maintain higher profit in their textile and clothing industry while at the same time reduce production. It is therefore urgent for Vietnam have policies and measures to strengthen comparative advantage of textile industry and overcome serious domestic obstacles. This dissertation aims at an in-depth investigation of comparative advantage of Vietnam’s textile and clothing industry and brings corresponding suggestions. 1.2. Objectives 1.2.1. General Objective 3 CHAPTER 1: INTRODUCTION The general objective of this research is to analyze the patterns and dynamics of Vietnam’s comparative advantage in textile and clothing industry in the period 2001-2011. 1.2.2. Specific Objectives  To systematize the theoretical foundation and empirical evidence of comparative advantage, making contribution to the development of new theory about comparative advantage.  To investigate the patterns of Vietnam’s comparative advantage in textile and clothing industry.  To analyze the dynamics of Vietnam’s comparative advantage in textile and clothing industry.  To assess the determinants and factors affecting Vietnam’s comparative advantage in textile and clothing industry.  To derive policy implications based on the empirical findings. Results of this research could be important in terms of helping to develop policies aiming at improving Vietnam’s comparative advantage 1.3. Dissertation structure This dissertation consists of five chapters. Chapter one describes the Statement of the problem and objectives of the Study. Chapter Two provides an overview of the literature on comparative advantage and factors affecting comparative advantage of a country in a given industry. Chapter Three describes indicators and index used to measure comparative advantage and then plus outlines the methods and models used in the study. Chapter Four presents the results over three parts, these being Vietnam’s export performance in textile and clothing industry, patterns of Vietnam’s comparative advantage in textile and clothing industry and determinants of Vietnam’s comparative advantage in textile and clothing industry. The discussion chapter reflects on the implications of the study’s findings and provides recommendations for policy makers. The final chapter presents the conclusions, the limitations of the study and gives directions for further research. 4 CHAPTER 2: LITERATURE REVIEW Chapter 2 LITERATURE REVIEW 2.1. Theoretical Foundation 2.1.1. Definition of comparative advantage In economics, comparative advantage is one of the oldest and most lasting concepts (Evans, 1989). Comparative advantage is commonly expressed as international differences in the opportunity costs of goods; that is, the quantity of other goods sacrificed to make one more unit of that good in one country as compared to another country. In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. According to the law of comparative advantage, a country must specialize in those products that it can produce relatively more efficiently than other countries (Krugman and Obstfeld, 2003). This implies that despite absolute cost disadvantages in the production of goods and services, a country can still export those goods and services in which its absolute disadvantages are the smallest and import products with the largest absolute disadvantage. It also implies that a country with absolute cost advantages in all its products will specialize and export those products where the absolute advantage is the largest, and will import products with the smallest absolute advantages. Comparative advantage thus also leads to specialization, but differs from specialization based on absolute advantage, in that a country will always import, whether or not it is more or less efficient overall in the production of all goods and services relative to other countries. Relating the law of comparative advantage, the question that frequently arises is how is it possible for a country that is less efficient in the production of all products to export any of these products to another country that is more efficient in the production of all these products? (Smit, 2010). The answer lies in the self-equilibrating nature of the trade balance between countries (Krugman, 1993). This means that in equilibrium, if the input cost is sufficiently lower in one country than another country, the price of the product will be lower in the low input cost country, even if that country is less efficient in the production of the product (Salvatore, 2002). Any deviations from equilibrium will automatically realign the exchange rate between the two countries to ensure new trade equilibrium. 5 CHAPTER 2: LITERATURE REVIEW According to Baumol and Binder (2009), comparative advantage underlies the economics analysis of international trade patterns. A country that is particularly adept at producing certain items – such as aircraft in the United States, coffee in Brazil, oil in Saudi Arabica should specialize in those activities, producing than it wants for its own use. The country can take the money it earns from its exports and purchase from other nations items that it does not make for itself. And this is still true if one of the trading nations is the most efficient producer of almost everything. The United States might, for example, be better than South Korea at manufacturing both computers and television sets. But if the United State is vastly more efficient at producing computers, but only slightly more efficient at making television sets, it pays for the United States to specialize in computer manufacture, for South Korea to specialize in television production, and for the two countries to trade. The idea of comparative advantage has been first mentioned in Adam Smith's Book The Wealth of Nations: "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage." But the law of comparative advantages has been formulated by David Ricardo who investigated in detail advantages and alternative or relative opportunity in his 1817 book On the Principles of Political Economy and Taxation. Ricardo established the result that countries can mutually benefit from trade if pre-trade relative prices of commodities in those