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Inter and Intra Company Competition in the Age of

Global Competition

A Micro and Macro Interpretation of the Ricardian Trade

Theory

T. Fujimoto and Y. Shiozawa

Introduction: Possibilities of the Ricardian trade theory

The objective of this paper is to discuss the possibilities of applying the classical

Ricardian trade theory to 21st century trade phenomena from the point of view of its

micro/macro reinterpretations. Our discussion is based on the following stylized facts

regarding the trade phenomena in the early 21st century:

Intensifying global competition which goes hand-in-hand with the end of the Cold

War and the emergence of the developing nations to the international arena, i.e.,

across-the-board expansion of global trade.

The expansion of microscopic intra-industry trade (the mutual import/export

between countries of similar goods which belong to a very fine classification of

commodities).

The multinationalization of firms (expanded foreign production and R&D of a

single firm)

The expansion of intermediate product trade together with inter/intra-industry

vertical division of labor.

This paper, by reformulating the Ricardian trade theory for explaining these

phenomena, provides a framework from the perspective of production sites, including

that of factory managers. This type of analytical perspective was generally absent in the

international trade theory to date. In this way, the paper attempts to integrate an

economics theoretical framework with the manager’s perspective that we often

encounter in our empirical researches.

The lineage and main themes of trade theory International trade theory to date,

either of classical or neoclassical strand, presupposed the existence of national borders.

Its main efforts focused on the clarification of the following two points. Firstly, to explain

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that free trade tends to increase global supply of goods, or in other words, to explain

gains from trade. Secondly, to shed light on the fact that there is a tendency, in free

trade, for various industries of each country to internationally specialize (international

division of labor), based on what is called the “principle of comparative advantage.”．

Trade theory to date has maintained and reinforced a level of persuasiveness with

respect to this topic, but we still can't say that its explanation of the 21st century trade

phenomena is sufficient. Two points should be considered.

First concerns “the gains from free trade.” Comparing autarchy case and trading

case (i.e. the case where products are all consumed in the country of production and the

case where some parts of products are exported and imported to be consumed in other

countries), both the Ricardian trade theory and the neoclassical trade theory try to

explain the gains from trade through a macroscopic analysis that the production

possibility frontier expands in the latter case, and thus indicating material advantage of

free trade. However, in the process of explaining this advantage, the micro perspective is

lost and the theory does not tell us what types of behaviors are unfolding at firms.

Second concerns what mainly influences industry and trade structures.

Although it is in general mathematically refined, Heckscher, Ohlin, and Samuelson type

neoclassical factor endowments theory (HOS theory) contains the assumption that the

production functions are identical regardless of the countries and firms. This assumption

implies factor price equalization theorem, which are far from stylized facts. It is well

known that the theory is not appropriate for forecasting actual trade patterns1.

Concerning intra-industry trade, one of the modern trade phenomena,

Krugman and Helpman depicted one of the mechanisms for this growing trend through

a model (the HK Model). This model (labeled now “New Trade Theory”) introduces

product differentiation and increasing returns to scale and explains that initial

specialization is strengthened by increasing returns and the process results into a stable

international specialization and to a trade pattern. But, this theory is constructed on the

unrealistic assumptions that each firm within the same industry is homogenous

worldwide and that consumers’ preferences are identical. The initial production location

1 HOS theory was later formulated as the multi-country, multi-production factor, multiple-goods Heckscher, Ohlin, Vanek theory (HOV theory). This theory took the stance that each country exchanges its production factors by means of trading produced goods . The formula had an easy-to-validate format for statistical tests. However, the result of actual tests showed that, with respect to predicting trade patterns and estimating trade quantities, there is a vast divergence from reality. See Bowen, Leamer and Sveikauskas（1987） and Trefler（1995）. The well-known Leontief Paradox was nothing more than one of these anomalies.

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determines everything but it is put forward as a result of pure chance. Neither the

heterogeneity of all of the companies nor their managerial efforts are considered.

More recently, Melitz (2003) analyzed the situation where heterogeneous firms

exist. His theory, which is sometimes called “New New Trade Theory”, raises the

question of why firms within the same industry divide into firms that engage in

exporting, and those that only specialize in domestic sales. Melitz successfully explained

this. On this point, we evaluate the theory highly, but it is not without its deficiency. In

Melitz's framework, the productivity level of each firm is randomly decided in a “draw of

straws.” In fact, how this heterogeneity of firms comes about, the New New Trade

Theory attributes it to chance, as with the New Trade Theory. On this point alone, we

must still say that the theory lacks depth of analysis and real-life applicability.

Extendability of the Ricardian theory and its proper issues The Ricardian

trade theory assumes that physical productivity (reverse of the labor input coefficient),

even within the same industry, varies depending on the country. Regardless of its

classical 19th century origins, its accuracy and power to explain 21st century stylized

facts has come to be regarded as superior to the neoclassical trade theory. In addition, as

simple as the mathematical expression of this model is, the theory is highly extendable

when applied to specific trade phenomena. For example, let’s look at dynamic trade

models such as the Flying Geese Formation Theory (or Flying Geese Paradigm) and

Product Cycle Theory. We can view them as types of dynamic Ricardian theory, if we

interpret them as assuming that the disparity in the labor input coefficient between

developed and developing nations within the same industry decreases together with

standardization of products, then the Ricardian theory predicts that the low-wage

condition will become the controlling factor in the international division of labor.

In the textbooks, it has been pointed out that the Ricardian theory is an

unsophisticated model with one production factor, and that the theory ignores the role of

capital, which is vitally important for modern day productions. This weakness has,

however, now been resolved by the Ricardo Sraffa Trade Theory (RS Theory). This

theory assumes the “production of commodities by means of commodities,” i.e. it assumes

that any goods are produced using labor and various types of material inputs. When the

manufactured goods are exported and are used as inputs in the production, they are, in

trade theory, referred to as “intermediate goods”. Shiozawa (2007) has shown that a

theory that includes trade of intermediate goods in many country, many commodity case

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is possible.

RS Theory attempts to reflect modern-day trade conditions, more so than

standard neoclassical trade theory. The HOS theory, in its standard form, does not allow

movement of capital as a production factor2. By explicitly dealing with intermediate good

inputs, we see that the Ricardian theory, extended to as RS theory is valid for a certain

type of situations that include physical inputs, as will be demonstrated in Section 5.

Theory also has sufficient extendability for to include stylized facts

characteristic to modern mass production, regarded as “economies of scale.” The HK

Model, which assumes the existence of fixed costs (thus includes economies of scale),

considers firms to be homogenous and ignores their heterogeneity. But RS Theory, with

respect to the fact that it makes technology choice possible, is a theory that allows for

heterogeneity, not only between countries, but also between firms within a single country.

We can also think of Melitz's model, which introduced the concept of heterogeneity of

firms, as a modern revival of the real-life applicability inherent in the original Ricardian

theory. The key concept of Ricardian trade theory is “differences in productivity.” On this

point, the New New Trade Theory has an affinity with the Ricardian theory.

The Ricardian trade theory was originally a very simple mathematical

expression. By consequence, it tends to be treated as an opener in standard international

economics textbooks. However, we feel, with respect to its ability to not only explain 21st

century trade phenomena, but also to its extendability to real life, it surpasses the 20th

century neoclassical theory.

The limitation of the Ricardian trade theory lies in the fact that the variance of

the labor input coefficients (physical labor productivity) for each industry and country is

taken as a given. It does not attempt to explain how these differences are constituted.

Input coefficients may be attributable to exogenous causes such as differences in relative

fertility and production technology, but we don't see any clear explanation of what

constitutes these differences. In this sense, it is fair to say that neoclassical theory,

which made the endowment of production factors its principle for explanation, went

deeper in its analysis. New New Trade Theory assumes productivity per factory as a

chance factor, and it is not explained how the physical labor productivity is constituted

in each factory.

In answer to these issues, for example, Fujimoto (2007a, 2007b, et al.),

2 We refer to Mankiw's blog article (Mankiw, 2007) as an example of recent debates on the basic contrast between Ricardian theory and HOS theory.

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departing from the simple truth stating that design location for new products precedes

production location, proposed a comparative advantage theory of design location based

on comparative design costs. This theory attempts to explain the firm’s choice of the

design site and the initial production site on the basis of characteristics of product

architecture and uneven regional distribution of organizational capabilities. But

regarding these points, the issues surrounding demand for “heterogeneous goods of the

same type,” which we don't deal with in this paper, need to be properly discussed.

Therefore, these issues are put aside to be discussed separately, and are not dealt with

in this paper.

What we deal with in this paper is the price competition of homogenous goods,

and the “survival of the fittest” competition between firms and/or between factories (of a

single company where each factory is in a different country). For those who are working

in the firms and factories, this competition is a fact of death or life and determines the

directions of their efforts. This paper returns to the simple logic of the Ricardian trade

theory (or RS Theory, which is an extended theory including intermediate goods).

Contrasting macro and micro interpretations of the said theory, the paper examines how

a labor input coefficient aij (physical labor productivity for individual firms or factories)

comes to be decided in real life competition between firms/factories.

Ricardian theory and the micro–macro loop We feel that, in order to truly

understand the phenomenon of “the genesis and consequences of the labor input

coefficients,” analysis of the current state and its future development from a micro–

macro loop perspective, is important, rather than the confirmation of present day

situation from the static equilibrium perspective . Indeed, we can think of the Ricardian

model as a dynamic process, i.e. as a circular chain of cause and effect (micro-macro loop)

where the reciprocal effects of the micro-competitive behaviors of each economic agent

create the macro economic conditions for the entire industry, and conversely, that type of

industry and income structures affects market entry decisions and competitive behaviors

of firms.

For micro-competitive behaviors, this paper considers not only the price

competition between firms/products, but also capability-building competition (Fujimoto,

2003) between factories for products of the same type. In other words, for a given

product, a capability-building competition, aiming at raising productivity and quality, is

deployed between factories (workplaces) and this deep-level competition precedes the

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price competition on the surface level. With this precondition, it is thought that inter-

company price competition begins to take root. Amidst this uncertainty, the daily

“compete-to-survive” behaviors of firms causes the industry to precipitate; that is to say,

an industrial competition evolves, which is observable only by looking up from

production-sites theory, or from the “factory's point of view”. Here the daily competitive

behaviors of managers and factory leaders results in the overall structure within a

particular industry.

On one hand, as the aggregate result of decisions of each unit about entry-to/

retreat-from markets for products/factories of each country, the changes in macro

industrial structure come about through divisions arising between growth industries

and declining industries, or divisions to pure imported goods industries, pure exported

goods industries, and non-traded goods industries. In other words, macro industrial

formation is decided as if “the country chooses the industry,” and this analysis implicitly

assumes looking-down-from-above, from the “rulers’ (or policy makers’) viewpoint””

As industry is a semi-macro phenomenon, in discussing the industry, from a

micro and macro angle, Ricardian trade theory has fertile implications and a realism

that other models don't possess, regardless of its simple model, which is what we would

like to make clear in this paper.

Specifically, the paper firstly makes clear that the two equivalent inequalities

that demonstrate the comparative advantage are rooted in two differing viewpoints in

the Ricardian theory. As will be explained in detail in Section 2, contrasted with the fact

that the conventional “inter-national comparison of inter-industrial and intra-national

productivity ratio” is a macro-inequality based on the viewpoint of policy makers, the

“inter-industrial comparison of inter-national and intra-industrial productivity ratio” is

a micro-inequality based closer on the perspective of management and factory leaders.

As a result of these differences, the “intra-industrial and inter-national productivity

comparison” has a broader applicable range and is closer to reality in analyzing

international competition between present day multinational companies or between

factories within those multinational companies.

Ricardian theory and the realities of the factories The Ricardian theory of

comparative advantage is a fundamental concept. As mentioned above, it is without fail

explained in the introductory part of international economics, but in a textbook

treatment has come to be regarded as a beginner-level theory, which helps to lead into

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the more modern neoclassical HOS theory. However, the HOS theory explains

international trade patterns based on factor endowment ratios. Owing to the structure of

the theory itself, it does not have a framework to analyze competition between firms, or

competition between factories across the same multinational company. Considering the

significance of intermediate goods trade, heterogeneity of firms, and the existence of a

huge variety of traded goods that we widely observe in the real world, the Ricardian

theory, in contrast to the HOS theory, is a unique trade theory that is more appropriate

for analyzing modern competitive circumstances. This paper proposes to provide an

appropriate framework for the analysis of more specific but more modern situation of

inter-firm competition within the same industry, and intra-firm competition between

factories within the same multinational firm. It exemplifies what kind of judgments

corporate management and factory leaders, such as the factory head, use as a basis for

rolling out their competitive efforts.

The Structure of this Paper Besides the “Introduction” and “Conclusion,”

this paper is largely divided into two parts. The first part runs from Section 2 to Section

4 and looks into issues surrounding existing trade theories. The second part runs from

Section 5 to Section 7 and explores the micro benchmarks put forth in Part 1. It

describes just what kind of thinking and responses are rolled out on the production field.

The main stance of this paper is in Part 2, but we think the long introduction prior to

Part 2 is necessary, which composes Part 1, in view of many misconceptions surrounding

trade theory.

Below, we will simply introduce each section. Firstly, in Section 2, we examine

the logic on how trade directions and specialization pattern are decided from Ricardo's

four numbers. This explanation can be found in any textbook, but the fact that there are

two ways to look at the ratios is not really paid much attention. From the four numbers,

we can make four ratios and obtain two comparative inequalities. The two options

correspond to two different viewpoints in considering comparative advantage. One, the

inter-industrial ratio comparison is commonly used for the explanation. But the other,

intra-industrial ratio comparison is rarely explained. We will contrast two comparisons

as representing different viewpoints and theoretical scopes, regardless of the fact that

the inequalities are mere different expressions which are logically equivalent.

In Section 3, we focus on the possibilities for acquiring information. The inter-

industrial ratio comparison and the intra-industrial ratio comparison, mentioned above,

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are actually deeply related to the viewpoint of the analyst. This section demonstrates

that on one hand you have the macro viewpoint represented by policy makers, while on

the other hand you have the micro viewpoint represented by firms and factory leaders.

The two viewpoints were already inherent in the original Ricardian explanation, but in

the ensuing trade theory since then, we have to say that the micro viewpoint seems to

have been suppressed. This paper aims to analyze the inter-firm competition and intra-

firm competition (i.e. inter-factory competition within a single multinational company)

from an international specialization perspective. In order to dot it, recovery of the micro

perspective is necessary. Section 4 is a simple survey on current trade theories from this

perspective.

In Section 5, which is the beginning of Part 2, using the framework up to Section 4, we

explain what kind of competition is created in relation to production ratios in Country J

and Country C, which are only evocative of Japan and China. The issues we raise here

are the circumstances (i) where labor productivity are mainly related to competition, (ii)

where yield constants or yield ratios become the competitive arena, and (iii) where fixed

costs will be related to the competition..

In Section 5, we consider the case where wage and exchange rates in both

countries is held constant. In contrast, Section 6 discusses just how international

competition develops when changes in macro market conditions are involved; namely

wage and exchange rates. Here the micro efforts of firms and the macro exchange rate

conditions condition each other reciprocally, and we analyze the manner in which the

economic climate fluctuates. In Section 7, firm level strategic decisions are considered

from the same micro–macro loop viewpoint with regard to the international competition.

Section 8 is the Conclusion and summarizes the results obtained through this paper.

From Section 2 until Section 6, we basically assume that production cost is

proportional to production volume. In the final section of Section 5, depreciation of fixed

costs is dealt with (pertaining to areas like machine facilities), but this paper does not

discuss higher-order competition, such as designing philosophy and process architecture.

This does not mean that these competitive factors are not important. For modern

international competition, these capability-building competitions are more essential

competition arenas. For the authors’ prospects on these aspects, please refer to the

bibliography at the end of Section 5.

We have eliminated from this paper all discussions outside cost, such as

differences in product quality and accuracy of delivery times. Accordingly, there is no

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discussion of quality and delivery differences stemming from the differences in design

thinking and process architecture. We consider more important to demonstrate clearly

and simply the possibilities inherent in the Ricardian theory, rather than to incorporate

these factors and to make the explanation longer and more complicated.

2. Perspectives and methods for analyzing comparative advantage

First, let us examine the inequalities that tell which country has comparative advantage

in which good. Anyone who has learned international trade theory must have contended

with this at one time. Normally, in international economics textbooks, a model with two

countries, two goods and one primary factor is assumed, and the following four numbers

are shown, which correspond to the labor input coefficient of each country and each

good3.

Table 1

Good 1 Good 2

Country J aJ1 aJ2

Country C aC1 aC2

The labor input coefficient is also called the “basic unit” or “man-day per

product” in the production site terminology, and is the reciprocal of physical labor

productivity.

The condition that Country J specializes in Good 1, and Country C specializes

in Good 2 is usually expressed in the following form:

aJ1/aJ2 < aC1/aC2 (1)

If we transform the equation, it can also be written as

aJ1/aC1 < aJ2/aC2 (2)

Both inequalities are mathematically equivalent. If inequality (1) holds, then

inequality (2) holds. Conversely, if inequality (2) holds, then inequality (1) also holds. In

3 Also, in text books, it is usually explained that while Adam Smith advocated the principle of absolute advantage, Ricardo came up with the principle of comparative advantage. With regards to the accuracy of this understanding, the authors have some doubts. For example, Smith (1776) Volume 1, Section 1, Paragraph 4 suggests that Smith had already realized the international trade based on comparative advantage.

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this way, inequalities (1) and (2) are merely different ways of expressing the same

situation, but when we choose one of these inequalities and try to know what pattern of

specialization is possible, two expressions have a substantial difference in perspectives.

The two comparative expressions

Inter-industrial ratio comparison Inequality (1) means that the ratio of labor

inputs for the production in Country J, of Good 1 compared to Good 2, is smaller than

the labor input ratio for the production in Country C, of Good 1 compared to Good 2.

