comparative advantage of vietnam’s textile and clothing industry

i



Thai Nguyen University
Socialist Republic of Vietnam

Southern Luzon State University
Republic of Philippines
Thesis Title:
Comparative Advantage of Vietnam’s Textile and
Clothing Industry

A Research Proposal Presented to the Faculty of Graduate School
Southern Luzon State University Lucan, Quezon, Philippines
Thai Nguyen University S.R Vietnam
In Partial Fulfillment of The Requirements
for The Degree Doctor in Business and Administration

SUPERVISOR: ASSOCIATE. PRO, DR NGUYEN KHANH DOANH
STUDENT NAME: LE ANH TUAN
ENGLISH NAME: JOHN



THAI NGUYEN, 2013


ii

ACKNOWLEDGEMENTS
Throughout the course of research leading to the completion of this thesis, I have
gratitude to many people, who have provided me with tremendous help and support
in one way or another, which I think I cannot possibly acknowledge in full measures.
First and foremost, I would like to express my sincere thanks to Vice Associate Pro.
Dr.Nguyen Khanh Doanh, my advisor, for his invaluable thoughts, insightful
suggestions and useful guidance throughout the thesis works. Sincere appreciations
were also to the committee members for their propositions, valuable comments, and
constructive suggestions which were of substantial value to this study.
I would like to faithfully acknowledge professors of SLSU & TNU at DBA Program
at University of Thai Nguyen for their insightful lectures in different subjects that
provide me knowledge and technique to develop a good research.
My sincere thanks are extended to my entire friends for their meaningful discussion,
hospitality and friendships.
Finally, I am profoundly grateful to my parents, my wife, my sisters and my brothers,
who have been always with me in every situation. They have been table source of
encouragement and sharing during my work.



LIST OF CONTENTS

iii

LIST OF CONTENTS
Chapter 1: INTRODUCTION 1
1.1. Problem Statement 1
1.2. Objectives 3

1.2.1. General Objective 3
1.2.2. Specific Objectives 4
1.3. Dissertation structure 4
Chapter 2: LITERATURE REVIEW 5
2.1. Theoretical Foundation 5
2.1.1. Definition of comparative advantage 5
2.1.2. Theories of comparative advantage 7
2.1.2.1. Ricardian model 7
2.1.2.2. Heckscher – Ohlin model (H-O) 10
2.1.3. Factors affecting comparative advantage 14
2.1.3.1. Technological Superiority 14
2.1.3.2. Resource endowments 14
2.1.3.3. Availability of credit 16
2.1.3.4. Economies of scale 16
2.1.3.5. Technological Gap (Benefits of an Early Start) and Product Cycle 17
2.1.3.6. Demand Patterns: Demand Considerations 17
2.1.3.7. National and International Policies 17
2.1.3.8. Factors affecting export performance 18
2.1.4. Comparative Advantage framework 21
2.1.5. Competitive advantage 21
2.1.6. Linking comparative advantage and competitive advantage 24
2.1.7. Measuring comparative advantage 27
2.1.7.1. Balassa’s Index of Revealed Comparative Advantage 27
2.1.7.2. The Donges and Riedel Measure 27
2.1.7.3. Wolter Index 28
2.1.7.4. Michaely Index 28
2.1.7.5. Export Share Ratio 29
Chapter 3: RESEARCH METHODOLOGY 30
3.1. Measuring comparative advantage 30
3.1.1. Revealed comparative advantage 30

3.1.2. Trade balance index 31
LIST OF CONTENTS

iv

3.1.3. Trade specialization 32
3.1.4. Market share 32
3.1.5. Alternative Specifications of Revealed Comparative Advantage 33
3.2. Analyzing the Structural Stability 34
3.2.1. Stability of Revealed Comparative Advantage 34
3.2.2. Intra-Distribution Dynamics 35
3.3. Indices of Mobility 36
3.3.1. Shorrocks Index (M
1
) 36
3.3.2. Shorrocks Index (M
2
) 37
3.3.3. Sommers and Conlisk Index (M
4
) 37
3.4. Measure of Export Concentration 37
3.5. Trade Compatibility 38
3.6. Modeling the determinants of comparative advantage 38
3.6.1. Model description 38
3.6.2. Model specification 40
3.6.3. Choosing between FEM and REM 41
3.7. Data sources 41
Chapter 4: EMPIRICAL FINDINGS 43
4.1. Vietnam’s Export Performance in Textile and Clothing 43