countries are different (Caves and Jones 1977). Recent comparative advantage analyses are frequently based on the Heckscher - Ohlin (HO) model of international trade or its extensions. The basic version of the H-0 model was developed in a context of two inputs and two outputs. The two central hypotheses of this model, as described by Leamer (1984), are: (1) immobility of some production factors between countries, and (2) factors can be used in different combinations to produce different goods. The model also assumes that all countries have access to the same technology and free trade. The main implication of this model is that, given the restrictive set of assumptions, a country will export commodities whose production makes intensive use of factors locally abundant, and will import commodities that are produced with factors relatively scarce (Caves and Jones 1981), that is, a country will have comparative advantage in the production of the good which intensively uses factors abundant in that country. Thus, trade flows are dictated exclusively by factor endowments. The resulting main difference between the Ricardian and Heckscher-Ohlin implications is that the Ricardian theory explains international trade on the basis of differences in technology (or productivity) 6 CHAPTER 2: LITERATURE REVIEW whereas the Heckscher-Ohlin model explains trade on the basis of differences in factor endowments. In determining the most efficient patterns of producing and trade, it is comparative advantage matters. Thus, a country can gain by importing a good from abroad even if that good can be produced more efficiently at home. Such imports make sense if they enable the country to specialize in producing those goods at which it is even more efficient. And the other, less efficient country should specialize in exporting the goods in whose production it is least inefficient. 2.1.2. Theories of comparative advantage The theory of comparative advantage is likely one of the most important concepts in international trade theory. Leamer (1984) suggested that the main purpose of trade theory is to describe and predict the responsiveness of outputs and factor prices to changes in output prices and factor supplies and also identify which commodities are exported and which are imported. Two basic models were initially developed to address these issues: the Ricardian model and the Heckscher-Ohlin model. 2.1.2.1. Ricardian model Caves and Jones (1977) describe the Ricardian model as the oldest and simplest trade model in which the details of production are fully incorporated. According to the classical Ricardian theory of comparative advantage, relative labor productivities determine trade patterns. The Ricardian model plays an important pedagogical role in international economics (Golub and Hsiehh, 2000). Ricardo’s theory of comparative advantage is based on the labor theory of value (Salvatore, 2002). The Ricardian model assumes that i) labor is the only factor of production that is remunerated, ii) all labor is homogeneous and all occupations pay the same wage, iii) in any occupation the number of man-hours required per unit of output is constant and independent of the output level, that is, real cost per unit is constant and, iv) labor is mobile among industries but immobile between countries (Caves and Jones 1977). These unrealistic assumptions led to the incorporation of opportunity cost into the explanation of the theory of comparative advantage. If the Ricardian theory of comparative advantage is redefined in terms of opportunity cost, then a country will have a comparative advantage in the production of goods and services if such goods and services can be produced at a lower opportunity cost. This implies that a country will have a comparative cost advantage in the 7 CHAPTER 2: LITERATURE REVIEW production of those goods and services that can be produced at a lower opportunity cost than in other countries (Salvatore, 2002). The Ricardian model can be easily understood in the context of a two-country, twocommodity model. Adapting Caves and Jones (1977), imagine a simplified closed economy in which only two commodities, X and Y, can be produced. Let aLX and aLY each represent the constant real labor costs per unit of output in the production of X and Y, respectively. If output levels are given by Zx and Zy, the total level of labor allocated to X and Y would be aLX Zx and aLYZy, respectively. Assume labor is fully employed, aLX Zx + aLYZy = L (1) The assumption of fixed labor requirements per unit of output implies that equation (1) describes a straight line transformation schedule (see Caves and Jones 1977, p. 76). This implies that in the Ricardian model, relative prices are fixed and determined by the real labor costs per unit of output aLX and aLY. To see this, we ask how much extra Y could be produced if X output is reduced by one unit. This reduction would release aLX units of labor. Since aLY units of labor are required to produce one unit of Y, aLX /aLY extra Y units could be produced. Since aLX /aLY represents the relative price of X, and this ratio is constant, relative prices are constant. In this case, the straight line transformation curve would also imply that the relative supply function (Zx/ZY) is horizontal. This implies that demand has no role in determining pre-trade relative prices. Now suppose that this country engages in trade with another country that also produces only X and Y. In the Ricardian model, patterns of trade are completely determined by technological differences between countries, or put in another way, trade flows are determined by the countries' pre-trade relative prices. Let aLX* and aLY* each represent the constant real labor costs per unit of output in the production of X and Y in the foreign country, respectively. In a general form, the foreign country has comparative advantage in X only if < (2) Equation (2) makes evident the counterintuitive nature of the Ricardian model. Following the example offered by Ricardo and later replicated by Caves and Jones (1977), suppose the home country has higher labor costs per unit of production than the foreign country in both