Because the labor input coefficient is the reciprocal of productivity, it is possible to say

that the relative productivity of Good 1 compared to Good 2 in Country J is higher than

Country C. Here the basic comparison is made between the two-industry ratios of input

coefficients (or labor productivities) for each of Country J and Country C respectively.

Because the base ratio is taken from between differing industries, this type of

comparison can be called the “inter-industrial ratio comparison”4.

When inequality (1) holds and Country J specializes in Good 1 and Country C

specializes in Good 2, both countries gain from trade. The reason can be understood in

the example below.

For example, assume that both Country J and Country C had remained in

autarchy. Now, assume that e1 quantity of Good 1 is exported from Country J to Country

C, and in exchange, quantity e2 of Good 2 is exported from Country C to Country J. In

this case, we cane further assume, from inequality (1), that the following inequality

holds:

aJ1/aJ2 < e2/e1<aC1/aC2 (3)

If Country J continues to consume the same amount up to date, then it is sufficient for

Country J, to increase the production of Good 1 by e1, and conversely, it will reduce

production of Good 2 by e2. At this time, the total labor amount required by Country J to

consume the same amount of Good 1 and Good 2 as up until this point will be reduced by

the following amount.

aJ2 e2 －aJ1 e1

From the left inequality in (3), this is the positive quantity. Therefore, Country J can

reduce its total labor time, even if it continues to consume the same amount as before.

4 This ratio can be interpreted in various ways. As we demonstrate later, it can be taken as ratios of relative prices in a closed economy, marginal rates of transformation, or opportunity costs. However, in this paper, to contrast with (2) we use the symmetrical and neutral expression “inter-industrial ratio.”

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This is the gains from trade for Country J.

A similar calculation can be done for Country C as well. For Country C to be

able to continue to consume the same amount as before, it has to import quantity e1 of

Good 1 and export quantity e2 of Good 2. At this time, the necessary total labor amount

for Country C is reduced by the amount below:

aC1 e1 － aC2 e2 .

From the right inequality of (3), this is also a positive quantity. Therefore, Country C can

reduce its total labor time, if it continues to consumption the same amount as before.

This is gains from trade for Country C. In this way, trade is not just a zero sum game. A

participant to the trade does not gain from trade by the sacrifice of the other. In trade, if

the appropriate exchange is made, both countries can gain5.

For both countries to get gains from trade, the directions of trade are not

optional. For example, if Good 2 is exported from Country J to Country C, and Good 1 is

exported from Country C to Country J, the necessary labor time of both countries would

increase to consume the same quantity of goods. Then, what kind of trade patterns

would be profitable for both countries? Or, in the same context, what kind of

specialization patterns should be chosen to obtain profits for both countries? The answer

lies in the evaluation of expression (1). When inequality (1) holds, as it has already been

stated, the productivity for Good 1 from Country J is greater than Country C. At this

time, both countries would gain when Country J exports Good 1 and Country C exports

Good 2.

Expression (1) is a condition calculable from Country J's point of view. A

transformation can be made to expression (1) to meet Country C's point of view, which is

the following inequality:

aC2／aC1 ＞ aJ2／aJ1 (1')

This means that productivity of Good 2 in Country C is higher than that of Country J. As

a mathematical condition, (1) and (1') are equivalent. The only difference between (1)

and (1') is on which country's perspective the calculation is made.

The foregoing is the standard explanation written in textbooks relating to gains

from trade and trade pattern (or specialization pattern). Up until this point, expression

(1) or (1') was commonly used in order to determine which country has comparative

5 What we have demonstrated here is not the only trade profit. Here with both countries' demand as being constant, it has been demonstrated that through trade, both countries could reduce the total necessary labor. However, if we hold both countries' labor quantity as constant, it is possible to show that through trade, the total world production would increase.

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advantage in which product. The expressions (1) and (1’) can be called inter-industrial

ratio comparison. As a result of excessive popularization, there is a misconception that,

in order to determine comparative advantage, you have to conduct an inter-industrial

ratio comparison, using (1) or (1'), as will be mentioned later. But of course, comparative

advantage can also be determined using expression (2), which is logically equivalent to

expression (1). In expression (2), the basic comparison is made between the two-country

ratios of input coefficients (or labor productivities) for each of different industries. This

kind of comparison can be called “intra-industrial ratio comparison.”

Intra-industrial ratio comparison There is freedom to examine trade directions

or specialization conditions by linking coefficients of Table 1, either horizontally or

vertically, and by comparing resulting ratios. When comparing horizontally, expression

(1) is acquired, and when comparing vertically, expression (2) is acquired. Because

expressions (1) and (2) are mathematically equivalent, when (1) or (1') holds, then (2)

will also hold, and conversely, when (2) holds, (1) and (1') will also hold. In other words,

this is also the condition that Country J specializes in Good 1 and Country C specializes

in Good 2.

Expression (2) is made from the perspective of Country J. The same condition

can be derived for the perspective of Country C:

aC2／aJ2 ＞ aC1／aJ1 (2')

Mathematically, (2) and (2') are equivalent, and thus they are also equivalent to (1)

and (1').

As it was easy to understand the gains from trade by inserting e2／e1 into

expression (1), the ratio of goods exchanged by both the countries, it is easier to

understand the situation by inserting wC／wJ into expression (2), the ratio of wage rates

for both the countries:.

aJ1／aC1＞ wC／wJ＞ aJ2／aC2 (4)

where ｗC is Country C's wage rate and ｗJ is Country J's wage rate. For simplicity, the

below analysis assumes that transport cost and tax rate is zero, unless otherwise stated.

For brevity of expression, let us assume that wage rates wC and wJ are

expressed in a common currency unit. The currency can be that of Country J or of

Country C or can also be that of a third country (for example, US dollar). In such

situations, even when the wage rate doesn't change for each country's currency, the wage

ratio ｗC／wJ also changes, if the exchange rate for the currency of both countries

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changes.

In this situation, based on the left hand inequality of expression (4), the

following inequalities hold:

ｗJ aJ 1 < ｗC aC 1 or ｗJ / ｗC < aC 1 / aJ 1,

where ｗJ aJ1 is the production cost of Good 1 in Country J and ｗC aC1 is the production

cost of the same Good in Country C6. For the international competition with respect to

Good 1, Country J will have an advantage over Country C, when transport cost and

customs tariffs are negligible.

Similarly, from the right hand inequality in (4), the following inequalities hold:

ｗC aC 2 < ｗJ aJ 2 or wC / ｗJ < aJ 2 / a2

This means that Country C has an advantage over Country J for the international

competition with respect to Good 2. If we summarize two expressions, and if we take the

inequalities that come before “or,” then

ｗJ aJ 1 < ｗC aC 1 and wC aC 2 < wJ aJ 2 (5)

This also shows the conditions where Good 1 is exported from Country J to Country C

and Good 2 is exported from Country C to Country J. It is equivalent to expression (4),

but demonstrates a more detailed economic relationship than that demonstrated by

expression (1) or (2). In fact, expressions (4) and (5) show the conditions when trade is

made in a monetary economy, using a currency as medium of exchange.

As stated later, the relationship expressed in (5) can be easily generalized to

the cases of many countries and many goods. This is unlike the case of expressions (1)

and (2). Expressions (1) and (2) are only significant for the confined context of a two-

country, two-commodity scenario. They disregard the monetary exchange relationship,

and at this point the expressions (1) and (2) are somewhat insufficient as conditions by

which to discern trade patterns and specializations.

The inequalities acquired from the left hand side or from the right hand side of

expression (4), possess general contents, which do not depend on a specific country or

good. If a certain country, firm, or factory A producing a certain Good k is more

competitive than with a certain country, firm or factory B, will depend on whether the

following expression holds true:

wa aAk ＜ wB aBk or wA／wB ＜ aBk／aAk (6)

6 Here, fixed costs involved for facilities and the like do not exist, but we feel that they are of a size that can be ignored. For a clear treatment of depreciation, see the final section of Section 5.

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Evaluation (6) is not particularly new. When considering labor productivity and

wage rates, it merely examines whether the cost price is more advantageous for Country

J or Country C with respect to the production of Good 1.In other words, it does nothing

more than compare the production costs for both countries with respect to each good.

This is an extremely simple judgment, but the meaning of this condition has not been

clearly explained in the conventional Ricardian theory. If you think about the fact that

Ricardo's theory of comparative advantage is often referred to as the “comparative cost

theory,” then it is a surprising paradox that wage rates are disregarded in typical

explanations.

The analysis of this paper beyond Section 4 is primarily based on expression (6).

As we will demonstrate in the following, expression (6) is an evaluation that can be used

by the management (or factory head) of each firm, and in that sense possesses a real-life

“micro” applicability. In terms of doctrinal history, there are few analyses that take the

perspective of expression (6). Even if they are equivalent, it is common to prioritize the

perspective of (1) as opposed to (2). Before we enter the analysis in the main body of this

paper beyond Section 4, we should conduct a simple discussion of why this type of

situation has arisen. We think there are two main points; differences in the way that

gains from trade are explained; and the different perspective of analysts and decision

makers, who are concerned with how to find gains from trade and make profit from it.

Ways to explain gains from trade

Regarding the explanation of Ricardo's theory of comparative costs, the question of

whether to focus on international comparison in productivity rates between industries

(inter-industrial ratio), or to focus on a inter-industrial comparison in productivity rates

between two countries within the same industry (intra-industrial ratio) is a

mathematically equivalent analysis, and as such there is no particular need to go into

detail about the differences. However, for the inter- and intra-industrial ratio

comparison, each one has a strong compatibility with different angles of analysis. A part

of this, as we have already shown, lies in the fact that expression (1) can easily be

extended to expression (3), and expression (2) to expression (4). Expression (3) tries to

examine gains from trade and directions of trade from a quantity angle, while expression

(4) tries to analyze from a price angle. However, there must have been a reason why

explanations based on the inter-industrial comparison ratio were preferred in the history

of the doctrine.

15

Prices before trade When one tries to think about gains from and direction of

trade, the starting point for many textbooks is the pre-trade prices (Or more precisely,

the prices before trade in an autarchy). If the profit ratio (or mark-up ratio) for

industries in each country was equal, the labor input coefficient and pre-trade price

would be proportional to one another. Therefore, as long as these ratios are related, it is

possible to switch the role of the price and labor input coefficients.

In the two-country, two-commodity case with its labor input coefficients in Table

1, the price ratio pJ1：pJ2 of Country J is equal to aJ1：aJ2, and the price ratio pC1：pC2 of

Country C is equal to aC1：aC2. These are inevitably the ratio comparisons between

industries. Condition (1), which decides the trade patterns, takes the following form

when expressed by prices:

pJ1 / pJ2 < pC1 / pC2

In this case, because of reasons that we have already explained, the gains from trade are

described if we insert e2 / e1 between the two members. More specifically, when Country

J exports e1 units of Good 1, and Country C exports e2 units of Good 2, they can reduce

the required labor quantity, as long as Country J and Country C consume the same

quantity as before. That is, if both countries are to make full use of their labor quantities,

then it is possible to produce more as compared to the total sum of productions when

both countries produce in a closed way

The ratio e2 : e1 under our discussion is called the “terms of trade” 7 (for Country

J). It is the exchange ratio of internationally traded goods. When the international price

for Good 1 is p*1 and the international price for Good 2 is p*2, condition (3) can be

rewritten as

pJ1 / pJ2 < p*1 / p*2 < pC1 / pC2 (7)

The international prices come between pre-trade price ratios for both countries (of course,

it is necessary to take common units for goods.) This chain of inequalities does not show

the gains from trade by itself, but the relationship is easy to understand because it

shows the correlation between pre-trade domestic prices and post-trade international

prices. The left and right inequalities of (7) can be rewritten respectively as follows:

p*2 / aJ2 < p*1 / aJ1 and p*1 / aC1 < p*2 / aC2 (8) 7 This kind of expression is only allowed when there is only one kind of an exported good and one kind of an imported good. When many kinds of products are traded, a different definition is required. Moreover, from e2 / e1 = p*1 / p*2 the terms of trade are equal to the ratio export price / import price.

16

This means that the produced value (= added value) per labor unit will be larger if

Country J specializes in Product 1 and Country C specializes in Product 2. When you

switch to produce a higher ratio good, the capitalists' profit rate increases, for the wage

rate stays the same while the produced value increases,. Therefore, this inequality, seen

from a capitalist perspective, provides a make-a-decision criterion for which good to

specialize in. Of course, this kind of analysis has no significance if the capitalist cannot

make comparisons across industries. However, as we will point out later, this relation

can be generalized to the labor input economy of many-country, many-commodity case.

There is one advantage for explanations that are based on pre-trade prices. This

lies in the fact that when analyzing gains from and direction of trade, it is not necessary

to discuss wage rates. As long as inequality (3) or (7) holds, there are in general

differences in the wage rates that prevail in Country J and Country C8, but an inter-

industrial ratio comparison make it possible to explain both the effects and direction of

introducing a trade without having to go into these problems. When explaining gains

from trade, this point might be one of the main reasons for the dominance of

explanations based on inter-industrial ratio comparisons9. Conversely, you could also say

that discussions concerning wage rate differences between the actual trading countries

was lacking, because inter-industrial ratio comparisons were dominant.

However, comparisons made on pre-trade price, and therefore also inter-

industrial ratio comparisons have a weakness proper to those comparisons. When you

leave the special circumstance of a two-country, two-commodity model and want to

examine more general cases, that weakness becomes clear.

8 It would be worthwhile to note that when ｗC / ｗJ ＝1 or ｗC ＝ｗ J, then aJ1 / aC1 < 1 < aJ2 / aC2 . This gives us inequalities aJ1 < aC1 and aJ2 < aC2, which show that Country J has an absolute advantage in Good 1 and Country C has an absolute advantage in Good 2. The doctrine that assumed to be the one for economists before Ricardo, was this theory of absolute advantage. With the theory of absolute advantage, the flow of trade was decided based on the magnitude of physical productivity, but it must be noted that their underlying assumption was that ｗC＝wJ．That is, they only discussed a case where there was no difference between the wage rates. 9 Another possible explanation is a reasoning based on opportunity cost. Opportunity cost is the quantity of Good 2 you can produce instead of producing one unit of Good 1.This is also called the marginal transformation rate or marginal substitution rate and for Country J, this is aJ1 / aJ2. There is not much of a difference in explaining gains from trade by using these concepts, but this opportunity cost explanation, which was proposed by Harberler (1930), does not only stop at the Ricardo model, but can also be applied to the HOS model (Refer to Deardorff, 2005b, Section 2.) This point may have contributed to the general acceptance of the inter-industrial comparison explanation, when one wants to explain gains from trade for the HOS model which was thought of as a more modern and higher level trade theory,.

17

Extendability to two-country, many-commodity case Firstly, let us consider a

two-country, many-commodity labor input economy. A labor input economy, or Ricardian

economy, is an economy where the only input for production is labor. In this economy, we

have two series of labor input coefficients; aJ i for Country J and aCi for Country C. In

total 2N coefficients are given. If we line all these up, we get

aJ1, aJ2, aJ3, …,aJN and aC1, aC2, aC3, … ,can.

This seems like a simple setting, but if we try to examine gains from trade and

directions of trade stating from an inter-industrial comparison within one country, we

encounter the following problems.

An inter-industry comparison is possible for any choice of good numbers i and k.

What does it mean when we compare these ratios across both countries? For example,

let us assume that the following is true

aJi / aJk < ek / ei < aC j / aCk

If we set the terms of the trade for Good J and Good k as ek / ei, then by using the same

logic as (3), a profit can be gained from the trade. However, there are N(N1)/2 of these

pairs. If you confine yourself to the trade of goods j and k, you may get the direction of

the trade. But, what does it mean? Even if you conduct an inter-industrial comparison,

based on pre-trade prices or on labor input coefficients (they are essentially the same),

the structure of the trade will not become apparent.

Because of the above circumstances, for a two-country many-commodity

international economics analysis, textbooks and papers will usually not make an inter-

industrial ratio comparison. Instead, they make a two-country intra-industrial ratio

comparison10. To be specific, they start by taking the ratios for two countries of labor

input coefficients of the same industry :

aJ1/aC1, aJ2/aC2, aC3 /aJ3, . aJN/aCN

Then they line them up in order of size and begin an analysis. For example, these ratios

are reordered according to size, and the numbers of goods are reassigned in such a way

10 If an inter-industrial comparison is at the core of the explanation for the two countries, two commodity case, and if an intra-industrial comparison is at the center of the analysis for two country, many commodity case. then it should be necessary to explain why that kind of change of perspective is required. However, textbooks that explain this are extremely rare. According to Deardorff (2005b), Harberler (1930) was the first to employ this kind of “chain of comparative advantage expressions.” Even Dornbusch, Fischer, and Samuelson (1977), who raise the subject of trade of two-country, and infinitely many-commodity case, and the many articles that have taken up the ball with respect to their formula, do not explain why we should swing over from the inter-industrial ratio comparisons to the intra-industrial ratio comparisons. As for pure formularity, it is effective to analyze a chain of the inter-industrial ratio comparisons for many country, two commodity case,, but this kind of case has no significance for real-life application.

18

that we have an increasing chain of ratios

aJ1/aC1 < aJ2/aC2 < aC3 /aJ3 < . <aJN/aCN (9)

There could be a case where the two items next to each other are equal, and you would

have to replace the inequality sign with an equality sign, but in order to keep the

description simple, we assume that all the items line up like the example above. You

could say that this compares each industry in Country C to each of the same industries

in Country J, and lines the ratios up in the order of highest productivity for Good 1,

Good 2, and so on. When you get this kind of inequality chains, a dividing point comes

somewhere to chain (9); goods to the left of this point are exported from Country J to

Country C, and goods to the right of this point are exported from Country C to Country J.