4.1.1. Overview of Vietnam’s Economy and Textile and Clothing Exports 43
4.1.2. Structure of Vietnam’s Textile and Clothing Exports 45
4.1.3. Direction of Vietnam’s textile and clothing exports 47
4.2. Patterns of Vietnam’s Comparative Advantage in Textile and Clothing 51
4.2.1. Patterns of Vietnam’s Comparative Advantage in Textile and Clothing 51
4.2.2. The Dynamics of Vietnam’s Comparative Advantage in Textile and Clothing53
4.2.3. Concentration of Vietnam Textile and Clothing Exports 56
4.3. Determinants of Vietnam’s Comparative Advantage and Competitiveness in
Textile and Clothing 57
4.4. Trade Complementary and Forecasting Vietnam’s Potential Exports 63
Chapter 5: CONCLUSIONS AND POLICY IMPLICATIONS 65
APPENDICES 67
REFERENCES 69
LIST OF TABLES

v

ABSTRACT
This Study is the first to attempt a systematic evaluation of the comparative
advantage for Vietnam’s Textile and Clothing Industry in the global market.
The study is timely as Vietnam has made an extensive effort to change its
international trade for some years and the consequent increase in competitive
pressures and technology transfers, is expected to have led to a restructuring of the
economy such that the composition of Textile and Clothing exports Volumne
reflects Vietnam’s comparative advantage in the global economy.
The timeliness of the study is also reinforced by the fact that increased trade
integration of Vietnam over the past few years is likely to have contributed to a shift
in comparative advantage in Textlile and Clothing Industry in the world market.
The Study identifies the pattern of comparative advantage using the
Balassa (1989) index for export data. The index has been calculated at the sector and

commodity level of the Harmonized System of classification. The Dissertation also
analyses comparative advantage according to factor intensity. The analysis shows
broad in the structure of comparative advantage of Vietnam’s Textile and Clothing
Industry.
I do hope that this Dissertation will serve as a useful source and provide valuable
reference material for researchers and policy makers associated with and interested in
export promotion strategy in Vietnam.


LIST OF TABLES

vi

LIST OF TABLES
Table 4.1: Basic Economic Indicators of Vietnam 43
Table 4.2: Contribution of Textile and Clothing to Vietnam’s Total Exports 44
Table 4.3: Annual Growth Rate of Vietnam’s Textile and Clothing Exports 44
Table 4.4: Structure of Vietnam’s Textile and Clothing Exports (in percent) 45
Table 4.5: Top 10 Textile and Clothing Export Markets of Vietnam (in percent) 47
Table 4.6: Importance of Vietnam in World Exports of Textile and Clothing Exports 49
Table 4.7: Summary of Statistics 51
Table 4.8: Measures of Trade Specialization 51
Table 4.9: Vietnam’s Revealed Comparative Advantage in Textile and Clothing 52
Table 4.10: Results of Galtonian Regression 54
Table 4.11: Transition Probability Matrix 2001-2011 55
Table 4.12: Mobility Indices 56
Table 4.13: Herfindahl Index 56
Table 4.14: Summary of Statistics 57
Table 4.15: Determinants of Vietnam’s Textile and Clothing Exports (REM) 58
Table 4.16A: Tariff rates applied by Vietnam on Imports of Textile (in percent) 61

Table 4.17: Trade Complementary 63

LIST OF FIGURES
Figure 2.1: Comparative advantage framework 21
Figure 2.2: Determinants of National Competitive advantage 24
Figure 2.3: Linking Comparative Advantage and Competitive Advantage 25



LIST OF ABBREVIATIONS

vii

List of Acronyms and Abbreviations
FDI Foreign direct investment
GDP Gross Domestic Product
H-O Heckscher-Ohlin
R&D Research and development
RCA Revealed Comparative Advantage
RSCA Revealed symmetric comparative advantage
RTA Relative trade advantage
SCA Sustainable competitive advantage
TBI Trade Balance Index
WB The World Bank
WTO World Trade Organization



CHAPTER 1: INTRODUCTION

1

Chapter 1
INTRODUCTION
1.1. Problem Statement
The textile and clothing industry has been historically the core industrial sector in Vietnam’s
economy due to its advantage in terms of factor endowments and market scale. Many
reasons explain why this has long been the key industry of Vietnam: it is a sector with
requires light investment; the technology is simple; it mostly uses unskilled labor, etc.
During the past years, Vietnam’s textile industry has made remarkable efforts and become a
main component in the textile industry in Southeast Asia and an important member in the
global textile market. With around 3,800 companies including state-owned enterprises, joint
stock and limited companies, the textile and clothing industry is the leading export sector of
Vietnam, making a considerable contribution to the country’s prosperity.
Vietnam’s textile and clothing industry has developed rapidly in recent years and has
become a main component of the country’s economy. The export value of textile and
clothing products has contributed the second largest share in the country’s total export
value. This sector has helped significantly to the increase in source of foreign exchange and
Vietnam’s gross national product (GDP). In 2006, the export value of the textile and
clothing products was 5.8 billion US dollars, making this industry the second most
important export sector of Vietnam only after crude oil. In 2007, Vietnam became an
official member of the World Trade Organization (WTO). This has provided Vietnam great
opportunities to develop, especially in terms of international trade as Vietnam receives equal
treatment and benefits in trade like other members of WTO, and it was not be subjected to
quotas anymore. Moreover, joining the WTO helps Vietnam access to global market,
expand export markets and increase value of goods exported. The textile and clothing
industry sector has seen an impressive period of development, with the trade volume
increasing around 8% after ten years, from 2001 to 2011. Despite the global economic
depression during the past years, the export value of this sector has continued to increase,
exceeding 11 billion USD in 2010, an increase of 24% compared with 2009, and 14 billion