commodities. Why should the foreign country import anything from the home country? Because, although the home country labor was at an absolute disadvantage in both 8 CHAPTER 2: LITERATURE REVIEW commodities X and Y, its disadvantage is relatively less in one of the goods. The foreign country has an incentive to focus on the production of the good it produces the cheapest, and import the good the home country produces the cheapest. Higher wages accompany higher productive labor in the foreign country. The assumption of immobile factors of production between countries guarantees that wages will not be equated. Strengths and weakness of the Ricardian model Major difficulties with the Ricardian model are: 1) labor is the only input considered - this implies, for example, that differences in factor endowments between countries play no role in explaining trade patterns, 2) the demand side of the model has no role in determining patterns of trade since pre-trade prices are determined exclusively by relative supply, and 3) differences in technology between countries is overemphasized, without explaining why methods of production should differ. Incomplete specialization: Perhaps the most problematic feature of the simple Ricardian model, from an empirical point of view, is the implication that countries specialize completely in tradable-goods production, except in case when a small country cannot satisfy demand of a large country. In practice, import-competing sectors rarely disappear in the face of foreign competition. There are two possible routes to reconciling incomplete specialization with differences in labor productivity: product differentiation and disequilibrium effects. A disequilibrium interpretation of the Ricardian model is that price and quantity arbitrage is incomplete, resulting in incomplete specialization in the short run. In long run equilibrium, either complete specialization or equality of unit labor costs would be attained, but the process of adjustment may be very slow. Alternatively, incomplete specialization (and intra-industry trade) can coexist with productivity differences, owing to product differentiation. With product differentiation, differences in technology can drive inter-industry trade, while intra-industry trade occurs because of product differentiation, as in Krugman (1981). Allowing for product differentiation also help address Bhagwati’s (1964) objection to test of Ricardian theory. Bhagwati argued that if the tests of Ricardians model are based on incomplete price arbitrage, then one should examine the link between trade prices and trade flows instead of going directly from labor costs to trade flows. With product differentiation, productivity differences, incomplete specialization, and commodity price equalization could be consistent. For example, in variant of Krugman’s (1981) model of Dixit – Stiglitz 9 CHAPTER 2: LITERATURE REVIEW monopolistic competition, if country X is relatively productive in industry A relative to industry B compared with country Y, X will produce more varieties and be a net exporter of good A, yet the price of each variety of good A will be equalized across countries by trade. In such a framework, there is no link between observed post-trade relative product prices and trade patterns, but there is a link between relative labor productivity and trade. Although the theory of comparative cost advantage is based on a set of strict assumptions, this does not invalidate the general acceptance of the theory in explaining gains from trade (Krugman 1990; Culbertson, 1986; Keesing, 1966). This is furthermore underscored by the fact that most of the principles of the World Trade Organization (WTO) are based on the belief in the validity of the law of comparative advantage (Root, 2001). Even the relaxation of most of the assumptions does not affect the general validity of the theory in any significant way (Harkness, 1983), and enough empirical evidence exists to support the theory of comparative advantage (Bernhofen and Brown, 2004; Schott, 2004; Uchida and Cook, 2005). The superiority of the theory of comparative advantage lies in the remarkable amount of useful information that it summarizes clearly and concisely. According to Salvatore (2002): “It shows the conditions of production, the autarky point of production and consumption, the equilibrium relative commodity prices in the absence of trade, the comparative advantage of each nation ... it also shows the degree of specialization in production with trade, the volume of trade, the terms of trade, the gains from trade, and the share of these gains to each of the trading nations”. It is this power of the theory that provides a convincing explanation why trade is a positive sum game (Krugman, 1994a, 1994b, 1998). 2.1.2.2. Heckscher – Ohlin model (H-O) Whereas the Ricardian model of trade conveys the essential idea of comparative advantage, it does not explain the direction of trade. Economists thus needed an alternative model of comparative advantage to explain the direction of trade. An important theory to explain the reasons, or causes, of comparative advantage differences between countries is the Heckscher-Ohlin (H-O) theory (Salvatore, 2002). According to this theory, countries differ with respect to their factor intensities, namely the labor and capital that are used in the production of goods and services. While there are many different resource explanations of comparative advantage, the H-O theory isolates factor abundance or endowments as the basic determinant of comparative advantage. Although the 10 CHAPTER 2: LITERATURE REVIEW H-O theory is based on a set of simplifying assumptions, relaxing these assumptions modifies but does not invalidate the theory (Salvatore, 2002). The H-O model contrasts with the Ricardian model by incorporating more realistic assumptions than the ones adopted by Ricardo. The H-0 model assumes two factors of production (labor and capital), differing factor-proportions, both across countries and across industries, and that countries are endowed differently in production factors (Leamer, 1984).1 In the H-0 model, trade is driven mainly by differences in factor