If you just want to know the possible trade patterns of trade between Countries

J and C, then it would be sufficient to get chained inequality (9). However, where does

the dividing point come in the above expression? Generally preferred situation is the one

that balances trade between the two countries (in other words, imports and exports are

equal). With respect to this point of understanding, this paper does not have any

fundamental differences with the ordinary textbooks and papers. However, this paper

delves deeper into analyzing the meaning of chained inequality (9) and postulates that

the chained inequality (9) reflects the price competitiveness of each product (in other

words, which country would have a cheaper production cost when an item is produced).

At a glance, this seems like an extremely obvious cost comparison, but this is the very

kind of cost comparison which is made constantly as daily practice on factory floors. The

essence of Ricardo's intra-industrial comparison is, we presume, this simple knowledge

that is applicable to these real-life questions.

Let us assume that the division point came in between numbers s and s + 1.

Goods less than s are produced in Country J, and goods greater than s are produced in

Country C. What does this stand for?

When we made an intra-industrial comparison, we used the wage ratio wC/wJ of

both the countries as an intermediary to get a relationship (4). Similarly it is also

possible to obtain the same relationship by means of chained inequality (9). Assume that

the following expression holds at the point of the trade balance:

aJ1/aC1<…<aJs/aCs<wC/wJ<aJ(s+1)/aC(s+1)<…<aJN/aCN (10)

Here, if we take the good number i to the left of wC /wJ, then from (10) we get

aJi/aCi<wC /wJ or wJ aJi <wC aCi .

19

This expression means that the cost for producing Good i in Country J is lower than that

in Country C. This means that it is more competitive to produce Good i in Country J

than in Country C. In the same way, if we take the good number k from the right of wC

/wJ then we get

aJk/aCk>wC /wJ or wJ aJk >wC aCk .

If we permute the two sides of “or” of the two expressions above, it is the same as the

discriminant expression (6) for Country J or C. Therefore, when expression (10) is true,

then the numbered goods to the left of wC /wJ will be produced in Country J, and the

numbered goods to the right of wC /wJ will be produced in Country C. Each country will

then export the goods produced to the other country as required.

The reasons for inserting the ratio wC /wJ into the chained inequality (9) is also

clear. The wage rates wC and wJ, are, as we have assumed, expressed by a certain

international currency. Even if the domestic wage rates, which is expressed by the

proper currencies, do not change, the ratio of the wage rates wC /wJ may also change if

the exchange rate of the currencies for both countries change. Now let us assume that

the currency of Country J strengthens compared to the currency of Country C. When

this happens, the ratio of the wage rate wC / wJ will decrease. If this value changes

sufficiently, then the expression (10) will no longer hold between number s and number s

+ 1, but will move to hold between smaller numbers s1 and s1 + 1. On the contrary, if the

exchange rate changes to strengthen the currency of Country C, then the ratio wC/wJ

will further move to right. If the ratio wC/wJ is situated sufficiently to the left, then the

goods that Country J can export will decrease, and the exportable goods of Country C

will increase. In an extreme case, if ratio wC/wJ is further to the left than the aJ1/aC1 ratio,

then there will be no products that Country J can competitively export. Its trade balance

will go into the red. Conversely, if ratio wC / wJ goes sufficiently to the right, then the

trade balance of Country C will be in the red. Based on the Intermediate Value Theorem,

there must be a point where the trade balance for both the countries will almost

vanishes for a certain appropriate wage rate ratio (or the exchange rate of the currencies

for both the countries)11. Instead of using expression (9), we get an expression (10) with

the help of wage ratio wC /wJ. The resulting expression thus gives a more unified and

systematic perspective, with respect to deciding on a trade pattern, and also for

understanding where the dividing point comes.

A similar discussion can be made with respect to prices in a closed economy. As

11 This is explained in more detail in Section 6.

20

already stated, the labor input coefficients and prices are functionally interchangeable

for a labor input economy, if the profit ratio for each country/ industry is the same.

Actually, if you are just looking at the possible trading pattern, then you can use in place

of the labor input coefficient the expression:

pJ1/pC1 < pJ2/pC2< pC3 /pJ3 < … <pJN/pCN (11)

This chained inequality has a dividing point somewhere and from this point, goods to

the left are exported from Country J to Country C, and goods to the right are exported

from Country C to Country J. However, where does this dividing point come to? Based on

the assumption that the prices of both the countries are expressed in an international

currency, the dividing point would appear when the prices of both the countries are

compared and where the price of one country is higher than the other country, that is, at

the point where you can insert the value 1:

pJ1／pC1 ＜… ＜pJs ／pCs,＜ 1 ＜pC(s+1)／pJ(s+1),＜…＜pJN／pCN (12)

When the price is shown in the currency of each country, it is of course necessary to use

an exchange rate to change the currencies of each country into an international currency.

When converted to a shared currency, the dividing point is ultimately nothing more than

distinguishing whether the production cost is cheaper when producing a good in Country

J or Country C12.

Note that although chained inequalities (9), (10), and (11), (12) are derived

from almost the same perspective. They are all intra-industrial ratio comparisons. As

previously discussed, chain of inequalities (9) and (11) cannot be derived from intra-

industrial ratio comparisons. Trade pattern for the two-country, many-commodity cannot

be revealed by considering inter-industrial ratios.

Many-country, many-commodity case with trade of intermediate goods To discuss

trade for many-country, many-commodity case in order to further generalize the problem

from the two-country, many-commodity case, directly using the intra-industrial ratio

comparison of labor productivity is not possible. This is the same for comparing the

inter-industrial ratio or ratio of prices of a closed economy. However, for many-country,

many-commodity case, an effective method is to compare production costs using the most

12 In order to say that trade profits exist (for example, the possibility of production totals expanding for the whole world through trade), then it is essential for the price systems in the two closed economies of Country J and Country (C) not to be proportional with each other. This is no more than an International Economics version of the general “Exchange Principle”. See, for example, Shiozawa (2007) Theorem4.1.

21

primitive form of comparative production costs, that is, wage rates multiplied by labor

input coefficients. In a natural way, you can generalize the expression (5) to the many-

country, many-commodity case by using wage rates.

For example, let us assume that there are three countries in this world called A,

B, and C. When the labor input coefficient for Good i is respectively expressed as

aAi，aBi，aCi, the productions cost for each respective country will be expressed as

wA aAi，wB aBi，wC aCi .

If we set the mark-up ratio of the industry for Good i to be the same for each country,

then this inequality relation will also be the inequality relation of the production costs.

Thus, when the wage rates wA，wB，wC are given, the only country that is able to

competitively produce Good i will be the one with the lowest production costs. When the

wage rate ratios are randomly chosen, it is not always the case that every country has a

competitive good (in other words, an exportable good). For every country to have at least

one competitive good, an expression similar (including weak inequality signs) to the

inequalities (5) must hold true.

For a certain wage rate system, even if all of the countries can competitively

produce at least a good, unemployment will arise during the traverse process from the

old closed economy to a new international price and production/trade system. However,

irrespective of the kind of demand structure and for given endowment of a labor force for

each country, an appropriate wage rate system exists such that a type of economy exist

where, all production is conducted competitively under a suitable world price system,

and all countries are able to realize full employment. If the world-wide demand ratio is

determined, then this kind of wage and price system will generally come together

unambiguously (with a probability of 1). You can also say this, not only for a labor input

economy, but also in a case where intermediate goods are traded and used as inputs.

You can also analyze gains from trade by comparing traded situation with the closed

economy situation.13

A kind of duality can be seen observed between prices and wage rates.14.Instead

of starting from wage rate, we can also analyze the trade situation starting from

international prices and by examining the conditions similar to condition (8). In this

sense, for a labor input economy, the competitive pattern can be given either by the wage

13 Refer Shozawa (2007). These theses analyze the unemployment that comes with trade and other conditions away from the “Maximum Frontier”. 14 This duality is of a completely different nature than the duality between price and quantity.

22

rate system or the price system. However, this dual relationship, will not hold when

input goods are traded. Only the expression with the wage will give the correct

competitive pattern.

Even in the general situation such as many-country, many commodity case with

intermediate goods and choice of production processes, the starting base of the study will

be the wage ratios. Once a system of wage rates is given, a unique minimal production

price system is determined and various issues will be solved, including the problem of

selecting which country's intermediate good to use as an input16.

In many-country, many-commodity case with traded intermediate goods, labor

input coefficients and prices in a closed economy are of almost no use as material for

deciding a trade pattern. As for this point, it will be sufficient to refer to the studies of

Alan V. Deardorff, who has contended with these problems for a long time17. In the case

where input goods are traded, whether it is many-country many-commodity case or two-

country many-commodity case, you cannot decide on possible trade patterns based on

the comparison of labor input coefficients or of the prices in closed economies18.

Midway summary In a two-country, two-commodity scenario, both inter-

industrial ratio comparisons and intra-industrial ratio comparisons were

mathematically equivalent operations. However, in textbook explanations, inter-

industrial ratio comparisons are overwhelmingly dominant. At the background of this

fact, it was pointed out that it was easier to demonstrate gains from trade based on

inter-industrial ratio comparisons rather than on intra-industrial ratio comparisons. In

addition, in a classical two-country, two-commodity scenario, there was a certain kind of

symmetry between analysis based on wage rates and analysis based on international

prices or terms of trade. Regardless of which method of analysis being chosen, the

results obtained were almost equal, and it was possible to read between the two methods

interchangeably. However, once input goods are introduced in the production and are

traded internationally, this symmetry breaks down.

At the core of this is the asymmetry between the wage rate system and the

price system. As already stated, when a system of wage rates is given, a minimal

16 See Theorem 3.1 Shiozawa (2007). 17 Deardorff (2005a) and Deardorff (2005b). In Deardorff (2005a) there are various illustrations given as formulae for deciding a comparative advantage in the case of intermediate goods inputs, but none of the definitions are satisfactory. 18 The famous Jone’s formula (Jones, 1961) for determining patterns of trade in many-country many-commodity case is no longer applicable in the existence of intermediate goods.

23

production price system uniquely exists. On the other hand, when a price system is

randomly assigned, there is no guarantee that a wage rate system corresponding to the

price system exists. A difference in the degree of freedom for wage rates and prices is

also important. The degree of freedom for the wage rate system is equal to the number of

countries (for the ratios, it is the number of countries minus 1) and the degree of freedom

for a price system is equal to the number of goods (for relative prices, it is the number of

goods minus 1). In the real-life world economy, the number of goods is far greater than

the number of countries. If the number of goods is greater than the number of countries,

including the case of two-country, many commodity case, it is possible to start an

analysis from the wage rate system, but the opposite is not possible.

In general, it is necessary to consulting the wage rate system when one wants

to determine international price system which makes trade possible between countries.

The starting point for this is relational expression (5). In the two-country, many-

commodity case, they are organized using chained inequality (10). However, as already

indicated, this kind of organization is not possible with three or more countries, and

even for two countries, it is not possible when intermediate goods are traded

internationally19.

The theory of comparative costs actually follows the simple principle of

international comparisons of production cost. In many-country, many-commodity case

with intermediate goods trade, there is no choice but to revert to this principle for

analyzing trade. Section 4 revisits this point of origin with an analysis of comparative

production costs. The method of comparison based on the prices in closed economies and

that of comparison of productivities are only effective in a special situation of two

country, two commodity economy or many commodity, two commodity economy. This

method of analysis has no possibility to be extended to more general situations.

3. Macro and Micro Perspectives for a Competitive Analysis

As stated in Section 1, this paper takes the position of discussing both trade and

international competition from the perspective of managers and factory heads in specific

industries. It takes the perspective of one economic agent in a huge economy. By

19 In the real world there are nearly 200 countries/ economic zones, but even based on a simple commodity classification, the number of goods is more than 30,000. If we classify them to a level where we can assure the degree of uniformity of quality assumed in this paper, then it would be necessary to have thousands of millions of types. Therefore, any way you look at it and no matter how realistic a situation is assumed, the number of goods vastly exceeds the number of countries.

24

necessity, it is a micro perspective. The conventional trade theory takes the perspective

of policy-makers or economists, which overlooks the entire economy, and is a macro

perspective.

Macro and Micro Explanations The difference between the micro and macro

perspective is where this paper separates itself from traditional analyses and also differs

in analysis method. Put it different way, traditional analysis took a macro perspective,

overlooking country level economy, and explained gains from trade and discerned trade

patterns. For this reason, traditional analysis could not hold the perspective of firm and

factory leaders, nor the analytical methods that this paper has as its goal.

The methods used in this paper are in no way eccentric or special. As already

stated, it is just a case of revisiting the point of origin, namely, comparative production

costs. However, because there is a long history of analysis conducted by economist from a

macro perspective (i.e., the perspective of policy makers), there is a deeply-rooted fixed

idea about the way in which the trade analysis has to be done20. As for the analysis

method we think that the aforementioned explanation is sufficient, but let us summarize

what we have discussed from the perspective of an analyst.

Differences in perspective and the possibility of obtaining information First, let us

return to the first comparative expression and take a note that conditional expressions

(1) and (2) stands on clearly different perspectives. The basis of these comparisons is the

physical labor productivity of each country/industry, but with respect to the possibilities

for obtaining concrete values, either measured or estimated, there are asymmetries in

the information depending on who gathers it and how it is compared.

If those conducting a comparison are the central planning authority in a

planned economy, or are the policy-makers of a single country, then it may be easy to

obtain the productivity data for any industry. However, for managers or those

responsible for factories, there is a significant difference, in general, in the possibility of

obtaining productivity data from their own company and some other company.

Regardless of the kind of industry, managers and those responsible for factories are very

20 An exceptional view was put forward by Gandolfo (1987), p.9. Noting that "[c]ompararative cost can be defined in two ways: as the ratio between the (absolute) unit cost of the two commodities in the same commodity, or as the ratio between the (absolute) unit cost of the same commodity in two countries," Gandolfo writes "Following common usage, we shall adopt the latter." Emphasis is his owns. "Absolute unit cost" means labor input per unit of production.

25

knowledgeable about their own firm or factory. Since it is the life-lines for firm‘s

management, they will not be able to neglect measuring productivity. Because the

productivity of competitors in the same industry is usually not revealed, it is not always

possible to obtain information. However, concerning that productivity, whether they are

competitors from their own countries, or those from another country, it is common to

have estimated values based on data such as the forecasted figures to the public in the

past, and so on. Furthermore, in the competitive world of today, for example, a firm in

Country J having a production factory in Country C would be able to know the

productivity for its own factory in Country C and from there would be able to estimate

the average productivity for the industry in Country C. In this way, managers have

relatively accurate estimates for values related to productivity in the same industry,

whether it is in their own country or in a foreign country,. On the other hand, managers

have difficulty estimating the correct productivity for different industries, even in their

own country.

From this perspective, when you look at expression (1), i.e. an inter-industrial

ratio comparison, it is considerably difficult to know future trade directions based on

assessments of whether or not this kind of inequality holds. If knowing and predicting

the direction of trade is a necessary part of assessments that are required to make

strategic decisions, such as whether a company can maintain its own production in the

long-term, or where to locate a self-owned factory, then relying on the inter-industrial

ratio comparison (which is expression (1)) would be extremely dangerous.

Next, let us look at expression (2), the intra-industrial ratio comparison. With

this expression in the form that it is, it has no meaning for managers and factory leaders

of Industry 1 or 2, who have only ever known the productivity data for their own

industry. This is because even if the ratios put out are productivity ratios for the same

industry, the right side, which should be compared with the left side, still requires the

productivity ratio from other industries. However, intra-industrial ratio comparison

expression (2) is related in a way that it easily connects to expression (6). The latter is

comprised of figures that a single industrialist would be able to obtain, such as the intra-

industry productivity ratio for the same industry and the wage rate ratio between two

countries.

At a glance, expressions (1) and (2) appear to be “a switching of the numerator

and denominator in the inequality.” However, although expression (1) and the analysis

that is its natural extension will lead to a macro perspective (in other words, the

26

perspective of the policy-makers), both expression (2) and its natural extension

expression (6) will lead to a micro perspective or to the perspective of an industrialist.

When you look from the perspective of who is comparing what, expressions (1) and (2)

actually have a vastly different significance.

Explanations in Quantity Terms and in Value Terms Let us take a look at

expression (3), which is a natural extension of inter-industrial ratio comparison (1).

When e1 and e2, which satisfy inequality (3) are given, and when e1 units of Good 1 are

exported from Country J to Country C, and e2 units of Good 2 are exported from Country

C to Country J, it is possible to reduce the total labor times of both Countries J and C

while maintaining the same consumption quantity, as already stated. This was one of

the methods used to demonstrate the gains from trade. The quantities mentioned here,

such as amounts of goods traded between two countries, the change of production

volumes as a result of the trade, and the consumption maintained as a constant, are all

physical quantities (as opposed to value terms).

Let us now take a look at expression (6) (the left side inequality), which is a

natural extension of expression (2). The subjects of comparison are ｗJ aJi and ｗC aCi,

which are but the value terms. If

ｗJ aJi <ｗC aCi ,

then the cost (and therefore price) of good i to produce in country J is cheaper than the

cost and price of the same good to produce in country C. In this situation, it is

advantageous for Country J to export Good i to Country C. If the opposite inequality

holds, then it is advantageous for Country C to export the same good to Country J.

This is a self-evident principle for any merchant or for any industrialist in a

monetary economy. For a merchant or an industrialist, it is evident it is profitable to

enter into trade. But, it is not directly evident whether this applies to Country J and

Country C and they can obtain gains from trade. However, when a trade is conducted

based on this principle (i.e. the principle to produce in the place of cheapest production

cost and export from there to other palaces), then it is easily known from a short

calculation that both countries gains from the trade under the condition that the trade is

balanced..