USD in 2011, an increase of 38% compared with 2010. The production and exports of
Vietnamese textile and clothing products contribute a considerable share in the world,
accounting for 18.6% of the world’s total exports in textile industry in 2010. Currently,
Vietnam ranks number five in the world in terms of textile and clothing exports, with over 2
million people working in this sector, accounting for nearly 5% of the country’s total labor
force (VINATEX, 2012). The increase in export value of the sector in recent years results
CHAPTER 1: INTRODUCTION

2

from the expansion in export market. Beside maintaining the traditional markets such as the
US, EU, Japan, the Vietnamese textile and clothing companies has expanded to new export
markets such as Korea, Taiwan, the Middle East, and Singapore.
Rapid development of Vietnam’s textile and clothing industry derives from many factors,
including abundant low-cost labor force and a stable political environment. Among them,
the most important advantage is human capital. The Vietnamese labor force has two main
characteristics, the first is its low price as well as the higher quality compared with some
other countries. Vietnam has a young population with a high percentage of people at
working age, an annual source supplementing the country’s labor force. Vietnam has gained
many economic benefits in the textile industry without a loss of the comparative advantage
in labor supply, and such an advantage is a driving force for the textile and clothing
industry’s further development. The second characteristic is its sustainability. Expansion of
urbanization and improvement in education in Vietnam has provided more high quality
labor for the textile and clothing industry, guaranteeing the supply of workers for future
development.
Besides, trade and economic policies have also contributed to the development of the
Vietnamese textile and clothing industry and helping Vietnam reach higher position in
global market of textile and clothing products. Textile and clothing industry has been
declared as an key industry of the country’s economy. Therefore, the Vietnamese
government has adopted policies promoting an export-led growth strategy supported by

strong foreign direct investment (FDI) inflows. The state monopoly of foreign trade was
abandoned. The non tariff barriers were reduced. Maximum import tariff rates were also
decreased. These measures have helped to reduce the anti-export bias resulting from the
structure of trade protection, which tended to reduce the profitability of exporting compared
to producing for the domestic market (Athukorala, 2006 cited in Jean-Rafael and Jean
Pierre, 2009). Tariff exemptions were also implemented for imported inputs used in the
manufacturing export products as well as tax incentives and Export processing zones have
multiplied (Jean-Rafael and Jean Pierre, 2009). Implementation of trade agreements have
affected trade liberalization and increased market access. After joining international
economic organizations such as ASEAN (in 1997) and WTO (in 2007), and signing bilateral
trade agreements (for example, with US in 2000), tariffs on imports and exports were
significantly reduced or dropped, bringing various economic gains and especially increased
market access.
CHAPTER 1: INTRODUCTION

3

It is obvious that Vietnam possesses a comparative advantage in textile and clothing
manufacturing. Nonetheless, Vietnam’s textile industry is facing various difficulties, such as
excessive resource reliance, most enterprises are medium and small size, low technology
and value added, indisposition in trade structure and highly concentrated export markets.
Another difficulty is the workers’ low level of skill, partly resulting in the low
competitiveness of textile products. Vietnamese textile workers are considered inferior in
terms of professional skills compared with other textile export countries. Among over 2
million people working in textile and clothing sector, percentage of skillful workers are
relative low.
Furthermore, supporting industries of textile and clothing manufacturing are still
undeveloped and cannot meet the demand from this sector. Domestic materials for this
industry are seriously deficient and the textile company are unable to rely on domestic
suppliers. Despite Vietnam having a natural conditions suitable for growing cotton, the total

cotton output is still not enough to provide for the textile industry. In 2007, Vietnamese
textile and clothing companies had to import around 90% of cotton material needed, and
70% of other materials for manufacturing such as fiber and fabric. Shortage of local
materials in one of main reasons resulting in decrease in business efficiency and in
comparative advantage of Vietnamese textile and clothing enterprises.
On the other hand, the textile and clothing industry is labor intensive. Development of the
Vietnam’s textile and clothing industry is still determined by labor costs. Vietnam’s
comparative advantage in textile industry mainly result from low labor costs. However, this
kind of advantage is tending to decrease as developed countries are persistently investing
new technologies into their textile and clothing industries and the advantage of cheap labor
in developing countries tends to be weakened along with improvement in productivity in
developed countries. The developed countries can maintain higher profit in their textile and
clothing industry while at the same time reduce production.
It is therefore urgent for Vietnam have policies and measures to strengthen comparative
advantage of textile industry and overcome serious domestic obstacles. This dissertation
aims at an in-depth investigation of comparative advantage of Vietnam’s textile and
clothing industry and brings corresponding suggestions.
1.2. Objectives
1.2.1.

