Country size and trade in intermediate and final goods

• Published date: 01 February 2018
• Date: 01 February 2018
• Author: Kwok Tong Soo
• DOI: http://doi.org/10.1111/twec.12538

ORIGINAL ARTICLE

Country size and trade in intermediate and final

goods*

Kwok Tong Soo

Department of Economics, Lancaster University Management School, Lancaster, UK

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INTRODUCTION

The recent rise of China has been associated with its (re-)integration with the world trading sys-

tem. In some circles, China is now known as the “factory of the world,”producing a large propor-

tion of the world’s manufactured goods (see for example The Economist, 2015). A concurrent

trend has been the increasing fragmentation of production, as final goods are assembled from inter-

mediate inputs which themselves are produced in different parts of the world (Jon es, 2000). The

paper in The Economist cited above suggests a link between China’s rise and its role in the global

value chain. Nevertheless, Hsieh and Ossa (2016) find only small effects on real income in the rest

of the world, of China’s productivity increase since the mid-1990s.

There is of course a large theoretical and empirical literature on the importance of intermediates

trade. The theoretical side has been dominated by models of monopolistic competition and

economic geography (see the synthesis provided by Fujita, Krugman, & Venables, 1999; Helpman

& Krugman, 1985). On the empirical side, Miroudot, Lanz, and Ragoussis (2009) and Sturgeon

and Memedovic (2010) show that intermediate inputs represent over half of total goods trade but

that this fraction has actually decreased since the 1960s. Implicit in the discussion about the role

of China in the world trading system is the effect of China’s size. The role of country size in

determining the importance of intermediate goods trade has not heretofore been discussed in the

literature and is the main focus of the present paper.

Divide all commodities into consumption goods and intermediate goods (where goods are clas-

sified according to the Broad Economic Categories (BEC) classification; more details are in

Appendix A). Figure 1 shows that, in 2012, there is a negative relationship between the share of

consumption goods in total exports, and the size of the economy as measured by real GDP. That

is, on average, a larger country exports a larger fraction of intermediate goods, and a smaller frac-

tion of consumption goods. The correlation coefficient is .3008, with a p-value of .0005. Note

that both China and India are outliers; they have much larger shares of consumption goods in their

*

An earlier version of this paper was previously circulated as “Trade in intermediate goods and the division of labour.”

Thanks to the editor, Chris Milner, and two anonymous referees for valuable comments and suggestions. The author is

responsible for any errors and omissions.

DOI: 10.1111/twec.12538

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:634–652.

exports than would be predicted given their size. More formal econometric evidence using a panel

of 170 countries from 1995 to 2014 is presented in Appendix A and supports the results of Fig-

ure 1.

The objective of this paper is to develop a simple theoretical model to explain the negative rela-

tionship between country size and the share of consumption goods trade.

Two final goods can be produced using intermediate inputs which are produced using labour as

the only factor of production. As in Smith (1776), the more the production process can be divided

into different stages, the larger will be the final output. The division of labour is combined with

Ricardo’s (1817) comparative advantage, so that countries specialise in different subsets of inter-

mediate goods, then trade both intermediate and final goods. We show two main results. First, we

show the relationship between the division of labour and comparative advantage in international

trade. Large countries gain relatively more from comparative advantage than from the division of

labour, while the opposite is true for small countries. Second, and consistent with the empirical

evidence, country size is negatively associated with the share of consumption goods in its exports

(equivalently, is positively associated with the share of intermediate goods in its exports).

There has been a recent resurgence of interest in models of international trade based on the

division of labour. A large portion of this literature revolves around models based on external scale

economies, for instance Grossman and Rossi-Hansberg (2010) and Ethier and Ruffin (2009). Choi

and Yu (2003) survey the earlier literature on international trade under external scale economies.

Relative to this literature, the present paper develops an explicit model of the division of labour,

rather than basing it on external economies. Also closely related to the present paper are Swanson

(1999), Zhou (2004) and Chaney and Ossa (2013). Swanson (1999) develops a model in which a

larger market size leads to productivity gains, because workers specialise in a narrower subset of

activities. Zhou (2004) develops a very different model which makes a similar point. Chaney and

Ossa (2013) extend the new trade model of Krugman (1979) to allow for multiple production

stages. However, Swanson (1999) does not explicitly consider the implications o f international

trade; the structure of the model means that this is not a straightforward analysis. In addition,

unlike Zhou (2004) and Chaney and Ossa (2013), our model is based on perfect competition, so

presents an alternative approach to the division of labour. In this sense, the paper is related to

Haveman and Hummels (2004), who provide an alternative explanation to the standard explanation

China

India

United States

0

0.2

0.4

0.6

0.8

Consumption Goods as a Share of Exports

5 7 9 11 13 15 17

ln (Real GDP)

95% CI

FIGURE 1 Scatterplot of consumption goods as a share of total exports against GDP, 2012 (N=131) [Colour

figure can be viewed at wileyonlinelibrary.com]

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