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201603Capabilities, Wealth, and Trade.pdf
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201603Capabilities, Wealth, and Trade.pdf
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Capabilities, Wealth, and Trade
John Sutton
London School of Economics
Daniel Trefler
University of Toronto, Canadian Institute for Advanced Research,
and National Bureau of Economic Research
We explore the relation between a country’s income and the mix of
products it exports. Both are simultaneously determined by countries’
capabilities, that is, by countries’ productivity and quality levels for
each good. Our theoretical setup has two features. (1) Some goods
have fewer high-quality producers/countries than others, meaning
that there is comparative advantage. (2) Imperfect competition allows
high- and low-quality producers to coexist. These two features gener-
ate an inverted-U, general equilibrium relationship between a country’s
export mix and its GDP per capita. We show that this inverted-U perme-
ates the international data on trade and GDP per capita.
I. Introduction
A country’s capability—meaning the set of goods the country is able to
produce and its quality and productivity in producing them —drives its
per capita income and the sectoral mix of its exports. Aspects of the re-
lationship between quality, income, and the sectoral mix of exports have
been analyzed by a number of researchers. Hummels and Klenow (2005)
We thank Michelle Liu and especially Leilei Shen and Qi Zhang for excellent research
assistance. We have benefited from seminar presentations at the Canadian Institute for Ad-
vanced Research, the London School of Economics, Princeton, Stanford, Toronto, and the
World Bank and are grateful for comments from Daron Acemoglu, Philippe Aghion, Ber-
nardo Blum, Avner Greif, Elhanan Helpman, David Hummels, Peter Morrow, and Bob
Electronically published May 6, 2016
[ Journal of Political Economy, 2016, vol. 124, no. 3]
© 2016 by The University of Chicago. All rights reserved. 0022-3808/2016/12403-0006$10.00
826
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
estimate the impact of a country’s per capita income and size on export
quality. Hausmann, Hwang, and Rodrik (2007) explore how the process
of “cost discovery ” affects the sectoral mix of exports, which in turn af-
fects per capita incomes. Flam and Helpman (1987) and Fajgelbaum,
Grossman, and Helpman (2011) examine the codetermination of qual-
ity, income, and the sectoral mix of exports in a model in which demand-
side consumer heterogeneity plays a central role. In contrast, we use a
supply-side Ricardian model to show how the general equilibrium logic
of comparative advantage provides important theoretical and empirical
insights into how quality capabilities simultaneously affect per capita in-
comes and the sectoral mix of exports (as well as prices, markups, and
profits at the firm level).
To bring out these insights as clearly as possible, we focus theoretically
and empirically on characterizing the range of countries exporting a spe-
cific good, as in Schott (2004), and on characterizing how these coun-
tries’ market shares vary with their incomes. A standard intuition for the
relationship between market shares and incomes runs through quality.
Hummels and Klenow (2005) show that rich countries must have high-
quality exports because, at the aggregate level, rich countries have high
prices and high world market shares. A related inference appears in
Khandelwal (2010), Baldwin and Harrigan (2011), and Hallak and Schott
(2011). We show both theoretically and empirically that this aggregate in-
sight does not carry over in general equilibrium to the sectoral level be-
cause of Ricardian comparative advantage. For example, the United States
is a high-quality producer of stainless steel, but this cannot be inferred
from US stainless steel’s high price and small world market share: the
United States simply cannot compete with markedly inferior Chinese stain-
less steel because US wages have been bid up by high demand for military
aircraft, virtualization software, and other hard-to-make goods and services
that only a handful of rich countries are capable of producing.
Our model has two key elements. (a) We make the Ricardian assump-
tion that products can be ordered by the scarcity of quality capabilities.
Specifically, if a country has high quality in good k, then it has high qual-
ity in all goods ranked below k. This means that low-k goods are ones
for which most countries have high quality and are in this sense “easy”
to make. In contrast, high-k goods are ones for which few countries
have high quality: they are “hard” to make. This assumption captures the
notion of relative (in a Ricardian sense) scarcity of quality capabilities.