General Objective
CHAPTER 1: INTRODUCTION

4

The general objective of this research is to analyze the patterns and dynamics of Vietnam’s
comparative advantage in textile and clothing industry in the period 2001-2011.
1.2.2.

Specific Objectives

 To systematize the theoretical foundation and empirical evidence of comparative
advantage, making contribution to the development of new theory about comparative
advantage.
 To investigate the patterns of Vietnam’s comparative advantage in textile and clothing
industry.
 To analyze the dynamics of Vietnam’s comparative advantage in textile and clothing
industry.
 To assess the determinants and factors affecting Vietnam’s comparative advantage in
textile and clothing industry.
 To derive policy implications based on the empirical findings. Results of this research
could be important in terms of helping to develop policies aiming at improving
Vietnam’s comparative advantage
1.3. Dissertation structure
This dissertation consists of five chapters. Chapter one describes the Statement of the
problem and objectives of the Study. Chapter Two provides an overview of the literature on
comparative advantage and factors affecting comparative advantage of a country in a given
industry. Chapter Three describes indicators and index used to measure comparative
advantage and then plus outlines the methods and models used in the study. Chapter Four
presents the results over three parts, these being Vietnam’s export performance in textile
and clothing industry, patterns of Vietnam’s comparative advantage in textile and clothing
industry and determinants of Vietnam’s comparative advantage in textile and clothing
industry. The discussion chapter reflects on the implications of the study’s findings and
provides recommendations for policy makers. The final chapter presents the conclusions,
the limitations of the study and gives directions for further research.
CHAPTER 2: LITERATURE REVIEW

5

Chapter 2
LITERATURE REVIEW

2.1. Theoretical Foundation
2.1.1.

Definition of comparative advantage
In economics, comparative advantage is one of the oldest and most lasting concepts (Evans,
1989). Comparative advantage is commonly expressed as international differences in the
opportunity costs of goods; that is, the quantity of other goods sacrificed to make one more
unit of that good in one country as compared to another country. In economics, comparative
advantage refers to the ability of a party to produce a particular good or service at a lower
marginal and opportunity cost over another. Even if one country is more efficient in the
production of all goods (absolute advantage in all goods) than the other, both countries will
still gain by trading with each other, as long as they have different relative efficiencies.
According to the law of comparative advantage, a country must specialize in those products
that it can produce relatively more efficiently than other countries (Krugman and Obstfeld,
2003). This implies that despite absolute cost disadvantages in the production of goods and
services, a country can still export those goods and services in which its absolute
disadvantages are the smallest and import products with the largest absolute disadvantage. It
also implies that a country with absolute cost advantages in all its products will specialize
and export those products where the absolute advantage is the largest, and will import
products with the smallest absolute advantages. Comparative advantage thus also leads to
specialization, but differs from specialization based on absolute advantage, in that a country
will always import, whether or not it is more or less efficient overall in the production of all
goods and services relative to other countries.
Relating the law of comparative advantage, the question that frequently arises is how is it
possible for a country that is less efficient in the production of all products to export any of
these products to another country that is more efficient in the production of all these
products? (Smit, 2010). The answer lies in the self-equilibrating nature of the trade balance
between countries (Krugman, 1993). This means that in equilibrium, if the input cost is
sufficiently lower in one country than another country, the price of the product will be lower
in the low input cost country, even if that country is less efficient in the production of the

product (Salvatore, 2002). Any deviations from equilibrium will automatically realign the
exchange rate between the two countries to ensure new trade equilibrium.
CHAPTER 2: LITERATURE REVIEW

6

According to Baumol and Binder (2009), comparative advantage underlies the economics
analysis of international trade patterns. A country that is particularly adept at producing
certain items – such as aircraft in the United States, coffee in Brazil, oil in Saudi Arabica -
should specialize in those activities, producing than it wants for its own use. The country
can take the money it earns from its exports and purchase from other nations items that it
does not make for itself. And this is still true if one of the trading nations is the most
efficient producer of almost everything. The United States might, for example, be better
than South Korea at manufacturing both computers and television sets. But if the United
State is vastly more efficient at producing computers, but only slightly more efficient at
making television sets, it pays for the United States to specialize in computer manufacture,
for South Korea to specialize in television production, and for the two countries to trade.
The idea of comparative advantage has been first mentioned in Adam Smith's Book The
Wealth of Nations: "If a foreign country can supply us with a commodity cheaper than we
ourselves can make it, better buy it of them with some part of the produce of our own
industry, employed in a way in which we have some advantage." But the law of
comparative advantages has been formulated by David Ricardo who investigated in detail
advantages and alternative or relative opportunity in his 1817 book On the Principles of
Political Economy and Taxation. Ricardo established the result that countries can mutually
benefit from trade if pre-trade relative prices of commodities in those countries are different
(Caves and Jones 1977).
Recent comparative advantage analyses are frequently based on the Heckscher - Ohlin (H-
O) model of international trade or its extensions. The basic version of the H-0 model was
developed in a context of two inputs and two outputs. The two central hypotheses of this
model, as described by Leamer (1984), are: (1) immobility of some production factors