As it has been stated several times, expressions (3) and (6) can fulfill the same

role when one contemplates on gains from trades,. However, for a quantity-term and a

value-term analysis, there is a huge difference from the standpoint of an individual or

27

industry member. If you try to conceive exports and production in quantity terms,

statistics are necessary. For the state men and government officials (the macro

perspective), to conceive the total exports and the total production is both necessary and

possible. However, for an individual or industry member (the micro perspective), to

conceive the total exports and the total production is not easy. On the other hand, wage

rates, material prices, and product prices are used for individual transactions, and can

form the basis for business judgment. While physical quantities do not have much

meaning unless they are aggregated, value-term judgment is useable for other

transactions when the prices are stable. This is the characteristic and operating

principle of the market economy.

If we assume a planned economy, then relational equations (1) and (2) will be

mutually on par with each other in the same way that they are mathematically

equivalent. However, in a market economy they are not necessarily equivalent since in a

market economy, even if a quantity-term analysis is possible from the macro perspective,

a micro perspective is not possible. Only the perspective of a price-term analysis is

possible for a micro economist.

The Macro and Micro Aspects of the Principles of Political Economy and

Taxation

In this section, we have distinguished two mathematically equivalent expressions (inter-

industrial ratio comparison and intra-industrial ratio comparison) focusing on the

perspectives which are closely related to the method of analysis. The discourse of the

comparative cost principle is constituted of the two different orientations. There are

series of oppositions: one focuses on production cost, and the other focuses on prices in a

closed economy; one takes as the main subject prices and the other wage rates; one

prefers quantity-term analysis and the other value-term analysis; one takes the macro

perspective and the other the micro perspective. These oppositions yielded various

ramifications, and they all constitute a comparative advantage theory as a whole. To

sum up, there were two series. On one hand there is the series of inter-industrial ratio

comparisons: price focus, quantity-term analysis, the macro perspective. On the other

hand there is the series of intra-industrial ratio comparisons: wage rate focus, price-term

analysis, and the micro perspective.

Traditional analysis was centered around the first series, and because of this,

international trade analysis was deployed inevitably from the macro perspective and

28

remained invariably the dominant paradigm. It seems to us very important to focus on

series 2, when one tries analysis based on industry or factory units. This paper is just

one example of that perspective, but at the end of this section we point out that even

Ricardo, who was the first to conduct a proper theoretical discussion on international

trade, actually included both these series in his theories/discussions. One thing that the

authors consider to be especially important is that Ricardo not only considered the

macro perspective21, but also considered the perspective of individual industrialists (or

merchants), when he contended for explaining gains from trade. Ricardo also

contemplated from the micro perspective.

Ricardo's Numerical Example First, let us take a look at the famous four numbers

which Ricardo has chosen as an example of trade between England and Portugal. Table

1 that we used as an illustration at the beginning of Section 2 is filled with the following

numbers in Ricardo’s example.

Table 2 Ricardo's Numerical Example

Cloth Wine

England 100 120

Portugal 90 80

It should be noticed that no units for cloth and wine are defined explicitly. This is

because Ricardo assumed that both cloth and wine had the same value and would be

exchanged one against the other22. This point is not often clearly explained, but in

paragraph 14 of Section 7 there is an expression: “the quantity of wine which she

(Portugal) shall give in exchange for the cloth of England.” In following paragraphs 15

and 16, he uses a definite article when he talks about cloth and wine, indicating that he

continues to maintain this exchange relationship.

If you focus on this point, the logic of Ricardo's explanation is clear. In

paragraph 16, after the explanation of the labor quantity required for production, he

states, “England would therefore find it her interest to import wine, and to purchase it

21 As a typical example of the macro discussions in the Ricardo Trade Paper (Ricardo, 1821, Chap. 7), we can bring paragraph 12 to our attention. Here, Ricardo points out that, “ The pursuit of individual profits is linked to the total universal profit in surprising ways,” and identifies that this pulls up the production quantity of the whole world, and increases general profits. 22 If expression (3) is used, this means that Ricardo assumed that e1 = e2 (=1).

29

by the exportation of cloth.” Again, in paragraph 17, after referring to the amount of

labor required for the production of wine in Portugal, he similarly remarked, “[i]t would

therefore be advantageous for her (Portugal) to export wine in exchange for cloth.” Why

is it advantageous for England to export cloth and import wine, and for Portugal to

export wine and import cloth?

This is because the figures in Table 2 show the labor quantity necessary for the

production of a fixed quantity of cloth and a fixed quantity of wine that are exchanged in

trade. Paragraph 16 makes the following. Calculation: “[T]o produce the cloth may

require the labor of 100 men for one year, and if she attempted to make the wine, it

might require the labor of 120 men for the same time. England would therefore find it

her interest to import wine, and to purchase it by the exportation of cloth.” The second

sentence of paragraph 17 also makes the same account: “To produce the wine in Portugal,

might require only the labor of 80 men for one year, and to produce the cloth in the same

country, might require the labor of 90 men for the same time. It would therefore be

advantageous for her to export wine in exchange for cloth.”.

Here, it should be noted that no comparison are conducted, be it either “inter-

industrial ratio comparison” or “intra-industrial ratio comparison.” As proof, the

decisions made by England are being inferred regardless of its relationship with

Portugal. It is the same case for Portugal. Paragraphs 15 and 16 paragraphs in Ricardo’s

Trade Chapter do not rely on the result of calculation, which compares two ratios of

expression (1) on Section 2 of this paper, or the ratios replaced by Ricardo’s four magic

numbers:

100／120 < 90／80.

This kind of comparison is not conducted at all.

A revised assumed example This point becomes clearer when we examine

Table 3 in place of Table 2

Table 3 Revised Numerical Example

Woolen Goods Grape Wine

England 100 120

Portugal 80 90

The required labor for England does not change, but the required labor for Portugal

for cloth and wine are interchanged. In this table, expression (1) holds true, which is:

30

100/120 = 0.833 < 80/90 =0.888

However, Ricardo's explanation does not hold in table 3. To put it precisely, it

holds for England, but not Portugal. In fact, rather than importing cloth from England

in exchange for wine produced by 90 laborer years, it would take only 80 laborer years

for Portugal to directly produce the same quantity of cloth within its own borders. Thus,

even if English capitalists agree to export cloth and import wine, Portuguese capitalists

would not agree (at least with the current terms of the trade) to export wine and import

cloth. In this case an exchange is not possible between two countries, for it requires

mutual consent of both parties.

Why does a trade not take place between England and Portugal in case of Table

3, even if England has a comparative advantage over Portugal in Good 1 (i.e. cloth)? The

reason is evident. In order that trade is favorable for both parties, we know that the

terms of trade must meet condition (3) as well as comparative advantage expression (1)

holds true. While in Table 2 the 1:1 exchange meets condition (3), in Table 3 the 1:1

exchange does not meet condition (3). In Table 3, the allowed cutoff for the terms of the

trade is narrow. When the amounts of cloth and wine in the table are set as the unit, the

following condition must be met so that an x amount of wine would be exchanged for one

unit of cloth:

0.833 ＜ x ＜ 0.888

If x, or the amount of wine to be exchanged for cloth, is 1, this inequality will not hold.

Therefore, let us start afresh and set x as 0.85. This is to assume that 0.85 units of wine

will be exchanged for 1 unit of cloth. As in the case of Table 3 following the example of

Ricardo, if we were to write a table with the amounts of goods which are exchanged at

the ratio 1:1, then the table will be revised as follows:

Table 4 Table for terms of trade at 1:1

Cloth Wine

England 100 102

Portugal 80 76.5

The apparent labor input coefficients for Table 3 and Table 4 are different. It

may look like two tables have different productivities. In reality, the productivity for

both countries/both goods has not changed at all. Only the unit of wine is replaced by a

new unit. In Table 4, Ricardo's reasoning comes back for both England and Portuguese.

31

That is to say, England would benefit from producing cloth with 100 people and,

importing wine in exchange for wine, instead of using 102 people to produce the same

amount of wine. Portugal would benefit from producing wine with 76.5 laborers and

importing cloth in exchange of wine, instead of using 80 laborers to produce the same

amount of cloth.

From the above numerical examples, it is realized that Ricardo's original

explanation of comparative production cost is not the one that takes two productivity

ratios, one from one’s own country and one from another country and compares them.

Actually, it is not really necessary to use that kind of approach (which requires an

elaborate explanation). By focusing on a mutually exchanged quantity, Ricardo

demonstrated that it is possible to make mutually advantageous trades between both

the countries even if one of the countries has low productivity in all goods.

If we follow the logical order of the explanation, expression (3) comes first. From

(3), the terms of the trade e1 and e2 are given. Then we obtain the units for both goods

and we can tabulate the labor quantity, which is required to produce each unit of goods

for both countries. If you rearrange the left hand side of expression (3), you get

aJ1 e1 <aJ2 e2 .

This means that the labor quantity required for your own country (Country J) to produce

e1 units of Good 1, which is to be used for exports, is smaller than the labor quantity

required for your own country (Country J) to produce e2 units of Good 2, which would be

imported in exchange for e1 units of Good 1. The inequality from the right hand side of

expression (3) can be rearranged as

aC2 e2 ＜ aC1 e1 .

This shows that capitalists of Country C also can get gain from trade, when they export

e2 units of Good 2 and import e1 units of Good 2..

Ricardo's Perspective So what was Ricardo’s perspective of analysis? It is

clear that his perspective was not that of expression (1), where two countries and two

industries are compared (the macro perspective). What Ricardo used with respect to the

theory of comparative advantage was the numerical quantities to be exchanged for

international trade and the labor quantity required to produce those quantities of goods.

When looked at from the English side, what was necessary was the required labor

quantity to produce cloth and wine in England, and when those were 100 and 120, he

stated that it was profitable for the English to export cloth and import wine. The same

32

can be said for Portugal. It is implicitly understood that decisions to trade were made,

when traders of both countries were unaware of each other’s circumstances. Rather, the

exchange ratio for cloth and wine are assessed beforehand and calculation is conducted

based solely on the production circumstances with one's own country. This is the first

point to reconfirm: Ricardo's perspective was not a universal one that went beyond the

boundaries of countries. It is not a macroscopic or transcendental one which looks the

whole world from above. However, according to our classification in the previous section,

it is also certain that his perspective was based on the inter-industry comparison.

Ricardo and the capitalists who are making the decisions along with him, are

progressing on the premise that they know the mutual labor quantities required for both

the production of cloth and wine.

However, this premise is not either necessary. Even if the production cost is not

calculated, if you know the domestic price, you can take the place of capitalists and

decide on whether it is advantageous to export cloth and import wine. In Section 2, we

observed that the conditions on the terms of trade can be expressed in the following

inequality forms:

pJ1/pJ2 < p*1 /p*2 < pC1/pC2 (7)

Here let us recollect that p*1 and p*2 were the prices of goods, which are effective in the

international trade. If you have the left hand side of the inequality (7), then for the

English capitalists or merchants it is profitable to purchase Good 1 at the domestic price

and sell it at the international value. This is nothing other than to export Good 1 from

England. Similarly, for Portuguese capitalists or merchants, if you have the right hand

side of inequality (7), it is profitable to purchase Good 2 at the domestic price and sell it

at the international price. This is to export Good 2 from Portugal. It is then plausible to

pressume that Ricardo's explanation imagine a situation that is prior to the

establishment of complete equilibrium (in other words, prior to the situation that both

international prices and domestic price become completely proportional).

Moreover, from Section 7 paragraph 15 to paragraph 17, he just shows how

trades come together, but does not assert that this is advantageous to England/Portugal

from a macro perspective. England and Portugal are often chosen as subjects, but if you

take a closer look into the details, Ricardo takes the capitalists (not the “total capital”

but “individual capitalists”) of England and Portugal as agents of assessment. In this

sense, Ricardo made an analysis from the micro prospective.

33

An Example with Shoes and Hats With respect to Ricardo's explanation,

another passage that would shed light on our argument is the note that was attached in

paragraph 18, after the explanation of “cloth and wine.” Instead of cloth and wine,

Ricardo refers to the production of shoes and hats as a reference. There are two

individuals, and both are able to produce shoes and hats. Let us call them A and B. A is

superior to B, for both shoe and hat production. A excels B in productivity by 33% for

shoes and 20% for hats. Ricardo questions himself if there is a mutual profit for both

parties when A produces only shoes and B produces only hats and concludes

affirmatively.

This example, gives a fairly different impression than the tables that had been

made up until this point, for the comparison has been given by a degree of “superiority”

and not by the labor input coefficients. Therefore, let us choose some specific figures and

make a table, similar to Table 123. One of possible examples is Table 5.

Table 5 Production Time for Shoes and Hats

Shoes (1 pair) Hat (1)

A 9 5

B 12 6

Here, in the table, the necessary labor time is shown when both individuals produce a

pair of shoes or a hat. Let us assume that A and B both work for 180 h. In that time, A

can produce 20 pair of shoes or 36 hats and B can produce 15 pairs of shoes or 30 hats. If

you divide the number of units A produces by the number of units B produces in the

same time, then we get the following table, which is in agreement with Ricardo's

specifications.

Quantity of

shoes produced

by A

20 Quantity of

shoes produced

by B

15 ratio 1.33

Quantity of hats

produced by A

36 Quantity of

shoes produced

by B

30 ratio 1.20

23 This table does not presume that the units of two goods are exchanged against each other. In order that the table gets an exact similarity, it is necessary to change it into Table 6.

34

If we replace Table 5 by Table 1 and set A as Country J, B as Country C, shoes as Good 1

to shoes and hats as Good 2, Ricardo would be conducting the following comparison:

(1/aJ1)/(1/aC1) > (1/aJ2)/(1/aC2) .

This is not expression (1) or (2). But if you flip the inequality over by switching the

numerator and denominator of each side, this is nothing other than the intra-industrial

ratio comparison (2). This should be obvious, for different agent’s ability for the same

work (shoes or hats) is compared. In Ricardo's chapter On Foreign Trade, there is no

explicit expression that refers to an inter-industry ratio, but a comparison of

productivity ratios of different agents in the same work (read industry) is explicitly

conducted. In other words, there is no proof that Ricardo really reasoned in terms of

inter-industrial ratio, but the above footnote proves that he did think in terms of intra-

industrial ratio.

Furthermore, until now it has not been made clear how many hats can be

exchanged for one pair of shoes. Exchange ratio is not determined uniquely but it must

lie in a narrow interval limited by certain ratios. For example, if 19 hats are exchanged

for 10 pairs of shoes, then you get Table 6.

Table 6 Required Time of Labor for the Quantity of Exchanged Units

Shoes (10) Hats (19)

A 90 95

B 120 114

If 19 hats are exchanged for 10 pairs of shoes, and if there is enough demand, then in

terms of labor time, it is in the best interest of both for A to produce shoes and B to

produce hats. This is the logic explained in Ricardo's works stating that there is a

mutual benefit to both England and Portugal24. In order to decide the exchange rate, it is

necessary to compare two ratios of their productivity:

9/5 = 1.8 and 12/6 = 2

The rate of 19 hats to 10 pairs of shoes must be placed between the two ratios. However,

if deciding upon a specialization pattern, it is sufficient to compare productivity with

24 Furthermore, for this kind of exchange rate to hold true, the wage rate wA of A has to be about 0.27 times higher than the wage rate wB of B, if A and B are employed. Ricardo usually sets the wage rate for a laborer within a country to be a constant, but in this type of example where there are differences in the labor productivity of an individual, similar to the case of international trade, differences arise in the wage rate. The wage rate ratio will be wA ／wB which is in between 1.2 and 1.33.

35

respect to the same good. What Ricardo was thinking about in the note in paragraph 18,

was this kind of intra-industry ratio comparison.

The Micro/ Macro Perspective and Reality

Standard trade theory to date has attempted to explain two big propositions: 1) That

free trade brings about gains from trade, and 2) That comparative advantages will give

rise to the differences (international specialization) in the industrial structure of each

country.

The Macro Bias of Gains from Trade Explanations Of the two propositions, the

first “the explanation of gains from trade,” is naturally made as if it were a discourse of

the policy makers who are responsible for international trade. It has a strong flavor of

“macro explanations” so as to oppose protectionism and mercantilism. In other words, it

has a strong tendency of evaluating the country’s economy as a whole by its production

and consumption possibilities in quantitative terms. This explanation of “gains from

trade” is the one that is stressed first in textbooks for international economics. On this

reason, the macro explanation is implicitly prioritized in the development of the

Ricardian theory, and this fact explains why the scheme often seen these days holds true.

Obviously, we think that the authors of the textbooks themselves completely

understand that the Ricardian theory, through a simple transformation of expressions,

allows both micro and macro interpretations (Krugman; Obstfeld, 2002, et al.).

Many textbooks take into account the interchangeability of these two

explanations, but there are not many that clearly explain the differences. It does not

seem like there are any textbooks that refer to the fact that these two interpretations

imply huge differences of perspectives, either for the agents who make decisions or for

the analysts who contemplate on trade. Once standard textbooks become

“institutionalized,” it is no surprise that, among the general readers, there are those that

believe that only the macro interpretation is possible. In this way, the logics of industry

level analysis in the Ricardian theory has been ignored up to now, mainly due to a

preference for macro analyses and perspective. We have to say that this was a great loss

for economics. This paper aims to revive the Ricardo’s micro perspective and analyze

international competition at a firm/industry level.

An Explanation of Industry Structure and Micro Reality Again, even in

36

the case of proposition 2, which explains the actual structure of the industry with the

Ricardian theory of comparative advantage, a contrast can sharply be seen between the

micro and macro perspectives. The resulting industrial structure and trade structure

can be explained as a macro phenomenon, but macro explanations are insufficient for

the process to arrive to that structure. The assumption that the policy makers of both

countries exchange figures for the “marginal rate of substitution,” and come to an

agreement on how to specialize internationally, may be possible for two countries in a

planned economy, but is impossible for two countries based on market economy. For

example, even if central decision making was possible, and the government had the will

to force noncompetitive firms in its own country to withdraw from the market, it is

difficult to think of this giving rise to a positive result, both from the viewpoint of the

government ability of obtaining information and of decision-making.