1
Staiger. Trefler thanks CIFAR and the Social Sciences and Humanities Research Council of
Canada for financial support.
1
For concreteness, let there be K goods, K countries, and two quality levels. We are as-
suming that goods and countries can be ranked such that good k is produced at low quality
capabilities, wealth, and trade 827
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(b) We assume that goods are differentiated only by quality (pure vertical
differentiation) and are supplied in markets characterized by Nash equi-
librium in quantities (Cournot competition). We use this assumption to
ensure that differing levels of quality will coexist in equilibrium. Elements
a and b generate a correlation between a country’s income and its export
mix. A country that can produce only a few goods at high quality will sur-
vive in only a few markets, and these will be the low-k or easy markets. As
a result, derived demand for the country’s labor will be low and wages will
be low. Thus, low-wage countries will export low-k goods. A country that
can produce many goods at high quality will have a high derived demand
for its labor and have high wages. High wages will make the country a
high-cost producer of low-k goods. Hence, a high-wage country will sur-
vive only in high-k markets.
This Ricardian sorting generates an inverted-U relationship between
income and market shares at the sectoral level. To understand why, con-
sider a country whose capabilities improve at the sectoral level: that is,
the country improves its quality in a k-ranked good until it reaches the
world quality frontier, and then it improves its quality in the next, higher-
ranked, good. During this quality improvement process, demand for the
country’s labor rises, as do its wages. As quality rises in good k,thecountry’s
world market share of the good rises initially because quality must rise fas-
ter than wage costs. This “direct” or “quality” effect underpins the Hum-
mels and Klenow aggregate correlation. However, as quality then rises in
a higher-ranked good, wages continue to rise, thus killing off the coun-
try’s competitiveness in good k: even though the country is a high-quality
producer of good k, its world market share must decline as capabilities
rise in higher-ranked, tougher-to-make sectors. This familiar intersectoral,
general equilibrium feedback through the labor market is what we call
the Ricardian or wage effect. It is the reason for the downward-sloping sec-
tion of the inverted-U relationship between income and market share. The
model generates a large number of other theoretical predictions, which
we describe below, but our empirics are concentrated on this inverted-U
relationship.
Turning to our empirical work, we investigate the sectoral-level, in-
verted-U relationship between income and market shares using data for
94 countries in 2005. Data are from COMTRADE (four-digit Standard
International Trade Classification [SITC] and six-digit Harmonized Sys-
tem [HS]) and, to a lesser extent, the US imports file (10-digit HS). The
by firms in countries ranked 1, ..., k 2 1 and produced at high quality by firms in countries
ranked k, ..., K. Then the number of countries that can produce good k at high quality is
decreasing in k; i.e., high-quality capabilities are scarce and this scarcity is relatively greater
for higher-ranked goods.
828 journal of political economy
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
theory states that the inverted-U relationship is driven by labor market
spillovers across sectors. We thus confine our attention to country-good
pairs for which the good is important in the country’s export basket and,
by implication, in the country’s labor market. For each good separately,
we build a “product range,” that is, a range of incomes defined by the
income levels of the poorest and richest exporters of the good. Product
ranges are related to Khandelwal’ s (2010) quality ladders: the latter de-
scribes a range of qualities while the former describes a range of in-
comes. We will not be estimating quality and hence will have nothing
to say about quality ladders.
2
Schott’s (2004) work on “overlap” leads
us to expect that product ranges will be large, and this is indeed what
we find. (The finding is not driven by China.) We then nonparamet-
rically estimate the relationship between income and world market
shares and show that it is exactly as predicted by the theory. (1) For those
products produced only by the richest countries, the relationship is pri-
marily positive: the direct or quality effect dominates. (2) For those prod-
ucts produced only by the poorest countries, the relationship is primarily
negative: the Ricardian or wage effect dominates. (3) For the remaining
“middle” products, the relationship is inverted-U, as first the quality effect
and then the wage effect kick in. Restated, Ricardian comparative advan-
tage based on relative scarcity of quality capabilities leads to general equi-
librium wage effects that are central for understanding the cross-country,
cross-sector relationship between quality, per capita income, and the sec-
toral mix of exports.