between countries, and (2) factors can be used in different combinations to produce different
goods. The model also assumes that all countries have access to the same technology and
free trade. The main implication of this model is that, given the restrictive set of
assumptions, a country will export commodities whose production makes intensive use of
factors locally abundant, and will import commodities that are produced with factors
relatively scarce (Caves and Jones 1981), that is, a country will have comparative advantage
in the production of the good which intensively uses factors abundant in that country. Thus,
trade flows are dictated exclusively by factor endowments. The resulting main difference
between the Ricardian and Heckscher-Ohlin implications is that the Ricardian theory
explains international trade on the basis of differences in technology (or productivity)
CHAPTER 2: LITERATURE REVIEW

7

whereas the Heckscher-Ohlin model explains trade on the basis of differences in factor
endowments.
In determining the most efficient patterns of producing and trade, it is comparative
advantage matters. Thus, a country can gain by importing a good from abroad even if that
good can be produced more efficiently at home. Such imports make sense if they enable the
country to specialize in producing those goods at which it is even more efficient. And the
other, less efficient country should specialize in exporting the goods in whose production it
is least inefficient.
2.1.2.

Theories of comparative advantage
The theory of comparative advantage is likely one of the most important concepts in
international trade theory. Leamer (1984) suggested that the main purpose of trade theory is
to describe and predict the responsiveness of outputs and factor prices to changes in output
prices and factor supplies and also identify which commodities are exported and which are
imported. Two basic models were initially developed to address these issues: the Ricardian

model and the Heckscher-Ohlin model.
2.1.2.1. Ricardian model
Caves and Jones (1977) describe the Ricardian model as the oldest and simplest trade model
in which the details of production are fully incorporated. According to the classical
Ricardian theory of comparative advantage, relative labor productivities determine trade
patterns. The Ricardian model plays an important pedagogical role in international
economics (Golub and Hsiehh, 2000).
Ricardo’s theory of comparative advantage is based on the labor theory of value (Salvatore,
2002). The Ricardian model assumes that i) labor is the only factor of production that is
remunerated, ii) all labor is homogeneous and all occupations pay the same wage, iii) in any
occupation the number of man-hours required per unit of output is constant and independent
of the output level, that is, real cost per unit is constant and, iv) labor is mobile among
industries but immobile between countries (Caves and Jones 1977). These unrealistic
assumptions led to the incorporation of opportunity cost into the explanation of the theory of
comparative advantage. If the Ricardian theory of comparative advantage is redefined in
terms of opportunity cost, then a country will have a comparative advantage in the
production of goods and services if such goods and services can be produced at a lower
opportunity cost. This implies that a country will have a comparative cost advantage in the
CHAPTER 2: LITERATURE REVIEW

8

production of those goods and services that can be produced at a lower opportunity cost than
in other countries (Salvatore, 2002).
The Ricardian model can be easily understood in the context of a two-country, two-
commodity model. Adapting Caves and Jones (1977), imagine a simplified closed economy
in which only two commodities, X and Y, can be produced. Let a
LX
and a
LY

each represent
the constant real labor costs per unit of output in the production of X and Y, respectively. If
output levels are given by Zx and Zy, the total level of labor allocated to X and Y would be
a
LX
Zx and a
LY
Zy, respectively. Assume labor is fully employed,
a
LX
Zx + a
LY
Zy = L
(1)
The assumption of fixed labor requirements per unit of output implies that equation (1)
describes a straight line transformation schedule (see Caves and Jones 1977, p. 76). This
implies that in the Ricardian model, relative prices are fixed and determined by the real
labor costs per unit of output a
LX
and a
LY
. To see this, we ask how much extra Y could be
produced if X output is reduced by one unit. This reduction would release a
LX
units of labor.
Since a
LY
units of labor are required to produce one unit of Y, a
LX
/a

LY
extra Y units could be
produced. Since a
LX
/a
LY
represents the relative price of X, and this ratio is constant, relative
prices are constant. In this case, the straight line transformation curve would also imply that
the relative supply function (Zx/ZY) is horizontal. This implies that demand has no role in
determining pre-trade relative prices.
Now suppose that this country engages in trade with another country that also produces only
X and Y. In the Ricardian model, patterns of trade are completely determined by
technological differences between countries, or put in another way, trade flows are
determined by the countries' pre-trade relative prices. Let a
LX
* and a
LY
* each represent the
constant real labor costs per unit of output in the production of X and Y in the foreign
country, respectively. In a general form, the foreign country has comparative advantage in X
only if






<






(2)
Equation (2) makes evident the counterintuitive nature of the Ricardian model. Following
the example offered by Ricardo and later replicated by Caves and Jones (1977), suppose the
home country has higher labor costs per unit of production than the foreign country in both
commodities. Why should the foreign country import anything from the home country?
Because, although the home country labor was at an absolute disadvantage in both
CHAPTER 2: LITERATURE REVIEW