Those who are can explain the changes in the industrial and trade structure in

a realistic way are those corporate management and factory leaders, who have to

understand the current status and foresee futures of terms like exchange rates, wages,

material prices, and the quality and price of rival products. These people are struggling,

at the same time, with issues such as productivity improvements in their factory; cost

reductions by reducing item numbers and prices of parts and materials; measures to

maintain product prices and to secure sufficient orders. These are the activities that the

first author of this paper calls the firm’s activities to enhance capability. Through these

activities, the average and the variance of labor input coefficients in each

country/industry change dynamically. The management and leaders of firms/factories do

not see the labor input coefficients (aij = the inverse number of labor productivity) as a

given at all. Rather, factory leaders in reality work every day on improving labor

productivity (1/aij) given those factors like wages, exchange rates, and the product prices

of competing companies. Irrespective of these efforts, if the produced goods cannot

survive the competition in the market, then the firm or factory has no choice but to

withdraw form the market.

The average and the variance for the labor input coefficients are determined

for each industry and each country, as a result of collective market activities like entry

into the market, competition within the market and withdrawal from the market. We

must first analyze the micro variables and the behaviors that change them, with the

exchange rate and wage rate of both countries and other macro variables being assumed

as given. The interaction of these behaviors of each factory/firm/industry determines the

37

macro variables as aggregates. The dynamic state of the economy lies in this kind of

micro–macro loop. The macro structure is no more than the result of these loops going

around many times.

4. A Comparative Advantage Seen from the Micro Perspective

In order to analyze the competitive relationships or comparative advantage relationships

in terms of a unit like firm or factory, the “granularity” of industry classifications is an

important perspective. In other words, when we assume the labor coefficient aJi of Good i

in Country J, where i ＝ 1 to N, the problem is of what order we should take N to be; 2,

10, 100, or 30,000?

As is already known, the two-country, two-good model (N = 2) has come to be the

standard form in trade theories. When dividing up the national economy into two big

divisions, it is normal for these large groups to be categorized into the agricultural and

manufacturing industries; heavy and light industries; and assembly and process

industries. However, in Ricardo’s original studies, he represents traded goods as

individual products such as “cloth and wine” or “shoes and hats.” He only raises two

clear examples, but it is implicitly assumed that the comparative advantage theory is

extendable to an economy where many goods are produced and traded.

The idea of extendability is even inherited in standard modern-day textbooks.

The primary goal for both the classical trade theory (Ricardo) and neoclassical trade

theory (HOS Theory) was to explain the factors which induce trade and analyze its

economic effects. Perhaps, for this reason a macro explanation using the two-country,

two-commodity model was the central player. However, at such a time, it was clearly

emphasized, both directly and indirectly, that the theory could be extended to the case of

many goods scenario. In fact, one of the theoretical efforts in the 20th century was to

extend the theory to many-country, many-goods. The change of interests in trade theory

called for an analysis with finer granularity. Such a trend can be seen in line with a

focus on intra-industrial trade and the multinational firm as a modern day trade

phenomenon.

The standard HOS theory as well as the Ricardian theory were based on the

two-commodity model and adopted a macro perspective, concentrating its interests on

inter-industrial trade between countries. However, in the 1960’s, the product cycle

theory (and the flying geese formation theory before it) presupposed a “many-commodity

38

(good) model” and vividly described how new products were developed one after the

other and how the production location would serially shift from more advanced country

to less advanced country. The multinational firms as central players in production

location transfers came into the spotlight and the micro perspective was strengthened.

Moreover, the so-called New Trade Theory was born in the 1970s. It discussed the

growing importance of intra-industry trade, and the perspective was shifted to the

variety of products level within an industry. Here the existence of many goods within the

same industry was assumed. In recent years the New-New Trade theory emerged. It

focuses on the heterogeneity between individual firms/factories and the perspective

shifted even further to a more micro level. You could say that this type of shift from a

macro to a micro perspective, and the shift from a two-commodity model to a many-

commodity model that goes hand-in-hand with the first shift, was the necessary result of

efforts on the part of the researchers who tried to analyze the real world situation with

intra-industry trade, intra-firm trade, and inter-firm international trade and others.

In standard institutionalized textbooks on international economics, there are

still many instances where trade phenomena are interpreted from a macro perspective.

There was no problem with this at the time when the subject of research for

international economics centered around the discussion about general categories related

to international specialization, such as the reasons of trades, gains form trade, industry

vs. industry competition, and the inter-industry trade,. At that time, no viewpoint of a

micro perspective was necessary for the comparative advantage theory, and there was no

reason to distinguish two perspectives, i.e. the micro and macro perspectives.

However, modern international competition is increasingly becoming something

that takes place between companies. Furthermore, competition is arising between

factories within the same multinational firm, Parallel to with the shift from the inter-

industry trade to the intra-industry trade, and to the highly refined intra-industry trade,

the main interest in trade analysis has shifted as well. It is becoming more and more

difficult to analyze the actual state of trade phenomena by using only the macro

perspective that international economics has traditionally emphasized. As seen in

Section 3, this “difference of perspectives” goes as far as the formulation and

understanding of the most basic inequalities related to comparative advantage. In this

sense, this is an issue that touches on the foundations of trade theory.

The Micro Perspective in a Many-Commodity Economy In the two-country,

39

two-commodity case it is possible to easily switch between the macro interpretation and

the micro interpretation. However, it is not clear whether this is possible in a many-

commodities scenario. At least intuitively, the more the number of goods (N) increases, it

is probable that the macro analysis of trade, as seen from the viewpoint of policy-makers,

would encounter limitations with respect to the calculation abilities, which were

highlighted by those opponents against planned economy during The Socialist

Calculation Debate.

However, economic transactions do not take place by actually solving these

difficult problems to calculate. Instead, as seen in Section 2, a much simpler micro-

mechanism comes to intervene so as to effectively solve these apparently difficult

problems. Expression (6) shows this mechanism. This expression is composed of four

variables, the wage rates wJ, wC and the labor input coefficients aJi, aCi of the two

countries involved in producing the same good. These are numbers that an industry

member (a corporate manager or a factory leader) of country J or C can obtain or guess.

Therefore, expression (6) can be written in either of the following forms

ｗJ aJi < ｗC aCi, (13)

or

aJi/aCi < ｗC/ｗJ. (14)

When the wage rates for two countries are given, expression (13) shows that Country J

can have a lower cost price than Country C, with respect to Good (i). Expression (14),

which is equivalent to expression (13), indicates that, in order to keep competitiveness

vis-à-vis country C, Country J has to maintain its productivity wJ /wC times more than

that of Country C. For example, when the wage rate of Country C is 1/10th the wage rate

of Country J, then the productivity of Country J must be ten times higher than that of

Country C. As stated in Section 2, the authors of this paper consider that this very

expression is at the foundation of the “comparative cost principle,” and there is no

intention to repeat that point here. However, the factory leaders or presidents of

small/medium firms in Country J, who are threatened by competition from Country C,

keep always in mind those relations expressed by (13) or (14) and discuss with their

colleagues and subordinates how to maintain the these relations with regard to

productivity. Expressions (13) and (14) are the basic forms of the comparative cost

principle, which are adaptable to the reality of micro-level competition.

This basic expression holds no matter how fine the product classifications

are. Any commodity classification system is not fine enough to identify two commodities

40

as the same one in the sense that demanders assume them to be equal with respect to

their qualities and characteristics. As pointed out at the end of Section 1, this paper does

not deal with the question of competition between “heterogeneous products of the same

kind” or products of different quality within the same category of classification As we

have emphasized, this kind of competition is important. Expressions (13) and (14) hold a

theoretical significance only for limited cases of competitions between goods of the same

kind and same quality. This paper contemplates this extremely narrow case, but it is

notable that such an analysis has not been carried out till date.

The level of relative wages An important item for comparing production

costs wJ /wC or its inverse wC /wJ is basically given for individual industry members. The

ratio wJ /wC can be changed by lowering the wage rate of the firm's own-factory, or by

lowering the exchange rate between two countries. However, as will be discussed in

Section 6, to see the ratio wJ / wC as a variable contains a serious misconception.

The wage-rate ratio wJ /wC basically has to be considered as a given, but this

ratio is not fixed for all times. When attempting to judge comparative advantages for

relatively long term according to expressions (13) and (14), having a vision about how

the ratio wJ /wC will change is just as important as having good prospects with respect

to movements in the productivity of both the countries. In other words, it is just as

important to predict the movement of aJi and aCi. As seen in Section 6, this ratio is not

decided by the technology coefficients (including labor productivity coefficients) of both

the countries alone. One of the major factors deciding the ratio wJ /wC is the exchange

rate of both the countries. Exchange rates depend on the balance of payments (including

trade and investment balance) of both the countries, and fluctuate erratically with

financial speculation. Therefore, regarding the ratio wJ /wC, one should be satisfied to

have a rough estimate of the upper and lower limits of rises and falls.

5. The Inter-firm/Inter-site Competition between Countries J and

C

The following takes a micro perspective seen from one industry member, and discusses

the competition which took place across firms and sites (factories) between Japan and

41

China in recent years. As already stated, the goal of this paper is not to try and show the

results of specific empirical studies, but to present a theoretical framework suitable for

describing competitive relationships in situations of international competition. Therefore,

rather than directly referring to either Japan or China, a fair level of abstraction is put

forward where it postulates competition between the two countries of Country J and

Country C. Even if a specific case is raised, it is cited as an example and it is not the

main thrust to verify the facts.

In Sections 5 and 6, we depart from what is normally called the “Ricardian

Model of Trade,” where only labor is inputted, and consider a two-country, many-

commodity scenario where goods are inputted to produce goods. In these two sections,

only firms/factories producing a single good are considered. The subscript number i will

omitted and it will not appear as an index to differentiate goods produced or an industry.

All the indexes used in the following (other than J and C) indicate the goods (or labor) to

be inputted.

Trade of Raw Materials and Intermediate Goods and Competitive Conditions

First, let us consider two firms/factories manufacturing the same products in Countries

J and C. These firms/factories could be independent firms with each other or could be a

factory in Country J and a factory in Country C of a single multinational company. The

assumption of the competition with the same good will be more severely satisfied in the

latter case, because in that case we are considering the same brand of the same firm as a

product 26. To keep it simple, we shall assume that just one good, Good G, is produced.

For the moment, we assume a company that specializes in a single product, and an

analysis of a product-diversified company will be postponed in Section 7.

Let us assume the input coefficient vectors of the firms in Countries J and C

related to the production of Good G as follows:

aJ = (aJ0 aJ1 aJ2 … aJ(N − 1) aJN)

aC = (aC0 aC1 aC2 … aC(N − 1) aCN)

Here, 0 is an index that indicates the labor input. When it becomes necessary to deal

with heterogeneous labor, 0 can be further subdivided into L1, L2, L3... LT, and so on.

Even when there is heterogeneous labor, if the wage ratio for different qualities of labor

26 Even if the same good is produced, at the very least the brand differs when the producing companies differ. In the short-term, when brand loyalty is effective, there can be competition other than for price. When the brand is the same, heterogeneity of the product shrinks to the smallest extreme and the assumption of it being the same good holds strictly.

42

is held constant, the following discussion still holds. In the following, to shorten the

explanation, it is assumed that labor is homogeneous and only labor input quantity is

related to the production quantity.

Among components of input coefficient vectors, the numbers from 1 to N

indicate material input coefficients, such as inputs of raw materials and parts. The

vector that just extracts the material input components are written as

aJ+ = (aJ1 aJ2 … aJ(N − 1) aJN) and aC+ = (aC1 aC2 … aC(N − 1) aCN)

These raw material and parts are produced goods and are traded and inputted in the

production.

Trade of Intermediate Goods For a long time, international trade theory only

dealt with two kinds of commodities: the endowed resources as production factors and

the products that were produced and traded but ultimately consumed and that would

not be used for the production. The situation that produced goods can be internationally

traded and used as inputs was excluded from its basic assumptions. However, it is

commonly observed that goods produced in Country A are imported and inputted into

the production of Country B. Trade falling in this category is quite important in terms of

traded volumes and in terms of effectiveness of gains from trade as well. Theorists

became aware of the necessity to analyze this kind trade and products. As a result, in

international trade theory, when inputs are traded beyond national borders, these

produced goods are called “intermediate goods.”

Without mentioning McKenzie (1954), the trade of intermediate goods is one of

the most striking facts with respect to international economics. Without the trade of

intermediate goods, Lancashire could not be the cotton industry center of the world and

Japan and Korea would not have been able to become economically developed countries.

Samuelson (2001) points out the fact that “gains from trade” based on the trade of

intermediate goods are tremendous, and proposes this effect to be called the “Sraffa

Bonus.” As an extension of the HOS theory and the Ricardian theory, many trials were

made in order to build a general theory of trade that includes intermediate goods, but by

the obvious relationship that production cost depends on input price and input prices are

determined by the international competition, there was a major difficulty in creating a

general theory including traded intermediate goods. One of the successful theories in the

line of Ricardian Trade Theory is The Ricardo–Sraffa Trade Theory (RS trade theory),

introduced in the beginning of this paper.

43

The input coefficient vectors aJ and aC indicate the level of production

technology and the organizational capabilities that firms or factories possess.

Hypothetically, even if the factories of Countries J and C have the same production

technology (for example, using production equipment to which the production technology

is built-in), then it is well known as a stylized fact in the production site that the labor

inputs aJ0 and aC0 for both the countries would greatly differ when their organizational

capabilities differ27. On the contrary, even if the organizational capabilities are at the

same level, the input coefficients aJ and aC for both countries can differ based on the

selection of production technology. When the production amount is s, the factory in

Country J obtains s units of Product G consuming labor quantity s aJ0 and a materials

input basket s aJ+. Similarly, the factory in Country C will obtain s units of Product G

consuming labor quantity s aC0 and material inputs s aC+.

The Reality of Ricardian Input Coefficients In the Neoclassical School's

analysis (stemming from HOS), substitutability of inputs is ordinarily assumed.

However, rather than generalizing situations to be analyzed, it just introduces an

unrealistic degree of freedom. In reality, if we assume that Product G, which we are

currently discussing, was to be an automobile, then it would be necessary to combine

such parts as an engine, two headlights, and four tires and wheels (excluding the spare)

and so on in order to produce one car. However, it is not possible to reduce the number of

engines by increasing the labor quantity, or to reduce the number of tires by increasing

the number of headlamps. In fact, in the process assembly industry this kind of design

information is called a BOM (Bill of Materials), and is one of the most important pieces

of information in manufacturing and the necessary numbers and items to be inputted to

produce a unit of product cannot be varied arbitrarily.

In this way, for machinery production (which includes the transport machinery

and electric machinery), the product to be produced is specified in detail using a design

chart and BOM, and in accordance with this, the quantity of parts and raw materials to

be inputted are strictly controlled. Of course, there can be a situation where the input

quantity per product may vary depending on the defect rate for work during assembly.

Value Engineering (VE) is popular in the manufacturing industry. You try to realize the

same functionality with a smaller number of parts and simpler mechanisms. Therefore,

you should think that even for the same products, coefficients vary through time. But, at

27 Clark and Fujimoto (1991); Fujimoto (1999); Fujimoto (1999; 2000a; 2000b; 2001).

44

any given time, with the given product specification, the input coefficient of a product is

strictly fixed and, in this sense, there is no possibility for the substitutability of inputs.

HOS theory, which is based on substitution of inputs, is thus far from the reality and the

higher degree of freedom does not confirm that HOS theory has a wider applicability.

The labor input time, which depends heavily on the organizational capability, changes

much more often than material inputs. The labor time required for the production is

measured in total man hours or man day measured by “how many laborers are required

to work for how long time?”

When the production quantity changes, it is often hinted that the per unit

inputs change for labor and goods. However, this is quite an unrealistic speculation,

which does not deserve to be discussed here28. Increasing returns in the New Trade

Theory can be analyzed by assuming that the utilization rate per time period changes for

a given fixed facility. In this paper, however, we will not venture into the analyses of

what happens when such changes occur in the input coefficients, except for the cases, for

example, where coefficients change as a reorganization effect of production process. In

other words, we assume that the depreciation cost for fixed-asset equipment per product

is small, and can be neglected in comparison to the costs of labor and raw materials. In

the chemical industry (and other or other process industry) it is possible (in principle) to

produce the same product based on different processes but the choice of such different

processes can be treated as a choice of technologies.

Inter-site International Competition with Regards to Manufacturing Cost Let

us consider a scenario, where the product designing and the layout designing of the

manufacturing process are finished and a production is being carried out competitively

in both the countries. Assume that the freight charges between Countries J and C are

small, and that we can ignore the transportation costs per unit of product, then the

prices of input goods are equal for both the countries. On the other hand, we cannot say

that the wage rate, which is the labor input price, is equal for both countries. Actually,

we were told that in average there was a 10–20 times difference in the wage rates

28 Regarding the form of the cost function, there was a long debate in both The United States of America (The Marginal Cost Controversy, c. 1946-1952) and Germany (The 3rd Controversy on Management Economics Methodology c. 1951–60), but the fact that the variable cost is proportional to the production volume was almost perfectly demonstrated during the 1930s by the statistical investigation by Joel Dean(1976).

45

between Japan and China29. Here, let us represent wJ as the wage rate of Country J and

wC as the wage rate of Country C. As already pointed out, the two rates should be

expressed in a single international currency.

In this kind of situation, what kind of competition can the firms in Country J

and Country C undertake? First, let us examine the cost structure of both the countries.

When the input coefficients are given as above, the unit cost for the production of Good

G in the firm/factory in Country J (hereafter, Firm J) is given as

wJ aJ0 + <aJ+, p>，

and the unit cost in the firm/factory in Country C (hereafter, Firm C) is given as

wC aC0 + <aC+, p>.