endowments, leading to the main conclusion that a country with balanced trade will export the commodity that uses intensively its relatively abundant factor and will import the commodity that uses intensively its relative scarce factor (Heckscher-Ohlin theorem). Leamer (1984) offers a straightforward proof to this theorem. Consider two commodities Xi andX2. In equilibrium, factor supply equals to factor demand K = aK1X1 + aK2X2 (3) L = aL1X1 + aL2 + X2 Let V represent the vector of endowments (K, L) and X the vector of outputs (X1, X2).Then these equations can be written as V = AX or -1 (4) X=A V where the inverse exists provided the relative input intensities are unequal, that is, aK1/aL1 ≠ aK2/aL2. The linearity of these equations allows us to write world outputs Xw as a function of total world endowments Vw, that is, Xw = A-1Vw. Because all countries face the same international prices of output and consumers maximize identical homothetic utility function, each country consumes commodities in the same proportions, C = sXw, where s is the country's 1 The complete set of assumptions, as described by Leamer (1984), under which the main conclusions of the model can be reached, are: (1) the number of goods and factors are equal to two; (2) production factors are completely immobile between countries but move costlessly between industries within a country and (b) commodities are traded freely at zero transportation cost; (3) input and output markets clear competitively, (4) countries have costless access to the same technology; (5) the variability of factor endowment ratios among countries is less than the variability of factor input intensities across industries (see pages 4 through 6 for a precise definition of variability). This condition is necessary to ensure factor price equalization across countries; (6) all consumers maximize an identical homothetic utility function. 11 CHAPTER 2: LITERATURE REVIEW consumption share of world output and C is its consumption vector. Trade balance requires that p'X = p'C - sp'Xw (value of production equals value of consumption), where p is the price vector (p1, p2). Thus, balanced trade implies S = p’X / p’Xw, (5) that is, the consumption share is the ratio of own GNP to world GNP. In the context of the H-0 model, net exports is defined as the difference between production and consumption: T=X–C T = A-1V – sA-1Vw (6) T = A-1( V – sVw), Which is A-1 times the vector of excess factor supplies: V – sVw = [ ]=[ [ ] [ ] ] (7) To conclude the argument, Leamer (1984) demonstrates that if a given country is relatively capital abundant (K / Kw > L / Lw), than the excess factor supply vector has signs (+,-). This is assured by the fact that the consumption share is a weighted average of capital share and the labor share s= = = = [ ( ) ( )] (8) where w is the factor reward vector: w = (A')-1 p . This implies that s is bounded by K/Kw and L/Lw, and consequently K/Kw > s is equivalent to K/Kw > L/Lw. The last step in determining the sign of the net export vector of a capital abundant country is defining the effect of pre-multiplying a vector with signs (+,-) by the inverse of the matrix A: A-1 = [ where | | = ( ]/| |, ] =[ )= [ ] (9) If X1 is the capital intensive industry, then | | > 0, and A-1 has the sign pattern [ ]. Thus, if the country is abundant in capital, the vector of excess factor supplies has sign pattern (+,-), and trade therefore has sign pattern T = [ ] [ ] = [ ]. This implies 12 CHAPTER 2: LITERATURE REVIEW that the capital abundant country exports the capital intensive commodity X1 and imports the labor intensive commodity X2 (Leamer 1984). A number of empirical studies have been conducted to verify the H-O theory. One of the first such studies was conducted by Leontief (1953), who found that, irrespective of the general believe that the United States was expected to be an exporter of capital-intensive products and an importer of labor-intensive products, the results confirmed just the opposite. The paradox was later confirmed by Baldwin (1971). Similar results were reported in studies based on data for Japan, Germany, India and Canada (Baldwin, 1979). The Leontief paradox has led economists to look for alternative explanations for the H-O theory. The most important of these was the introduction of differences in human capital (Keesing 1966; Baldwin 1971) as an explanation of the paradox. Others were the product cycle theory (Vernon 1966) and the technology gap theories (Gurber et al., 1967; Gold 1981) that incorporate time as a dynamic extension to the basic H-O theory. Most of these theories were mere modifications and extensions of the basic H-O theory and did not reduce the validity of the theory in explaining the direction of trade between countries. The Ricardian and the H-O models are important to make clear the definition of comparative advantage, a term frequently misused. These models are also used as guidelines in the construction of the empirical model. The connection between the theoretical models and the problem at hand stems from the fact that the theory allows one to form expectations on what determines the configuration of international supply of textile products, what causes this configuration to change and how countries move toward a new equilibrium when economic conditions change. Moreover, theoretical models allow us to contrast results from empirical models with expectations. The importance of having a solid theoretical reference cannot be overstressed. For instance, several studies have tried to explain and forecast patterns of production and trade based on differences in absolute production costs. For instance, these studies tend to conclude that textile and clothing production will increase in areas where it can be produced cheaper in absolute terms. Although this idea may seem intuitive, it is misleading. The Ricardian model suggests that relative costs (and not absolute costs) are important in determining patterns of production. In theory, it is possible to manufacture textile products in regions where absolute costs are not the lowest. Thus, in order to form a correct expectation of the allocation of world supply 13