When Congress approved the North American Free Trade Agreement (NAFTA) in the mid-1990s, American manufacturing workers watched uneasily, waiting for middle-class jobs to be siphoned off to developing countries, where low-cost labor would allow firms to produce goods cheaply. But Professor Amit Khandelwal’s new research about trade patterns suggests that U.S. firms can keep production and jobs at home while remaining competitive.
The prevailing theory about trade patterns posits that countries trade because each has uniquely abundant resources. The theory predicts that a country will export the products or services that use those resources most intensively and that this specialization allows countries to profit from trading. China, a country with abundant labor, would specialize in labor-intensive goods, like shoes and apparel, because large numbers of low-wage workers in China can make shoes more cheaply than U.S. workers. The United States would produce aircrafts and machinery, which require a more skilled workforce, at a lower cost than China since skilled labor in China is scarce.
But import data from the 1990s contradict this standard framework, Khandelwal explains: both developed and undeveloped countries were producing the same broadly classified sets of goods and exporting them to both developed and undeveloped countries. Rich countries were exporting expensive shoes and poor countries were exporting cheap shoes to the United States and other developed nations. These data suggest specialization was occurring, not across markets, as the theory says it should, but rather within markets, where specialization is reflected in differences in quality. Khandelwal theorized that the degree of quality specialization might be different across markets.
But what is the measure of quality? Khandelwal defined quality, not by price alone, but by price and market share when the prices of two goods were equalized. “Suppose Germany and China manufactured the exact same shirt, but the German shirt cost more to produce because the imported raw materials and labor cost more. The objective quality is the same,” he says. If quality were measured only by price, the German shirt would sit higher on a quality scale. “Now, suppose you price the German shirt and the Chinese shirt the same. Higher quality should be assigned in this scenario to the shirt that achieves a higher market share.”
Khandelwal next compared quality ladders for different products. A product with a long quality ladder will have many different rungs of quality between the highest and lowest levels of quality. Certain products, like machinery, have long quality ladders. Other products, like apparel, have short quality ladders, with only a few rungs separating the highest level of quality from the lowest. While a consumer may perceive a great difference between an Armani T-shirt and a T-shirt from Wal-Mart, for example, the actual difference in the materials used to make both shirts is not very great compared to the difference between the materials used to make low-end machinery and high-end machinery.
Khandelwal found that developing countries produce goods at most levels of quality for products with shorter quality ladders but produce closer to the bottom rungs for products with long quality ladders. Developed nations, in contrast, position themselves on the uppermost rungs of all ladders. This means that for products with short quality ladders, both developed countries and developing countries compete with one another to occupy the top rungs of the ladder. For goods that have longer quality ladders, there is less competition at the top. In rich countries, industries with long quality ladders experience fewer decreases in employment than those with short ladders, and it’s in the former industries that Khandelwal found firms in developed nations concentrating their production.
Overall, companies in developed nations that manufacture goods at the highest rungs of quality ladders in industries with long ladders will be more competitive — and their labor forces less susceptible to outsourcing — than those that stick to industries with shorter quality ladders. “The problem for an American firm producing footwear and apparel is that there is nowhere to go,” Khandelwal explains. “You hit the top rung of the ladder and China is right next to you. You’ve run out of space.”
Amit Khandelwal is assistant professor of finance and economics at Columbia Business School.