Here, as already stated, aJ+ is the material input coefficient vector of Firm J, aC+ is the

material input coefficient vector of Firm C, and p is the price vector for goods including

input goods. In addition, <aJ+, p> and <aC+, p> which appear here are the total values of

the material input coefficient vectors for Firms J and C (that is, the sum of values of

each good, which is the product of the quantity and the price of the good)..

In quite a wide situation, we can assume that the two production costs, <aJ+, p>

and <aC+, p>, are nearly equal. If both the Firms J and C produce the Good G based on

the same design chart, and if the defect rate (the complement of the yield ratio) is of the

same level, then the goods input vectors aJ+ and aC+ for a unit of production are the same.

When raw materials and parts are traded internationally, the price of inputs would only

differ between Countries J C within the range of transport costs, but we have assumed

that this range is at a negligible level. Then, for the time being, we can assume that

labor productivity (or the inverse of labor input coefficient) are different, reflecting

differences of firms’/sites’ organizational abilities, but in terms of material productivity,

material input cost are the same30.

Of course, there are cases when this assumption does not hold true. For

example, it is the case when the layout of the production process is different for Country

J and Country C, or even though the two firms have the same material input coefficients,

when the cost of transport per product is large enough to be neglected as product cost.

29 The wage rate in Shanghai, where many Japanese companies have entered the market, is extremely high even within China, and as a comparison across Japan and China you can assume wage-rate ratios such as 5:1 or 3:1. 30 By examining intermediate goods questions explicitly, the effective scope of discussions that only focuses on the issue of labor input coefficients becomes clearer. As we indicate here, the applicable scope of the Ricardian Comparative Cost Principle is much larger than what the expression “labor input economy” suggests.

46

We will discuss later these cases separately.

Now if we can assume hypothetically <aJ+, p> = <aC+, p>, then the international

competition around manufacturing costs will ultimately be the competition around per

unit labor costs wJ aJ0 and wC aC0. For Firm J to continue to produce competitively with

respect to Firm C, the following condition is necessary

wJ aJ0 < wC aC0 or aJ0 /aC0 < ｗC /ｗJ. (15）

This is none other than expression (13) or (14) where the produced good is set as G, or

expression (6) from Section 231.

Competition for Reductions in Input Coefficients

We have called elements of the foregoing vectors aJ and aC input coefficients, but it does

not mean that these coefficients are not fixed once for all. These coefficients are also

called “basic unit” and “man-hours” in the fields of production engineering and

management. In addition, if we only talk about labor input coefficients, the inverse of aJ0

and aC0 is called “physical labor productivity.” The main agent in micro interpretations of

comparative advantage is the factory head of Firm J. For this person, labor productivity

of his factory is not a given constant like the so-called “labor input coefficient.” Rather, it

is a variable that changes constantly by the continued capability-building efforts of

laborers, production site leaders and factory directors. This is not something that we can

control freely, but at least in the micro perspective, or for the factory head, it is

something that one can endeavor so that it will change in a favorable direction.

Competition for Enhancing Labor Productivity From this context,

decreasing the basic units aJ0 and aC0, or raising the labor productivity, is one of the

major objectives of Firm J's managers and factory heads. The same is true for Firm C's

managers and factory heads. These activities form major part of the two firms'

capability-building competition (Fujimoto, 2003). In opposition to this, the labor

productivity in an overseas (competitor) factory is something which changes but which

the home country cannot control. Also, the average wage rate of workers for the two

countries may have some margin of freedom within a fixed band, but it is not possible for

these individual managers or site-leaders to change it significantly. In this sense, it is

better for factory heads to think of wage ratesｗJ andｗC as given. Therefore, if you

31 Because the good has been fixed as G, the good number i has been abbreviated, and instead, the coefficient 0 has been added as a subscript (index) to show clearly that it is a labor input coefficient.

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separate those which you can control (own-factory physical labor productivity) and those

which you cannot (both countries' wage rates and physical labor productivity at other

companies' factories), then expression (15) can be expressed as follows:

1／aJ0 ＞ (ｗJ／ｗC) (1／aC0). (16）

Expressing it in this way shows managers’ objectives more clearly. Expression (16) shows

for the managers of Factory J the necessity to keep Factory J's productivity higher than

the product obtained by multiplying the wage ratio of two countries times the Factory

C's productivity. In reality, you often hear conversations in the production line the

discussions like “If China's wage is a tenth of ours (ｗC/ｗJ = 1/10), then we must have

to achieve productivity (1/aJ0 ＝10 × 1/ aC0) of ten times that of China.” among those

involved in Japan's factories32.

From the foregoing, expressions (15) and (16) are the first reference formulae

when one considers international competitiveness (whether or not there is a comparative

advantage) of ones own company. Of course, a certain set of conditions should be

presumed, but this is the first judgment for the managers of Firm J. to make It is very

interesting that this is almost an exact restatement of comparative advantage

expression (4) and its extension to a many-commodity case, expression (6). Expression

(6) and the corresponding expressions (13) and (14) are usually thought of as valid only

for a labor input economy, known as the “Ricardo Model,” namely, an economy where

only labor is inputted to produce goods. However, as demonstrated here, even in the case

where input goods are traded as intermediate goods internationally, we have shown that

these expressions hold a clear significance for a certain specific situation. A change of

ordinary understanding with regards to the validity range of the Ricardian Comparative

Cost Theory is requested.

Next, if we turn our focus from the perspective of Country J to Country C, then

the same discussion applies. In order for Firm C to be competitive in production of Good

G, the following inequality must hold:

1/aC0 > (ｗC/ｗJ) (1/aJ0) (16’）

32 The above expression, for the sake of simplicity, abstracted transport costs, customs, quality differences, and delivery date differences, but in reality, when these factors are taken in consideration, the productivity ratio can be lower than wage ratio for a domestic factory to remain competitive. For example, in a survey conducted by the authors in 2000, the wage for the Japanese operations J of Japanese car manufacturers was roughly five times that of Chinese operations C（ｗC/ｗJ = 1/5)，and productivity was roughly three times that of China（ｗC／ｗJ = 1/5)，but Japan operations were able to maintain competitiveness over Chinese operations.

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Remarks of the same kind are possible as the case of (16) with respect to which variables

are the object to work on and which should be regarded as given.

A Longer Term Perspective Let us go back to the perspective of Country J

again. Assume a situation where ｗC／ｗJ is fixed. Now assume that Firm C raised its

labor productivity. When this happens and if Firm J's labor productivity is fixed, then

inequality (15) will no more hold and sooner or later the following conditions will

appear :

wJ aJ0 ＞ wC aC0 or aJ0／aC0 ＞ ｗC／ｗJ . (17）

This is equivalent to condition (16'). In this case, it would be difficult for Firm J to

continue to produce Good G over a longer period of time. If the factory head of Firm J

wants to maintain production and employment of his factory, then it is inevitable to

maintain expression (16) so long as other conditions cannot be changed. He will be

required to raise labor productivity of his own factory.

As an example, when we can estimate the present day wage-rate ratio between

Japan and China at least at 5:1, then to maintain condition (16), the labor productivity

of Firm J's factory must be made to be more than five times that of the labor

productivity at Firm C's factory. It is not easy to bring out that degree of difference in

productivity between Japan’s and China's factories; however, depending on the industry

it is possible. Certainly, in the case of certain type of industries, for example the case of

petro-chemical industry for general use, where production technology is embodied in the

equipment, technology is standardized and moreover where it is difficult to differentiate

their organizational capabilities from other factories, then it is not easy to achieve a

sufficiently high level of relative productivity to offset that hurdle when faced with a

low-wage competitor country. The only method to escape this situation is to appeal large

scale production. The product life cycle hypothesis assumes this kind of scenario for

products in the standardization stage.

However, in the case of goods which require minute reciprocal adjustments

between the processes and tasks in the process designing and in the commercial

production, and when the organizational capabilities (relating to those adjustments)

would be reflected as differences in labor productivity and quality, we have actually

observed (especially in Japan) that the same factory's productivity has been improved on

the scale of three or even five times in a short period of time. For example, in many of

Japan’s machining factories, various ideas are applied in order to reduce workers' loss

49

time (standby time, wasted time) that doesn't create added value. For example,

modifications are made to tools such as cutting edges so that they could be operated with

“one touch”; automation, and semi-automation based on limit switches; single worker to

engage in multiple machine tasks ( “multi-tasked worker”). The high labor productivity

resulting from these minute but various efforts is often called the “learning effect,” but

at its essence, it is a reduction in total labor time aJ0 per product, stemming from an

accumulation of detailed tweaking of production processes and tasks, rather than being

due to “speeding up” or “making more efficient.”

The factory head's tasks, however, don't stop at realizing a certain level of labor

productivity. So long as Firm C's labor productivity remains fixed and both the countries'

wage-rate ratios stay fixed, then it is sufficient to achieve a constant labor productivity,

but Firm C's labor productivity is increasing as time passes. This is because Firm C

wants to compete with its production of Product G and tries to increase the productivity.

If condition (16) holds strictly, then Firm C's production of Good G will be in the red, or

won't be able to achieve their profit target ratio (when we assume certain range of

markup rate). Irrespective of this situation, Firm C continues to produce Good G. The

reason to do that is that as production continues, productivity increases, and in the

future they may be able to change their situation to fulfill expressions (17') and (16'). If

Firm C holds this kind of strategy and if it arrives to realize wanted level of productivity,

mainly by learning by doing, Firm J's will face a serious situation and competitive

condition (16) will be progressively broken down.

In the actual situation, we cannot assume that the wage rate and exchange rate

remain constant through time. All these figures may fluctuate. Therefore, it is not easy

to predict long-term sustainability of a factory, for the micro conditions whether a

factory’s operation is sustainable or not is determined by these figures together with the

productivity of the factory concerned and and those of the competitors.

Competition with respect to Intermediate Goods Costs and Fixed Costs

Until this point, we have considered the scenario where, with respect to comparisons of

both countries' production costs, intermediate goods costs were roughly the same for

each country's factory, that is, the following condition was fulfilled

<aJ+, p> ≒ <aC+, p> . (18)

In many industries, this kind of situation holds approximately and this legitimizes the

analysis based on the assumption of Ricardo's labor input economy. But, this kind of

50

situation does not necessarily hold in all industries. In the following section we will

discuss international competition in situations where (18) does not hold.

Effects of the Yield Constant and Yield Ratio (mainly in the process industry) In

the classification of manufacturing technology, there are industries such as the chemical

industry, the steel industry, the semiconductor industry, and other process industries

including food products industry, whose material productivities called “yield constant,”

“yield ratio” and “basic unit” are vital to the cost competition. In these industries, the

material costs (including fuel cost) account for a large proportion of manufacturing costs

and the difference of yield constant, yield ratio, and basic unit can change greatly the

unit cost of the products. For such industries, hypothesis (18) never holds, and the mode

of competition varies greatly33.

In order for Firm J (or Firm J's factory) to remain competitive with Firm C (or Factory C

of the same multi-national Firm J) while producing the same product, it is necessary to

maintain the following inequality:

wJ aJ0 + <aJ+, p> <wC aC0 + <aC+, p>.

A separate discussion is normally needed with respect to transport costs and customs for

two cases where the product is exported from Country C to Country J and where it is

exported from Country J to Country C, but we will not discuss this point in detail for

this is easily understood In addition, there may be a minor difference for raw materials

price depending on country, but here also we will assume that the material prices of both

the countries are the same.

Even if the labor input coefficient is nearly equal for both countries J and C,

and Country J's wage rate wJ is five times Country C's wage rate wC, Factory J can

maintain its competitiveness, when the proportion of materials costs accounts for a large

part of the unit cost, and if we have a certain difference in the yield constant. For

example, let us assume that wages account for ten percent with respect to the

composition of Factory J's unit cost. When J's unit cost is exactly 100 then

Factory J's Cost Wages 10 Raw Materials 90 Total Cost 100.

33 Changes in material productivity and differences between firms can also occur in the assembly industry. For example, a certain Japanese car maker in the 1990s, in order to counteract cost pressure owing to a high yen, strengthened its Value Engineering (VE) activities to rationalize manufacturing design without lowering product functionality. When faced with a change from an old model to a new model, the company reduced the number of bolts required in a certain luxury model by 20%.

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If we assume Factory C's yield constant ten percent worse, cost composition of Factory C

is something like this (we are assuming wJ/wC =5):

Factory C's Cost Wages 2 Raw Materials 99 Total Cost Price 101.

In this situation, Factory J can maintain its competitiveness with respect to Factory C.

In the case of a product where wages account for 20%, whether Factory J can

keep competitiveness depends on how big the difference of yield constant is. For example,

if the difference is only 10% or 20%, the competitiveness would be lost, but if the

difference is the order of 25%, then, Factory J can well continue to compete with Factory

C, as you see as follows:

Factory J's Cost Wages 20 Raw Materials 80 Total Cost Price 100

Factory C's Cost Wages 4 Raw Materials 100 Total Cost Price 104

In this way, for products where the wage composition ratio with respect to total

unit cost price is low, factory with a high wage rate like Country J can maintain

competitiveness if it can realize a certain level of differences in yield constant or yield

ratio.

On the other hand, in industries where materials cost ratio with respect to the

unit cost is low, even with a marked difference in yield constant or yield ratio, the state

approaches to the situation where expression (18) holds. In this case, when there is a

large difference in both the countries’ wage rates, the factory in the high wage country is

forced to raise its own factory’s labor productivity sufficiently more than the other

country’s factory to counteract the factory within the low wage. country.

At a glance, this conclusion seems to contradict the popular understanding that

it is easier for developed countries to be competitive with high value-added products.

However, this conclusion holds only under the in the case the assumption that two

factories J and C are competing with the same product of the same quality (which is the

basic hypotheses that this paper sets out.) With respect to the competition where the

firms compete with different but substitutable products, or with the same product but of

different qualities it is possible that a different conclusion is obtained.

With respect to the reasons why differences in yield constant or yield ratio arise,

various factors can be considered. In the chemical industry, you may point out

differences in knowledge relating to control technology and optimal conditions, and

differences in knowhow relating to the mixing ratio of ingredients. If we assume they are

supported by the high skill of laborers who work in the factory, it is plausible that the

wages of skilled laborers are high. In the case of products where one product is composed

52

of many elements and components, such as liquid crystal displays and rockets, and when

it is requested that every one of those elements and components functions properly, it is

possible that the yield ratio of accepted products among finished product could be

extremely low.

In the case where the upper limits of yield ratio or yield constant can be

theoretically estimated, if the firm (or the business operation) in a developing nation can

raise yield ratio based on the technological knowledge, it would be difficult for a factory

(or the business operation) in a developed nation to continue to secure a yield ratio

difference in such a way that it could maintain competitiveness. However, there are

areas where a business operation's organizational capabilities can greatly affect yield

ratio, and in that case, there are situations where the business operations of a developed

country with high organizational capabilities can hold onto cost competitiveness over the

long-term. Whatever the case may be, for management to make a strategic choice, it is

necessary to build up a portfolio of products on the base of this kind of estimate and

calculation, keeping a close eye on the long-term movements of yield constant/yield ratio

and the long-term movements of wage rates and exchange rate.

Competition in Fixed Costs Product cost may differ even if labor

productivity or yield constant and yield ratio do not differ too much. Things related to

fixed installations and machines are one of such examples. For instance, imagine the

case where Factory J is producing product G using machinery equipment that is

depreciated, and Factory C using equipment that is still new. In this situation, even if

Factory J's proportional costs are higher than Factory C's proportional costs, Factory J

could still be competitive for a time, once you consider the depreciation cost per product.

If you purchase production equipment to produce the same product from third

party firm, its difficult to think of a huge difference in purchase price, whether the

purchasing entity is in Country J or Country C. However, in the case that a company

could internally manufacture production equipment, or in the case that the machine

making process is outsourced but detailed adjustments are conducted on site in response

to the actual production situation, Factory J may maintain its competitiveness as a

whole, if the Factory J has a higher organizational capability to do this despite the fact

that Factory J is losing to Factory C in direct labor costs and raw materials costs..

With respect to the depreciation costs of fixed equipment, there are many cases

where it is calculated as a constant without counting production volume. Because of this

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convention, even in the case where proportional costs are comparable, Factory J may

keep competitiveness when Factory J has a larger market share than it rival factory in C.

However, in such a case, there is a chance that Factory C will set off price competition in

order to obtain a larger market share by reducing its mark-up rate.

The designing and development costs for a product have the similar

characteristics as the depreciation cost for the fixed equipments. As long as products of

the same quality are produced, there is no necessity to differentiate between fixed costs

arising from design/development and fixed costs arising from equipment. However,

designing and development, without fail, has the aspect of designing and developing a

new product. Obviously these operations are something that changes the quality and

function of the product. Therefore, in so far as designing and development are relates to

competition, the resulting competition has to be seen as competition between “goods of

the same kind but of different qualities,” rather than the competition of the same

product. This kind of competition, as already stated, cannot be discussed just through

comparisons of production cost and will not be discussed in this paper. Those who have

an interest in the competition on this perspective, are requested to refer to Fujimoto

(2007a and 2007b)34. A framework of analysis which should be called “The Comparative

Advantage Theory of Design” is presented there.

6. Nominal Wage Rate/Exchange Rate and the Micro–Macro Loop

In the micro world of factories and production sites, labor input coefficient (and material

input coefficients) can no longer be regarded as given once production has been started.

They are rather an object which should be constantly improved by the efforts related to

capability-building. In general, the production process at high labor-productivity sites

will retain a higher organizational capability in manufacturing. The organizational

capability of a production site is the system of specific routines retained by the

organization that allow for the factory to stably maintain a high level of competitiveness

in productivity, as well as in lead times and quality of the production site (Nelson and

Winter, 1982; Fujimoto, 1999). For example, “The Toyota Production System” is said to

consist of over 400 organizational routines. These organizational routines, in fact, make

34 See also Fujimoto and Oshika (2006), Fujimoto and Helle (2001), where a rough idea of the

comparative theory of design is explained. See also papers cited in the footnote 27.