9

commodities X and Y, its disadvantage is relatively less in one of the goods. The foreign
country has an incentive to focus on the production of the good it produces the cheapest, and
import the good the home country produces the cheapest. Higher wages accompany higher
productive labor in the foreign country. The assumption of immobile factors of production
between countries guarantees that wages will not be equated.
Strengths and weakness of the Ricardian model
Major difficulties with the Ricardian model are: 1) labor is the only input considered - this
implies, for example, that differences in factor endowments between countries play no role
in explaining trade patterns, 2) the demand side of the model has no role in determining
patterns of trade since pre-trade prices are determined exclusively by relative supply, and 3)
differences in technology between countries is overemphasized, without explaining why
methods of production should differ.
Incomplete specialization: Perhaps the most problematic feature of the simple Ricardian
model, from an empirical point of view, is the implication that countries specialize
completely in tradable-goods production, except in case when a small country cannot satisfy
demand of a large country. In practice, import-competing sectors rarely disappear in the face
of foreign competition. There are two possible routes to reconciling incomplete

specialization with differences in labor productivity: product differentiation and
disequilibrium effects.
A disequilibrium interpretation of the Ricardian model is that price and quantity arbitrage is
incomplete, resulting in incomplete specialization in the short run. In long run equilibrium,
either complete specialization or equality of unit labor costs would be attained, but the
process of adjustment may be very slow.
Alternatively, incomplete specialization (and intra-industry trade) can coexist with
productivity differences, owing to product differentiation. With product differentiation,
differences in technology can drive inter-industry trade, while intra-industry trade occurs
because of product differentiation, as in Krugman (1981). Allowing for product
differentiation also help address Bhagwati’s (1964) objection to test of Ricardian theory.
Bhagwati argued that if the tests of Ricardians model are based on incomplete price
arbitrage, then one should examine the link between trade prices and trade flows instead of
going directly from labor costs to trade flows. With product differentiation, productivity
differences, incomplete specialization, and commodity price equalization could be
consistent. For example, in variant of Krugman’s (1981) model of Dixit – Stiglitz
CHAPTER 2: LITERATURE REVIEW

10

monopolistic competition, if country X is relatively productive in industry A relative to
industry B compared with country Y, X will produce more varieties and be a net exporter of
good A, yet the price of each variety of good A will be equalized across countries by trade.
In such a framework, there is no link between observed post-trade relative product prices
and trade patterns, but there is a link between relative labor productivity and trade.
Although the theory of comparative cost advantage is based on a set of strict assumptions,
this does not invalidate the general acceptance of the theory in explaining gains from trade
(Krugman 1990; Culbertson, 1986; Keesing, 1966). This is furthermore underscored by the
fact that most of the principles of the World Trade Organization (WTO) are based on the
belief in the validity of the law of comparative advantage (Root, 2001). Even the relaxation

of most of the assumptions does not affect the general validity of the theory in any
significant way (Harkness, 1983), and enough empirical evidence exists to support the
theory of comparative advantage (Bernhofen and Brown, 2004; Schott, 2004; Uchida and
Cook, 2005).
The superiority of the theory of comparative advantage lies in the remarkable amount of
useful information that it summarizes clearly and concisely. According to Salvatore (2002):
“It shows the conditions of production, the autarky point of production and consumption,
the equilibrium relative commodity prices in the absence of trade, the comparative
advantage of each nation it also shows the degree of specialization in production with
trade, the volume of trade, the terms of trade, the gains from trade, and the share of these
gains to each of the trading nations”. It is this power of the theory that provides a
convincing explanation why trade is a positive sum game (Krugman, 1994a, 1994b, 1998).
2.1.2.2. Heckscher  Ohlin model (H-O)
Whereas the Ricardian model of trade conveys the essential idea of comparative advantage,
it does not explain the direction of trade. Economists thus needed an alternative model of
comparative advantage to explain the direction of trade. An important theory to explain the
reasons, or causes, of comparative advantage differences between countries is the
Heckscher-Ohlin (H-O) theory (Salvatore, 2002).
According to this theory, countries differ with respect to their factor intensities, namely the
labor and capital that are used in the production of goods and services. While there are many
different resource explanations of comparative advantage, the H-O theory isolates factor
abundance or endowments as the basic determinant of comparative advantage. Although the
CHAPTER 2: LITERATURE REVIEW

11

H-O theory is based on a set of simplifying assumptions, relaxing these assumptions
modifies but does not invalidate the theory (Salvatore, 2002).
The H-O model contrasts with the Ricardian model by incorporating more realistic
assumptions than the ones adopted by Ricardo. The H-0 model assumes two factors of

production (labor and capital), differing factor-proportions, both across countries and across
industries, and that countries are endowed differently in production factors (Leamer, 1984).
1

