Is Our Economy Globalized? - The emergence of "New New Trade Theory" and needs for firm-level empirical analysis

Faculty Fellow, RIETI

Globalization progressing?

The term globalization, though difficult to define, has been on the lips of so many people that it seems to have become an indispensable item in one's vocabulary when talking about the current world. The World is Flat (Penguin Books, 2005), authored by Pulitzer Prize-winning journalist Thomas L. Friedman, provides a vivid description of the growing trend of outsourcing from the United States to India, a phenomenon receiving much attention recently, citing a number of instances and linking the ongoing situation to that of the Age of Discovery in which European explorers sailed for India but instead found a "new world." It is often said that today's world, where individuals are connected via the Internet, has entered a new era of competition and collaboration at a different level. Should economies in the world fully integrate, the raison d'etre of international economics, as a branch of economics, would be gone.

In reality, however, world economies are far from being integrated. With respect to the transnational mobility of people, visa requirements and immigration controls have been tightened in recent years. Likewise, cautious arguments regarding the liberalization of international capital flows gained ground after the Asian economic crisis, which served as a wakeup call. According to the textbook theory of international trade, the world economy, even when the mobility of production factors is hindered by national borders, can be restored to the original, utopian state of seamless integration, like the one that existed in the borderless time before the erection of the Tower of Babel, once the full liberalization of the trade of goods is achieved. As evidenced by the proliferation of free trade agreements (FTAs) that exclude agricultural products, today's world is obviously far from a state of free trade.

Globalization decisions of firms

So then what does exporting mean in practical terms for firms when an importing country eliminates trade barriers? In order to export their products, these firms still need to clear customs and must be familiar with the product safety regulations of the importing country. Additionally, it is at times necessary to establish a distribution network in the country and to absorb the risk of foreign exchange rate fluctuations. Only a limited number of firms would find it economically feasible to export their products, bearing all the additional resulting costs. Indeed, both in Japan and the U.S., less than 10% of manufacturers directly export their products to foreign countries. This has been established as a stylized fact through the accumulated research since that conducted by Bernard and Jensen using plant-level data derived from the U.S. Census of Manufacturers.

Indeed export is not the only option firms can choose for globalization. However, firms that have made direct investments and are engaged in production activities abroad are even smaller in number than exporters. Meanwhile, a growing tendency in recent years of firms to outsource various tasks to external contractors in foreign countries has been noted. With that said, however, my preliminary research using microdata of Japanese firms* found that only a limited number of large-sized firms are actually outsourcing their production activities offshore.

As such, corporate options for globalization are diversifying. And against such a backdrop, the structure of Japanese firms' cross-border production networks, or the pattern of international production sharing, has begun to change. Many Japanese firms, which set up production subsidiaries in Southeast Asia motivated by the sharp rise of the yen after the Plaza Accord, have long maintained a pattern in which parent companies or their group companies in Japan supply parts and components to subsidiaries in Southeast Asia. But these days this export pattern is becoming less common. Meanwhile, although procurement from local suppliers has increased over the years, local subsidiaries of Japanese firms are a part of such local supply networks. Likewise, sales by Japanese subsidiaries in Southeast Asia include not only final products - those exported to the U.S. and Europe or re-imported into Japan - but also intermediates supplied to subsidiaries in other Asian countries. Thus, it is becoming virtually impossible to grasp an accurate picture of Japan's trade and cross-border production network structures without collecting and compiling detailed data on business activities of globally operating Japanese companies (i.e. data on their exports and imports as well as on their local procurement and sales networks, including those of their joint venture partners) in addition to conventional customs clearance statistics.

New stream of international trade theory

Changes are also beginning to occur in the frontier of the research in international trade theories, which would mark the first major shift since the 1970s-1980s when then-prevailing "traditional" trade theory represented by the Ricardo and Heckscher-Ohlin models gave way to the "New Trade Theory" advocated by Paul Krugman and Elhanan Helpman. The previous shift was from theories grounded in comparative advantage in terms of differences in endowment of production factors and sector-specific input requirements under perfect competition to those that explain intra-industry trade accompanied by product differentiation under monopolistic competition. In comparison, "New New Trade Theory," which is emerging in the latest shift, is characterized by the focus on intra-industry heterogeneity (differences observable even among firms belonging to the same sector). Whereas the earlier two lines of trade theory (traditional and "New") have a commonality in that they depend on the "industry" as a unit of analysis, the New New Trade Theory, led by Marc J. Melitz and Pol Antras, examines firm-level variations. These pioneering scholars modeled a situation in which a limited number of global firms (those engaged in export, overseas production, and/or offshore outsourcing) and domestic firms (those not directly engaged in any such global activities) coexist within a single industry accompanied by considerable productivity gaps. It is hoped that full-scale empirical studies will be undertaken to test new theoretical predictions based on actual statistical data.

October 31, 2006

* Tomiura, E. (2005) "Foreign outsourcing and firm-level characteristics: evidence from Japanese manufacturers," Journal of the Japanese and International Economies 19, 255-271

October 31, 2006