Changing subjects, we next turn to motivating our use of a nonstan-
dard trade model, that is, one without perfect competition or constant
elasticity of substitution (CES) monopolistic competition. Consider ta-
ble 1. We ranked all six-digit HS codes by the size of their world exports,
chose the top 10 codes, and identified the seven industries to which they
belong. For each of these seven industries we then used firm-level data
on worldwide production levels to compute four-firm concentration ra-
tios. The second column of table 1 shows that the seven industries are
typically highly concentrated at the global level. With the exception of
auto parts, just four firms in each industry produce between 21 percent
and 70 percent of global output. Thus these industries, which account
for a huge 21 percent of global exports, are typically dominated by a
small number of very large firms.
To account for global market dominance by a handful of firms we
need a model with the following key feature: an infinite sea of low-quality
rivals cannot erode the market share of a high-quality incumbent. CES
2
The fact that we are not estimating quality means that our agenda is very different from
that of Khandelwal (2010) and Hallak and Schott (2011).
capabilities, wealth, and trade 829
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
and other monopolistic competition models do not have this key feature
because love of variety ensures that an (infinite) inflow of new entrants
reduces (to zero) the market share of any incumbent firm. Thus, such
models cannot explain why global markets can be dominated by a hand-
ful of firms. In contrast, high concentration in global markets is readily
explained by appeal to the above-mentioned key feature that low quality
cannot drive out high. Further, the simplest and most analytically tracta-
ble model having this property is the Cournot model with quality.
3
Our paper has four key elements: (1) multiple sectors that are ranked
on the basis of Ricardian scarcity of quality capabilities, (2) an imperfectly
competitive market structure that supports the coexistence of differ-
ing levels of quality, (3) endogenous income so that there can be general
equilibrium spillovers across sectors via t he labor market (wages), and
(4) empirical work relating income to market shares at the sectoral level.
With this in mind, we relate our paper to the existing literature.
Our results are driven entirely by supply-side considerations. Demand
considerations play no role in our work. Allowing for demand-side het-
erogeneity and demand for quality that rises with income has yielded im-
portant insights for comparative advantage and per capita incomes (e.g.,
Flam and Helpman 1987; Hallak 2006, 2010; Choi, Hummels, and Xiang
2009; Fajgelbaum et al. 2011). However, the demand side by itself does
3
See Sutton (1998, 71) for a discussion. Cournot competition in international trade
models appears in Neary (2003) and Neary and Tharakan (2012). The need to model small
numbers of exporters is also taken up by Eaton, Kortum, and Sotelo (2012). The fact that
individual exporters account for a large share of a country’s exports is documented by, e.g.,
Bernard et al. (2007). The fact that individual exporters account for a large share of a
country’s output appears in, e.g., di Giovanni and Levchenko (2012). Our result is about
the fact that individual firms account for a large share, not of a country’s exports or output,
but of the world market of a good. That is, our result is about market structure.
TABLE 1
Top Industrial Exports Are in Concentrated Industries
Industry
Share of
World Exports (%)
Four-Firm
Concentration Ratio (%)
Passenger cars 6.0 48
Semiconductors 5.2 35
Auto parts 3.2 9
Pharmaceuticals 3.1 21
Laptops 1.4 57
Mobile phones 1.3 56
Aircraft .9 70
Aggregate 21.0 37
Note.—This table lists the industries with the largest values of world
exports. Export data are from COMTRADE. Four-firm concentration ra-
tios are authors’ calculations based on data sources reported in App.
table G1. The aggregate four-firm concentration ratio is the export-
weighted average of the industry-level concentration ratios.
830 journal of political economy
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
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