In the H-0 model, trade is driven mainly by differences in factor endowments, leading to the
main conclusion that a country with balanced trade will export the commodity that uses
intensively its relatively abundant factor and will import the commodity that uses
intensively its relative scarce factor (Heckscher-Ohlin theorem). Leamer (1984) offers a
straightforward proof to this theorem. Consider two commodities Xi andX2. In equilibrium,
factor supply equals to factor demand
K = a
K1
X
1
+ a
K2
X
2

L = a
L1
X
1
+ a
L2
+ X
2

(3)
Let V represent the vector of endowments (K, L) and X the vector of outputs (X

1
, X
2
).Then
these equations can be written as
V = AX or
X = A
-1
V
(4)
where the inverse exists provided the relative input intensities are unequal, that is, a
K1
/a
L1
≠
a
K2
/a
L2
.
The linearity of these equations allows us to write world outputs Xw as a function of total
world endowments V
w
, that is, X
w
= A
-1
V
w
. Because all countries face the same international

prices of output and consumers maximize identical homothetic utility function, each country
consumes commodities in the same proportions, C = sX
w
, where s is the country's


1
The complete set of assumptions, as described by Leamer (1984), under which the main conclusions of the
model can be reached, are: (1) the number of goods and factors are equal to two; (2) production factors are
completely immobile between countries but move costlessly between industries within a country and (b)
commodities are traded freely at zero transportation cost; (3) input and output markets clear competitively, (4)
countries have costless access to the same technology; (5) the variability of factor endowment ratios among
countries is less than the variability of factor input intensities across industries (see pages 4 through 6 for a
precise definition of variability). This condition is necessary to ensure factor price equalization across
countries; (6) all consumers maximize an identical homothetic utility function.
CHAPTER 2: LITERATURE REVIEW

12

consumption share of world output and C is its consumption vector. Trade balance requires
that p'X = p'C - sp'X
w
(value of production equals value of consumption), where p is the
price vector (p
1
, p
2
). Thus, balanced trade implies

w

,
(5)
that is, the consumption share is the ratio of own GNP to world GNP.
In the context of the H-0 model, net exports is defined as the difference between production
and consumption:
T = X  C
T = A
-1
V  sA
-1
V
w
T = A
-1
(

V  sV
w
),
(6)
Which is A
-1
times the vector of excess factor supplies:
V – sV
w
=
 

 


 = 




 




 

(7)
To conclude the argument, Leamer (1984) demonstrates that if a given country is relatively
capital abundant (K / K
w
> L / L
w
), than the excess factor supply vector has signs (+,-). This
is assured by the fact that the consumption share is a weighted average of capital share and
the labor share
s =





=








= 



=






























(8)
where w is the factor reward vector: w = (A')
-1
p . This implies that s is bounded by K/K
w

and L/L
w
, and consequently K/K
w
> s is equivalent to K/K
w
> L/L
w
. The last step in
determining the sign of the net export vector of a capital abundant country is defining the
effect of pre-multiplying a vector with signs (+,-) by the inverse of the matrix A:
A
-1
= 











= 








/



,
where



= (








) = 














(9)
If X
1
is the capital intensive industry, then



> 0, and A
-1
has the sign pattern 




 
 
. Thus, if the country is abundant in capital, the vector of excess factor supplies has
sign pattern (+,-), and trade therefore has sign pattern T = 
 
 



 = 


. This implies
CHAPTER 2: LITERATURE REVIEW

13

that the capital abundant country exports the capital intensive commodity X
1
and imports the
labor intensive commodity X
2
(Leamer 1984).
A number of empirical studies have been conducted to verify the H-O theory. One of the
first such studies was conducted by Leontief (1953), who found that, irrespective of the
general believe that the United States was expected to be an exporter of capital-intensive
products and an importer of labor-intensive products, the results confirmed just the opposite.

The paradox was later confirmed by Baldwin (1971). Similar results were reported in
studies based on data for Japan, Germany, India and Canada (Baldwin, 1979).
The Leontief paradox has led economists to look for alternative explanations for the H-O
theory. The most important of these was the introduction of differences in human capital
(Keesing 1966; Baldwin 1971) as an explanation of the paradox. Others were the product
cycle theory (Vernon 1966) and the technology gap theories (Gurber et al., 1967; Gold
1981) that incorporate time as a dynamic extension to the basic H-O theory. Most of these
theories were mere modifications and extensions of the basic H-O theory and did not reduce
the validity of the theory in explaining the direction of trade between countries.
The Ricardian and the H-O models are important to make clear the definition of
comparative advantage, a term frequently misused. These models are also used as guidelines
in the construction of the empirical model.
The connection between the theoretical models and the problem at hand stems from the fact
that the theory allows one to form expectations on what determines the configuration of
international supply of textile products, what causes this configuration to change and how
countries move toward a new equilibrium when economic conditions change. Moreover,
theoretical models allow us to contrast results from empirical models with expectations. The
importance of having a solid theoretical reference cannot be overstressed. For instance,
several studies have tried to explain and forecast patterns of production and trade based on
differences in absolute production costs. For instance, these studies tend to conclude that
textile and clothing production will increase in areas where it can be produced cheaper in
absolute terms.
Although this idea may seem intuitive, it is misleading. The Ricardian model suggests that
relative costs (and not absolute costs) are important in determining patterns of production.
In theory, it is possible to manufacture textile products in regions where absolute costs are
not the lowest. Thus, in order to form a correct expectation of the allocation of world supply
CHAPTER 2: LITERATURE REVIEW

