In February 2011, China entered the “year of the rabbit” with the new status of second-biggest economy in the world. This symbolises the prominent role in production and trade China and other low-wage countries have acquired during the last two decades. The economic consequence of this new deal is one of the most discussed phenomena in developed countries. And one central question in these debates concerns the impact that competition from low-wage countries has on the specialisation of developed nations.
A growing number of papers suggest that developed countries should experience a specialisation in higher-quality and more sophisticated products. Indeed, this “intra-industry specialisation”, as named by Schott (2008), would appear to be consistent with comparative advantages.
Such specialisation may be driven by two complementary forces:
- a reallocation of sales and production from low- to high-quality firms and
- an increase in the intensity of innovation at the firm level that would improve the quality content of the average firm’s product.
Recent empirical findings show how changes in the world’s competitive environment, notably the rise in Chinese exports, have actually increased firms’ incentive to innovate. This validates the second argument, according to which international competition is a driver of innovation in developed countries (see Bloom et al. 2011).
New evidence on the reallocation effects among firms within an industry
The reallocation argument has been much less investigated. It relies on two stylised facts.
- First, many sectors display intra-industry trade patterns, with both high-wage and low-wage countries selling their products in the same destination markets (Schott 2004).
At odds with traditional theories of international trade, this suggests that nations are vertically specialised. That is, the only way goods produced in developed and developing countries can co-exist in the same destination markets is that these products are vertically differentiated.
Schott (2008) confirms the intuition, showing that, when competing with low-wage countries’ products, high-wage countries tend to produce better qualities, on average.
- Second, in addition to the vertical differentiation of countries, recent empirical studies have emphasised that within sectors and countries, firms are heterogeneous in multiple dimensions and in particular in terms of the quality of the goods they produce (see, among others, Baldwin and Harrigan 2011).
Since firms in developed countries differ along the quality dimension, they should be hurt differently by the surge of low-wage countries’ low-quality exports. Namely, low-quality firms in developed countries are expected to suffer relatively more than high-quality ones. If such asymmetries arise at the microeconomic level, we should observe a rebalancing of sales at the aggregated level and a rise in developed countries’ average quality.
While quite intuitive, this mechanism has not yet been tested empirically. In a recent paper (Martin and Méjean 2011), we fill this gap using firm-level data for France. We show that, over the 1995-2005 period, tougher competition from low-wage countries actually led to a rebalancing of sales in favour of high-quality firms.
Changes in the quality composition of French exports
To measure changes in the quality composition of exports, we adopt the Boorstein and Feenstra (1987) quality index. This index tracks changes in quality driven by a re-allocation of market shares across firms of different qualities. Using this index and firm-level data, we are able to quantify changes in the quality composition of bilateral French exports attributable to exports being reallocated across firms within a given sector.
Figure 1 documents the aggregate change in price and quality. Over the period 1995-2005, we observe that the aggregate quality of French exports has increased by 11%. On average, France tends to specialise in the production of higher-quality products. Throughout the period, low-quality producers have lost market shares in foreign markets with respect to their high-quality competitors. This intensive margin adjustment has been reinforced by extensive margin effects, namely a net entry of new exporters producing goods of better quality, on average.
Figure 1. Evolution of the aggregate price and quality of French exports
In a simple counterfactual exercise, we show that this specialisation has had a positive impact on France’s export performances. Results of this exercise are summed up in Figure 2. We compare the actual evolution in the value of exports (plain line in Figure 2) to the one that would have prevailed without any reallocation of demand across heterogeneous quality firms (dashed line). In our data, more than 20% of the increase in France’s exports (in value) is explained by quality upgrading. This means that, without the reallocation of demand towards high-quality producers, France would have lost more than 40% of its aggregate share in world markets. This represents an additional 10 percentage points with respect to its actual market share loss.