54

it possible to generate a stable superiority in productivity, lead time, and manufacturing

quality for Toyota and make up an organizational capability that is specific to the firm

and the production site.

In this way, the organizational capability of the production site of a firm is

specific to the production site or to the factory, but it is not impossible to learn and

obtain for foreign firms or for an overseas production site of the said firm.

Transfer of Organizational Capabilities For example, the various tricks and

techniques used to realize high productivity in Japanese firms are not all necessarily

kept secret. Certain elements of the Toyota-style capability exist as common knowledge

in areas like production engineering. Therefore, with respect to a particular production

process, a low productivity factory may gradually come near to the level of a high

productivity factory, if you continue to make efforts to raise labor productivity through a

process of trial and error. It may take a long time, but with respect to the automobile

assembly industry in Japan, America, and Europe, a kind of convergence has been

observed since the 1990s.

If such a general trend is observed, then advanced Firm J, so as to maintain

competitive condition (15), has to carry out capability building for its own Japanese

factories around the clock. This is the only way to keep competitiveness against foreign

firms or firms’ own overseas factories. A production site, which is unable to do this,

would have to abandon to continue the production in that site and give way to the

foreign firms or oversees factory of the same firm. As an aggregate effect of these kinds

of location transfers each country's industry structure would change continuously.

Firms and factories in today’s Japan have overcome the high wage handicap

and remain competitive in such items as luxury cars and a portion of industrial goods.

This has been possible based on capability-building efforts. One may cite as some of

examples products where implicit knowledge plays an important role in the production

process and products whose process architecture (design form) remain in the integral

side rather than modular side. On the other hand, in the fields where the “advantage of

backwardness” is manifest in a sense that catch up is relatively easy, it was difficult for

Japanese firms to maintain competitive advantage (14). For example, standard memory

semiconductors and digital products lost their competitiveness rather quickly, for in

those industries, key technologies (or design contents) were easy to standardize and

product/process architecture (design form) was relatively modular rather than integral.

55

Let us take a hypothetical situation. Assume many of Country J's industries

lose competitiveness owing to improvements of productivity in developing countries.

Country C will accumulate a huge surplus in the balance of payment and Country J will

accumulate a huge deficit. Then it is inevitable, in the long run, that the exchange rate

between the two countries will change. In this situation, even if the nominal wage rates

remain constant in the face-value of both countries' official currency, the wage-rate ratio

across national borders will change. There can also be another path in which the wage-

rate ratioｗJ /ｗC will change between Countries J and C. Lets assume that many firms

in Country J lose their competitiveness, and face bankruptcy. If new firms don't appear

and grow, the employed population may shrink at a rate surpassing the rate of decline in

the general population, and there could be a situation where society is inundated with

unemployed. In such a situation, the wage rate will be reduced nominally and in real

terms in the long run. On the other hand, Country C will come to domestically produce

products which it had traditionally imported from Country J, and may even come to

export them to Country J. When employed population growth rate exceeds the labor

force growth rate, labor shortages and wage rises occur. The wage-rate ratio ｗJ /ｗC

does not stay the same forever, but will change in the long-run.

Obviously, changes in the wage-rate ratio ｗJ /ｗC will have a strong impact on the

competitive situation of individual firms. For example, in the case of a sudden decline in

the wage-rate ratio ｗJ /ｗC, then a firm that would have lost its competitiveness if the

ratio remains constant, may regain the competitiveness. Conversely, if ｗJ /ｗC rises

suddenly, many firms in Country J will not be able to help losing competitiveness.

The wage-rate ratio ｗJ /ｗC is not a variable which is controllable by the efforts

of individual firms. But it is not independent of each firm's micro-level efforts over

capability-building and price competition. The efforts of each firm fighting for survival

are summed up at a macro level and the wage rate and exchange rate change. Individual

firms are affected by the aggregated result. The authors of this paper call this cycle of

causes “the macro–micro loop.” In this section, we discuss the micro–macro loop between

macro variables such as nominal wage rate and exchange rate, and the micro efforts of

firms.

Lowering Nominal Wage Rate/Exchange Rate and its Limitations In Section 5, we

considered the wage rates ｗJ andｗC of the two trading countries as a given for micro

56

agents (managers of firms and factory leaders). However, speaking from a macro

standpoint, of course wage rates trend naturally, but in certain cases they can seen as a

policy variable. Then, should wage levels be viewed as a given or as a manipulative

variable, when looked at from the managers and factory leaders perspective? It’s

common to hear statements from company mangers and economic journalists who state

that wage levels in this country should either be lowered or the country's currency

should be devalued (or a competitor country's currency should be devalued) to win out in

global competition. These are recommendations, which view wage levels and the

exchange rate as policy variables. However, are these claims appropriate as an economic

policy?

Now, let us assume that for Firm J's managers (or Factory J's head), have a

certain degree of control with respect toｗJ although they cannot control wC. For the

managers of Firm J (or Factory J) aside from raising labor productivity 1/aJ0 in

expression (16), there is another choice to maintain competitiveness. That is to lowerｗJ.

However, if we look at this in the long term, it is a difficult strategy to maintain.

First, let us assume that the Factory J could lower the nominal wage rate (ｗJ).

In the short run the product unit cost of the factory would be lowered, and the factory’s

cost competitiveness (aJ0 ｗJ) would temporarily increase. However, if it tries to maintain

competitiveness solely by devaluing the wage rate of their own factory without

endeavoring to improve productivity (1/aJ0) at all, the factory will be forced into further

wage cuts, for the productivity in the low-wage Country C improves and the rate of

improvement normally exceeds the increase of wage rates. The same story is applicable

when a new country with wage rate lower than Country C (e.g., Vietnam in place of

China) enters the market. Once this happens, domestic sites will have to endlessly carry

out wage cuts. In such a situation, the domestic workers' motivation will decline, the

risk of disputes heightens, the rate of workers leaving their jobs increases. The

organizational capabilities of the factory, which depend on the teamwork of multi-tasked

workers, will be dissolved and labor productivity will further worsen.

The act of cutting wages by the factory in a higher wage country has a high

chance of leading to ultimate closure, due to the aforesaid vicious cycle. In that sense, it

is hard to say that just trying to remain competitive through cutting wages is a

sustainable strategy in the long term. In other words, an industry comprised of factories

with organizational capability stagnating that can only stay competitive by cutting

wages is an industry in which Country J will never have a comparative advantage in

57

Country J. We should have no illusion that disappearance of such an industry is

avoidable for a long time.

Secondly, owing to the devaluation of the exchange rate, it is also possible to

have a circumstance where relative wage rates for Country J vis-à-vis Country C in fact

decrease. If for example the government induces the exchange rate in the direction of

devaluing Country J's currency, factories in Country J will be able to obtain the same

effect as wage cuts, even without negotiating wage cuts for individual companies In this

sense a least, devaluing the exchange rate is more desirable for managers than

negotiating nominal wage cuts and demoralizing their workers, for they may avoid the

vicious cycle previously stated.

In fact, on the stage of international political economy, this kind of

maneuvering between governments around the exchange rates is now very common. In

particular, rather than devalue their own currency, governments more often demand

their counterpart countries to revalue the currency of the latter.

In spite of political maneuvering, the exchange rate under the modern floating

rate system is not something that one government can completely control in the long

term. It fluctuates based on various economic and non-economic factors (economic

growth rate, saving rate, capital investment rate, interest rates, inflation rate, and

others).

The Exchange Rate in a Floating System Many general equilibrium models

assume that exchange rate would be determined at the point where trade balances. But,

in reality, it does not always settle on the point where imports and exports balance

between two countries. It is true that there is a mechanism working that stops the

balance of trade from getting too big, but in the medium term, many countries

experience a situation where trade balance leans in one direction. Japan has mostly run

a trade surplus in the last 30 years or more. However, if we go back to before 1970,

Japan had struggled with trade deficits for a long period. As is apparent from this

history, there is a tendency for surpluses and deficits to run for a long period. At the side

of trade surpluses and deficits, there is a separate movement of the balance of

international payments, which focuses on capital transfer. At the background of this

situation this is a difference between our country's growth rate and the saving rate.

Here speculative capital enters the market in order to make profit of this indeterminate

character of the exchange rate and the exchange rate becomes to fluctuate with much

58

more volatility.

There are many choices as to how a country's currency value should be

positioned. It depends on the circumstances of the country, but if it is one of the political

goals to raise the general income level of the public, then there is no way that devaluing

our own currency can pass as a policy goal based on a long-term perspective.

Devaluation of the currency may contribute to maintain competitiveness of our factories,

it also has a bad influence on the nation's economy, for it causes inflation stemming from

rising import prices. However, the essential point is. as we have discussed in the

previous section, that it only leads to abandonment of capability-building efforts at the

production sites. In those circumstances, you can't maintain a nation's average levels of

productivity and wages. As a conclusion, it should be noted that it is more desirable to

maintain or increase our currency values, and increase the average wage level35 in order

to improve the average living standard of the public,.

When looking at the exchange rate from a long-term perspective, it should not be

thought of as a policy variable, but as a quantity that decides the economic conditions

between countries. Even on this understanding, long term trend of the exchange rate

must be a key factor when one wants to dress up strategic policy related to the trade

problem. Precise estimate is not necessary, but you have to have the large trend in mind.

Even in Ricardo's chapter on international trade, there is a discussion relating to how

exchange rate and each country's currency value is decided, but we are unable to accept

his analysis as such for it displays a strong tendency toward a quantity theory of money.

However, couldn't we say that it is a simple interpretation based on the Ricardian theory

to think that the exchange rate is determined in loose relationship with respect to the

balance of trade, so that the balance lies within the allowed upper and lower limits?

These limits will be determined by various factors including each industry's relative

productivity and the relative wage rate between rival countries For example, if we take

world demand for each traded good industry on the horizontal axis (with the highest

productivity industry to the rightist), while on the vertical axis we take relative

productivity of each industry for a model case of two countries and many-commodities as

it is mentioned above, a chart can be given as follows:

35 In economic journalism, a tendency to welcome drops in the currency value can be seen. These kinds of statements must be based on the provisions that they ease immediate conditions for individual firms and industries in the direction to regain competitive advantage. But we cannot think they are due to demands from the perspective of the whole public.

59

If the upper and lower limits for allowed balance of trade are determined based

on economic and non-economic factors, and a relative productivity aJ0 /aC0 profile from

bottom to top are as a given, then the allowed range of both countries' wage rates and

exchange rate will also be determined at the same time. If Country C's factories by and

large catch up Country J in productivity (1/aC ↑), then as a whole the relative

productivity profile will drop. In that case, the relative wage rate ｗJ /wC (measured by a

common currency) will be adjusted so that it settles within the allowed limits for balance

of trade in the long term36. This adjustment will be realized, as mentioned above,

through the Country J’s nominal wage cut (w*J a↓), the Country C’s nominal wage up

(w*C ↑), the devaluation of J’s currency value, the revaluation of C’s currency value and

through the combination of all these four37.

Thus, from a macro adjustment perspective, there will be no big errors to think

that the exchange rate and nominal wage rates are determined simultaneously (or, more

appropriately, are determined through the micro–macro loop process), supposing that

the relative productivity profile for each industry (aggregated average of many

36 WJ and wC are measured in a certain common international currency by the initial agreement. If you use nominal wage rates w*J and w*C, expressed in Japanese and Chinese currencies, then it is necessary to multiply the ratio w*J and w*C by the two country’s exchange rate XJC (Japanese Yen over Chinese Yuan). 37 Symbols with asterisk w*J and w*C express the nominal wage rate measured by the country’s official currency, as opposed to w*J and w*C , which are expressed by the common international currency.

Relative Productivity/Wage Rate/Exchange Rate/Balance of Trade (Two-Country, Many-Commodity Model)

World demand for traded goods

aC0/aJ0

wJ/wC

Import =M Export = E

Balance of Trade Point (E=M)

Lower limit of Balance Upper limit of Balance

Allowed range of balance of trade

Relative productivity

Relative wage rate

Imported goods Exported goods

60

production sites), and the upper and lower limits for the allowed balance of trade are

given. In this loose sense, if the country is leaning towards running a trade surplus, then

the country's currency exchange rate will increase, and if the inverse is true, then it will

trend lower.

As a summery, although there is a certain degree of leeway, for politicians and

economists, in manipulating the exchange rate and nominal wage rates, it will be safe to

assume a macro causal relationship that “the total profile of relative productivity decides

the combination of wages and exchange rates,” if one thinks in the long run and in a

comprehensive way.

The Macro–micro loop in Country C Let us move our viewpoint from Country

J with higher wage rates to Country C with lower wage rates. The managers of Country

C will have different issues than the managers of Country J. For Country C's firms (or

for factories in Country C of a single multinational company), the issue for the time

being is how to switch from the first condition

aJ0 /aC0 < wC /wJ (19）

to the second condition

aC0 /aJ0 < wJ /wC (19’）

as fast as they can.

In a hypothetical industry area (say textile products or home electronic

appliances), when many firms in Country C succeed in their efforts, Country J's

production sites will lose competitiveness in the said product. It is thought that this

change in circumstances will cause a reduction of exports for Country J and an increase

in exports for Country C.

If we assume that this kind of reversal phenomenon (from export products to

import products) occurs in many industries, then the aforementioned macro adjustment

process will take place and Country C’s currency will be revalued (upwards) with respect

to the currency of Country J (we assume that we can ignore the relationships with a

third country at this point),. Whether you consider a floating system or a managed

currency system, it should be assumed that this kind of situation could occur sooner or

later. Another possibility is that we will see a sharp rise in the wages of Country C. In

particular, if the exchange rate for C’ currency is induced to move lower than the proper

level, and in the scenario that the economy of Country C is faced with inflationary

pressure, the pressure to raise the nominal wage rates would surely increase.

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In these circumstances, firms (or factories) in Country C will be put in the

confluence of two conflicting trends in relation to competitive condition (19). One of these

is improvements of the labor productivity in their factory (a reduction in aC0). The other

is a revaluation of the exchange rate xCJ (exchange rate of C’ currency over J’s currency)

or a rise of the nominal wage rate wC of the workers. In a situation where competitive

conditions were close to the changeover point from (19) to (19') and vis versa, firms (or

factories) which enjoyed the competitive condition (19') may be pushed into a competitive

condition (19), when there is a sharp increase for the exchange rate and when the

improvement of labor productivity does not keep up with the pace of revaluation. The

same thing could happen in the case when the wage rate suddenly rises due to the

tightness of domestic labor supply.

Fluctuations in the exchange rate do not reflect only the relative productivity between

the two countries. There are also short-term exchange fluctuations that go hand-in-hand

with capital movements and manipulations of the rate based on political intent. However,

let us here assume that the exchange rate, over the long term and on average, reflects

the total level of productivity of the two countries that trade. Each factory in Country C

will try to improve its competitiveness through improving labor productivity. But here

starts an eternal cycle. Factories of Country C in all industries will be doing the same

thing and the exchange rate will be raised as a result that many of factories will be a

strong exporter. Then, the relative wage wC will be coerced to get higher (due to an

increases in the exchange rate), and if looked at just from an international competition

angle, this will work to offset increases in labor productivity. It is thought that China is

experiencing this kind of process now, but Japan had also once experienced this same

process (with the U.S.A as its rival).

This is similar to the handicap in amateur golf. As a result of devoting

themselves, amateur golfers can reach a point where they can win back-to-back, but

when this happens, the handicap is revised to balance out the number of wins and losses.

In this analogy, the golfer's capability is the total productivity profile, the handicap is

the nominal wage and exchange rates (and by extension, the living standards of the

public), and “the balance of wins and losses” stands for the more convergent balance of

the trade.

To return to the subject, the above story means there exits a loop of interactions

between macro parameter, which is the exchange rate (or relative wage rate ratio) in the

case of international competition, and the micro variables such as productivities for each

62

factory. The causal chain forms a cycle, but those influences become effective always

with a time lag.

7. The Macro–micro loop on the meso-Level

Modern-day firms, or most of the larger firms, are both diversified firms (Chandler,

1962) and multinational companies (Hymer, 1976). Now, if following standard economics

terminologies we call the smallest unit a “micro-level economic agent,” then that is a

“operation unit” (factory, office) and not necessarily a “firm.” These units are the agents

who control inputs and outputs in the production and thus determine material and labor

input coefficients (material and labor productivity).

On one hand, if we call an aggregation of economic agents (operation sites)

having similar characteristics the “semi-micro” level, then an industry of a country

would be a typical “semi-micro” entity, being an aggregation of production sites in the

same region producing the same (or similar) good. Then, what about firms?

Of course, each firm or a marginal firm can be called a micro economic agent as

far it is an entity with only a single factory and has only one production unit in the

factory. However, diversified firms are fundamentally an aggregation of multiple

divisions and offices, and are made up of multiple sites which share the common

characteristics of “being under the control of the same capital.” In this sense, they should

instead be looked at as “semi-micro” or “meso” level economic units.

Meso-level economic agents and comparative advantage

Until now, we have basically considered the production of a single product of a single

production site of a single firm; but in the following, let us examine competitive

conditions for semi-macro or meso-level economic agents. Explicit examinations of these

circumstances are rather rare to be seen in the literature but these circumstances have

gradually increased their importance along with the multiplication of diversified and

multinational enterprises. In the following, we will typically discuss the situation where

the near-equality (18)

<aJ+, p> ≒ <aC+, p> (18)

holds. This is the same assumption we made in Section 5 hold when we considered the

situation where the intermediate products are internationally traded.

In the discussion below, as we will be taking into consideration the production

63

of multiple goods, we use again the symbol system from the scenario where the labor is

the only input. If the assumption (18) does not hold, many minuscule reservations and a

more complicated explication would be required, but as the key points for these analyses

are shown in the second half of Section 5, we will not enter in the details. If necessity,

the readers will be able to conduct an analysis by themselves. The objective of this

section is to demonstrate that the discussions based on the Ricardian comparative cost

principle are not only applicable for the case of multi-national and multi-divisional

companies, but that they also have a real life validity and can actually contribute to the

strategic analysis for these companies.

The Case of a Diversified Domestic Firm If you are a manager of a modern-

day diversified firm (or a factory that deals with multiple areas), then you have to build

a strategy that deals with how to assort your product portfolio. This decision may not

have a big influence in the short run, but evidently is vital for the firm in the long run

Let us assume that a certain diversified Firm E located in Country J enters

Industry 1 and Industry 2, and that the respective labor coefficients are aJ1 and aJ2. In

this case, the managers of Firm E stand in a similar situation as the aforementioned

“the policy maker” who does an inter-industrial analysis. That is, these managers know

not only the labor input coefficients of these two industries (two business units or two-

factories), but also the marginal rate of transformation aJ1/aJ2 between them.

With this information alone, you do not know which industry to maintain and from

which industry to exit. This is the limitation of the “inter-industrial comparison” that we

discussed in Section 2. However, now let us assume that, as a result of international

trade (or by means of market research), you came to know the international price ratio

p1 /p2. This is the terms of trade for both industries. We may also assume that wage wJ of

Firm E does not change for Business Unit 1 and Business Unit 2. In this situation, if the

inequality aJ1/aJ2 > p1/p2 holds, then p2 /(aJ2 wJ) > p1 /(aJ1 wJ) holds. Since the profit rate

is greater for Business Unit 2 than for Business Unit 1, if Firm E is to maximize its

profits with limited capital and staff numbers, then you should stop operation of

Business Unit 1 and concentrate its workers in Business Unit 2. Conversely, if aJ1/aJ2 <

p1/p2 holds, then p2/(aJ2 wJ) < p1/(aJ1 wJ) holds. In this case, Firm E should retreat from

the operation of Business Unit 2 and concentrate its workers in Business Unit 138. In

38 It must be emphasized that the Business Unit with the lesser profit rate may not be operating at a loss. Even in this case, the above recommendation is valuable when one wants to raise the firm’s total

64

other words, even if you try to raise labor productivity but if it seems difficult to

maintain the competitiveness of your company, while maintaining the international

value of your currency (the currency of Country J), then you should consider, either

exiting from that industry at all and turning over that business to your competitors or to

other countries. If you are the director and does not wish to close your factory, then you

must consider switching over to a new product.

In this way, with respect to the decision for modern-day diversified companies

which business to enter into and exit from, comparative cost analysis is still useful with

its ”macro perspective judgment” or “inter-industrial” comparisons of labor-input

coefficients. This is because a diversified company itself is a microcosm of one country's

industrial structure.

The Case of a Diversified Multinational Firm A typical modern-day

large firm is a diversified multinational company. What happens in this situation? Now

imagine a diversified multinational firm M that is producing two Goods 1 and 2, in each

of two Countries J and C. Firm M, through its firm activities, will know all of the labor

coefficients (productivity) aJ1，aJ2，aC1，aC2 and the wave levels wJ and wC of both

countries. Therefore, Firm M will be able to know, by the actual experience, all the

terms which appear in expression (4) in Section 2.

Now, let us assume that the following evaluation holds with respect to the firm:

aJ1 /aC1 < ｗC /ｗJ < aJ2 /aC2 （4）

If Firm M has confidence that this relationship will not change for a long time, you could

consider that operating Business 1 in Country J and Business 2 in Country C would be

appropriate by the comparative advantage principle. Conversely, if the following chain of

inequalities

aJ2/aC2 <ｗC/ｗJ < aJ1/aC1

holds, then it would be appropriate for Firm M to develop Business 1 in Country C and

Business 2 in Country J by the same principle.

This logic of analysis theory can also be extended to the situation where a firm

produces many products in both of countries J and K, as we have discussed it in Section

2 with respect to the case of two-countries and many-commodities,. That is, if Firm M

through those activities, recognizes that the chain of inequality (10), i.e. profit rate higher.

65

aJ1/aC1 <<aJs/aCs <wC/wJ <aJ (s + 1)/aC (s + 1)<<aJN/aCN (10)

holds, then the firm should choose businesses from Good 1 to Good (s) to produce in

Country J, and choose businesses from Good s+1 to Good N to produce in Country C. In

the case of a diversified multinational firm, managers build up a product portfolio in

each country, very much like a policy maker with a macro perspective makes decisions.

The Case of a Multinational Specialized Firm What about the Firm

U which specializes only in Industry i, but is already multinationalized. This firm can

easily know through its multinational activities, labor input coefficients aJi and aCi

(reciprocals of labor productivity with respect to Good i) for its production bases in

Country J and Country C, respectively. The firm also knows wage rate wJ and wC for

both countries. Therefore, if we know that the following inequality aJi/aCi < ｗC/ｗJ holds

true, then the Firm U would think that it should carry out production only in Country J,

according to the micro perspective comparative advantage criterion (the reverse also

holds true). However, if there are sufficient reasons to overcome differences in

production costs, in account of transport fees, customs, the stickiness of information, or

some other reasons, then Firm U will and maintain production in both countries. More

specifically, if multinational firm U through some historical reasons has succeeded to get

a productivity aCU that is superior to the local firm's productivity aCL, or in other words,

if the expression aCU <aCL holds, then Firm U will have the motivation to continue to

produce in Country C (Hymer, 1976; Dunning and Narula, 2005 et al.).

The Problem of “over-focusing” on the present situation

A multi-nationalized firm, specialized or diversified, can get more accurate production

data than a firm that produces within one country. On that point, multinational firms

have an advantage compared to domestic firms. However, it is also important to note

that this can also become a weak-point for the firm. That is the problem of being too

much depended on the current status (short-term information).

As we have seen in the foregoing passages, multinational firms, through their

international activities related to Industry i, can obtain information with respect to labor

input coefficients aJi and aCi and wage rates wJ and wC. Based on this information, the

firm can confirm if each country’s production cites have a the Ricardian comparative

advantage. Therefore, the firm can dress up an appropriate strategy with respect to the

66

locations to produce. However, thus obtained information is not the information that has

accurately estimated the organizational capability which permits each production unit to

attempt to raise productivity in the long term. One of the reasons includes the fact that

there are information gap to be filled between the top managers of these multinational

firms and each production site leaders. Of course, it cannot always be said that the

production site leaders have more objective and more accurate insight on the capability-

building abilities of the production site. However, on the other hand, it also cannot be

said that the top management of multinational firms thoroughly knows the capability-

building abilities of each business site (i.e long-term trends in aJi and aCi). The same

assertion applies to the top management of conglomerates, which have many business

divisions in many countries. .

The top management of diversified multinational firms can be swayed by short-

term information about the labor input coefficients (e.g., information statically grasped

from the financial closing statements for the year), and there is a possibility that they

will make mistakes in the long-term strategy. Because the capability building of a

production cite is a long-term evolutionary phenomenon, which may be analyzed only by

the evolutionary economics framework, management decisions based on expression (4)

and expression (10) ultimately must be made with a view on the future movements of

those variables concerned. Making a mistake on that point can lead to mistakes in

making long-term strategies on the account of being “over-focused”, so to speak, on

short-term cost information. If short-sighted firms like these increase, the industrial

structure of a country may suffer for a long time by the damage of wrong managerial

judgment

The Case of a domestic specialized firm The same problem can occur to a

certain degree in a multi-level domestic specialized company as well. However, to the

extent that it does not have an overseas base, the problem of “over-focusing” on short-

term data is not as big as with the previously stated multinational firms.

Then let us take a look at a small /medium Firm S that is active only in Industry i in

Country J. The only firm information that Firm S can get is the information related to

productivity aJi obtained at its production site in Country J, wage rate wJ at its

production base in Country J, and the purchase price for input goods and the like. With

regards to the situation of its rivals in Country C, it may probably have information

related to Good i price and vague information, guessed from the average wage rate wC of

67

Country C. In other words, it does not have precise information about aCi and wC or

availability of input goods and their purchase prices.

Under these circumstances, what Firm S can first do is to refer to the product

price pCi of its rival firm in Country C. It can compare that with its own production cost.

As a result of this comparison, if at present it is the underdog or it is understood that

rival companies may go on the offensive in a near future, then first of all, they will try to

reduce their own labor input coefficient aJi and input coefficients based on capability-

building efforts. For Firm S, there are not that many choices outside of this. When they

cannot adopt a strategy of shifting production site to Country C, then what Firm S can

do (excluding developing a new product) is nothing other than tackling improvements in

labor and material productivity. This is, so to speak, desperate behavior. In reality,

however, there are more than a few examples of small/ medium firms which are more

advanced and powerful than diversified/ multinational firms. Those firms excel in staff

training and capability building and can endure in a recession or under strong Yen

conditions. This is a positive aspect of Japan's small/medium firms (the collective of

production sites).

Efforts like these may not yield good results by themselves. However, efforts

like these may extend to other groups of production sites in Country J. Because these

firms and production sites have only limited options, similar capability-building efforts

are deployed throughout the various industries in Country J. When considered

individually, it may seem impossible that this kind of concerted effort may actually bring

about good results. In reality it is occurring. The productivity profile of Country J per

industry/site may improve, and the competitiveness of the country as a whole may be

regained. In other words, no matter how much the exchange rate and average wage rises,

they may be able to maintain sufficient competitiveness for the productions within their

own-country.

To put the situation inside out, information availability may cause a wrong

effect. If site-related information (e.g., wage and productivity) is too visible to the

competing firms, many of Country J's firms may plan to shift their production location to

Country C without trying to build capabilities for competitiveness by the efforts to raise

labor and material productivity. This may lead to the counter effect to promote

productivity in Country C and Country J could fall into a vicious cycle of weakening

competitiveness.

68

The Case of a specialized multinational firm As stated previously, in the case of

a multinational firm U specializing in a unique Industry I, the top management,

through the experience of production sites deployed internationally,. will know the labor

coefficients aJi and aCi at the production sites in Country J and Country C, and the wage

levels wJ and wC of both countries, In this case, based on whether aJi/aCi < wC/wJ holds, or

conversely, aJi/ aCi > wC/wJ holds, the decision will be made as to whether they should

keep the base of Country J or Country C. The problems are whether a judgment is made

through this process, based on the proper evaluation and assessment with respect to

medium/long-term movements. In this evaluation and assessment, most important one

is the estimation of the capability-building ability of each production sites.

For example, when aJi /aCi < wC /wJ is observed by the recent assessment, there

is a possibility that the managers of production sites in J will be satisfied with this

result and sufficient capability-building efforts（aJi ↓）will not be made. Conversely,

when aJi/ aCi > wC/wJ is observed on recent information, there is a possibility that the top

management of Firm U will easily conclude that the production site in Country J should

be closed definitely.

Generally speaking, as information such as aJi / aCi > wC /wJ is so clear and

evident, there is a strong possibility that before carrying out sufficient capability-

building efforts (aJi ↓), the top management of a multinational firm will decide to close

the base of Country J and concentrate its production in Country C. This is the problem

of misjudgment, some times called “over-focusing” problem. This kind of misjudgment

occurs especially when the capital markets gives a strong pressure to raise “short-term

results.”

Of course, in spite of Country J’s all capability-building efforts to raise

productivity (aJi ↓), if this is an unavoidable long-term trend in favor of production in

Country C, then an all-front shift of factories to Country C may be justified. However,

both labor productivity and wage rate and exchange rate widely fluctuate in the long run.

Relying too much on the short-term data, and making a hasty decision to concentrate

production site may cause a negative effect on the long-term results of Firm U,

productivity improvements in Industry i, and also on the living standards for the public

of Country J.

The Case of a Diversified Multinational Firm This risk, in the case of a

diversified multinational firm, can be much greater. Even under the aforementioned

69

circumstances, diversified multinational Firm M, can take a decision to maintain other

businesses in Country J. If the firm can shift its workers to these other businesses, the

decision to close the production unit of Good i will be much easier than Firm U which

does not have an alternative choice to produce other goods in the same Factory.

In recent years, some people in fact point out that there are differences in the

capability-building efforts within the domestic production sites between a Japanese

automaker (similar to the specialized multinational Firm U), and an electronic appliance

firm (similar to the diversified multinational Firm M). In a sense, you could say that

electronic appliance firms made an appropriate choice reflecting the long-term trends in

comparative advantage, but in another sense, these firms (diversified multinational

Firm M) may be possibly revealing a problem of “a lack of capability-building efforts”

relying too much on short term information.

This paper presupposes a dynamic micro–macro loop that cycles between micro

capability-building efforts and macro wage and exchange rate decisions. In view of this

dynamic framework, the problem that “foreign production deployment gives rise to

excessive shift to foreign production base” appears to be an extremely modern-day

problem. This can only be analyzed by a combination of the Ricardian comparative

advantage theory and the multinational company theory. In this sense, 19th century

Ricardian trade theory can be seen as applicable to most modern situation in which we

live today.

8. Implications for trade theory and conclusion

In this paper, we conducted various discussions focusing on how the managers of each

firm or factory leaders conducted and were able to conduct an analysis of their

competitive situation and made decisions with respect to firm’s future strategy, confining

to the narrow situation where the same product was being produced in two or more

countries. At the core of this discussion is the comparative cost theory, which originated

form Ricardo, but the paper focused on a somewhat different aspect than the

comparative advantage analysis traditionally taught in textbooks. The major points of

discussions are the following.

The Micro and the Macro Perspectives Traditional discussions are analyses

from the standpoint of policy makers (or economists, who think for the sake of policy

70

makers) who can overlook the whole world or one country, and are limited to what we

call the macro perspective. In contrast, when we take the standpoint of a company

manager, a comparative advantage analysis is forced to be made from a micro

perspective. Conventional trade theories focused mainly on the origins of international

trade, “gains from trade” and specialization as a problem of principles (Ricardian trade

theory, HOS theory). New Trade Theory and New New Trade have explained some

stylized facts, such as the reasons how an intra-industry trade occurs or why some firms

engage in the export while other firms do not.. These are big achievements but they also

demonstrate limitations in the methodologies.

Heterogeneity of firms is introduced in the

The New New Trade theory encompasses heterogeneous individual firms, but in

essence, it stops at a pattern analysis (why some firms engage in international trade and

some others remain specialized in domestic sales). It does not go as far as looking into

the dynamics of what kind of perspective and vision the company managers and factory

leaders have when they are engaged in competition. HOS theory and theories based on

General Equilibrium framework, remain essentially static for its character and are not

necessarily suited for an analysis of this kind of dynamic competition. What we aimed to

investigate, in this paper, was those circumstances which managers of firms and

factories face at, to analyze how those managers are making strategic decisions and

endeavoring in the global competition and how they should behave in the given

circumstances. To do this, it was necessary to return to the Ricardo's comparative cost

principle and rebuild the theory from a micro perspective.

Capability-building competition and industry evolution In a real-life

competition, the technology coefficients (labor productivity and input coefficients) we

have in the current situation, are not very important. More important than those is the

assessment of how these technological conditions you can change and improve, based on

the more or less objective judgments of the circumstance where you and your rivals

compete. Long-term trends have to be assessed dynamically i.e. based on the present

level of differences, the speed of improvements, and more fundamentally the assessment

on the capability building abilities of both your and your rival’s factory. The question of

which country's factory should and can produce a specific product competitively is not an

objectively determined fact, but is a result of how they succeed in capability-building

efforts, when each firm and the factory's managers try to strengthen/maintain

71

competitiveness. The evolution of an industry occurs, not just as an objective fact, but

rather as a result of strategic decisions of those managers.

The managers of diversified multinational firms, as they know too actually the current

competitive situation, may be lead to make incorrect and short-sighted decisions. To

avoid this kind of strategic mistake, along with always paying attention to the long term

trends of wage and exchange rate movements, you must correctly assess the competitors'

capability-building abilities as well as yours..

The Ricardo theory and the micro–macro loop International trade

patterns and competitive circumstances are the result of the interplay of those efforts as

above described and the macroeconomic conditions that those efforts induce as a whole.

Variations and selections take place in this dynamic process of international competition.

In this process, variations in the micro-level organizational capabilities, key technologies,

and relative productivity lead to the selection of production sites. And through this

selection process, the semi-macro structure of an industry changes and a new structure

of world-wide prices and wages emerges. Exchange rates and relative wage-rates comes

to be determined by the macroeconomic dynamics but they forms an environment for

firms and factories and induce them to further micro-level capability-building efforts and

decision making. All these processes compose a macro–micro loop.

In this way, the authors of this paper think that, based on an explicitly dual

interpretations of the Ricardian theory, clearly separating micro and macro perspectives,

a simple and better explanation can be made of present-day trade phenomena

characterized by global competition, international capability-building competition,

competition by means of intermediate input goods (processing trade and outsourcing),

and intra-industry trade in the most fine industry classifications. For the authors, it is a

truly interesting discovery that the classical trade theory, which was born in the

beginning of 19th century, and has a flavor of most simple theory at a glance, is actually

a powerful tool which serves a dynamic framework for the analysis of the various trade

phenomena of the 21st century.

72

Macro (National Economy, Global Economy)

Micro (Firms, Production Sites)

・Each country's industry structure/trade structure Xij

・Profile of labor input coefficient aij

・Capacity-building of the Production aij ↓

・Choice of Architectures for the Product

・Location Choice of designing site and production Xij

・Relative wage rate wi

・Exchange rate EJC

・Macro effects of input coefficients aij

・Macro effects of location choices Xij

The Micro–Macro Loop for the Ricardian Trade Theory

73

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