Figure 2. Impact of quality upgrading on the value of aggregate exports
Figure 3 proposes a decomposition of growth in French sectoral exports between 1995 and 2005. We distinguish three sources of growth: changes in individual prices that push the value of exports up, changes in quantities that push the volume of exports up, and changes in the quality composition that reallocate demand toward higher-quality, more expensive products. Figure 3 shows that quality is especially important in explaining the growth of France’s exports in footwear, leather products, and electrical machinery. These are sectors that have been dramatically affected by international competitive pressures.
Figure 3. Decomposition of the growth of sectoral exports
Despite the trend in aggregate quality (Figure 1), it is worth emphasising that our data exhibit a huge amount of heterogeneity in the direction and magnitude of quality changes across sectors and destinations (a flavour of this heterogeneity can be found in Figure 3). We use this heterogeneity to identify whether the observed specialisation has been driven by competitive pressure exerted by low-wage countries. Namely, we ask whether there is a systematic link between changes in quality in a given market and changes in the intensity of low-wage country competition.
The impact of international competition
As preliminary evidence, Figure 4 plots the change in the quality of French sectoral exports (averaged across destination markets) against the change in low-wage countries’ market share. It shows a positive relationship between quality upgrading and increased competition from low-wage countries. This suggests that the mean quality of French exports increases more over the period in those industries that are more exposed to low-wage countries.
Figure 4. Quality and low-wage countries' competition, across industries
To further asses the validity of this relation and gauge its causality, we turn to regression analysis. We explain changes in the quality of French exports, measured at the sector and destination country levels, by changes in low-wage countries’ market shares and various control variables. Our econometric analysis systematically displays a positive and significant impact of low-wage countries’ competition on quality.
In our baseline specification, we find that a one standard deviation increase in the market share of low-wage countries is associated with an increase in the mean quality of French exports of about 4%. On the other hand, our results show that enhanced competitive pressures exerted by high-wage countries have the opposite effect, pushing the mean quality of French exports down. This is consistent with quality changes being driven by international competition, with high-wage countries being increasingly specialised, within industries, in high-quality goods.
Our results show that, over 1995-2005, a period characterised by the surge of low-wage countries in international markets,
- France has specialised in the production of higher quality goods.
- This specialisation has had a positive impact on France’s export performances, dampening the fall of its market share in foreign markets.
Beyond the effect on aggregate trade, such adjustments in specialisation patterns are likely to have important macroeconomic consequences. Hausmann et al. (2007), for example, discuss how countries that specialise in higher quality goods can enjoy better growth performances in the long run. However, changes in the structure of production can also have important transitory effects. In particular, if the relative content of production in skilled and unskilled labour is not the same depending on the produced quality, a reallocation of production in favour of high quality goods is likely to modify labour-market equilibria (see Verhoogen 2008).
This may be part of the story when it comes to explaining the rising wage premium and employment inequalities between skilled and unskilled workers observed over the last 20 years in most developed countries.
Baldwin, Richard and James Harrigan (2011), “Zeros, Quality, and Space: Trade Theory and Trade Evidence”, American Economic Journal: Microeconomics, forthcoming.
Bloom, Nick, Mirko Draca, and John Van Reenen (2011), "Who’s afraid of the big bad dragon? How Chinese trade boosts European innovation", VoxEU.org, 3 February.
Hausmann, Ricardo, Jason Hwang, and Dani Rodrik (2007), "What you export matters", Journal of Economic Growth, Springer, 12(1):1-25, March.
Martin, Julien and Isabelle Méjean (2011), “Low-Wage Countries' Competition, Reallocation Across Firms and the Quality Content of Exports”, CEPR Discussion Paper 8231.
Schott, Peter K (2004), "Across-product Versus Within-product Specialization in International Trade", The Quarterly Journal of Economics, 119(2):646-677, May.
Schott, Peter K (2008), "The relative sophistication of Chinese exports", Economic Policy, CEPR, CES, MSH,23:5-49.
Verhoogen, Eric A (2008), "Trade, Quality Upgrading, and Wage Inequality in the Mexican Manufacturing Sector", The Quarterly Journal of Economics, 123(2):489-530, 05.