14

of textile products, it is necessary to consider the opportunity costs of factors associated
with the production of this commodity.
The Ricardian theory of relative costs can be viewed as posing necessary conditions to
determine the configuration of international supply of textile products. These become
sufficient conditions when the H-O requirements are met. The H-O model requires a
country to be endowed with the factors of production used intensively in the production of
textile products in order for this country to become a major international supplier.
2.1.3.

Factors affecting comparative advantage
2.1.3.1. Technological Superiority
Adam Smith’s principle of “absolute advantage” and David Ricardo’s principle of
“comparative advantage”, in general, are based on the technological superiority of one
country over another country in producing a commodity. The Ricardian model assumes
constant productivity, as there is only one factor of production (labor), and therefore
constant (opportunity) costs that leads to complete specialization. However, increasing
opportunity costs that often arise in multi-factor situations (law of diminishing returns) due
to limited quantity of some factors specific to an industry can easily be accommodated to
allow for incomplete specialization. Thus, in the Ricardian model, technological differences
in two countries are the major source of movement of commodities across national
boundaries.
While the principle of comparative advantage as expounded by David Ricardo was couched
in terms of technological superiority, the principle, when phrased in terms of comparing
opportunity cost or relative prices of goods and services between countries is sufficiently
general to encompass a variety of circumstances. Furthermore, although Ricardo’s
explanation of comparative advantage was in static terms, comparative advantage is a
dynamic concept. A country’s comparative advantage in a product can change over time due
to changes in any of the determinants of comparative advantage including resource
endowments, technology, demand patterns, specialization, business practices, and
government policies.

2.1.3.2. Resource endowments
Availability of resources in a country provides another source of comparative advantage for
countries that do not necessarily possess a superior technology. Under certain restrictive
assumptions, comparative advantage can be obtained due to differences in relative factor
endowments. As propounded by Heckscher and Ohlin, a country has a comparative
CHAPTER 2: LITERATURE REVIEW

15

advantage in the production of that commodity which uses the relatively abundant resource
in that country more intensively. For example, newsprint uses natural resources (forest
products) more intensively compared to textiles. Textiles use labor (L) more intensively
compared to newsprint. Canada is relatively abundant in natural resources (R) compared to
India. (R/L) Canada > (R/L) India. This implies R will be relatively cheaper in Canada as
compared to India. Thus, Canada has a comparative advantage in newsprint and will
therefore specialize and export newsprint to India. Likewise, India has a comparative
advantage in textiles and will therefore specialize and export textiles to Canada.
a. Traditional endowments
Land, labor, and capital are the traditional factors considered by the textbook models of
international trade. They are also the most commonly used factors in empirical studies of
patterns of trade across countries and across industries within countries. The treatment of
land and unskilled labor as endowments is less controversial than capital.
In addition to physical capital, human capital is also a source of comparative advantage. The
importance of human capital accumulation in economic performance has been studied by
many economists. Lucas (1988) argued that human capital accumulation is the ―engine of
growth citing the notable differences in productivity of human capital relative to the smaller
differences in productivity of physical capital across countries. Romer (1990) and Barro
(1991) carried out cross-sectional studies and found empirical support for the positive
relationship between human capital accumulation and economic growth. Recently, Barro
and Lee (2010) created a new dataset of stocks of human capital based on educational

attainment and found that length of schooling has a significant effect on output as well as
income at the country level, particularly for secondary and tertiary levels of education.
Some recent studies dealing with the impact of human capital accumulation on trade
performance include Spiros and Riezman (2007), Manova (2008) and Spiros et al. (2009).
Human skills can also be considered a resource. Countries with relatively abundant human
skills will have a comparative advantage in products that use human skills more intensively.
Certain products such as electronics require a highly skilled labor force (such as engineers,
programmers, designers, and other professional personnel). Such products may gain
comparative advantage in countries (such as Taiwan, Singapore, Hong Kong) that are
relatively better endowed with such skilled labor (Keesing, 1966). Government policies
aimed at better education and training can create such an endowment.
b. Knowledge and schooling
CHAPTER 2: LITERATURE REVIEW

16

These factors are country-specific only to the extent that efforts towards knowledge creation
and schooling actually stay within national borders. In the case of expenditures in research
and development (R&D), either private or public, patent rights embody the institutions that
secure the property rights on the created knowledge. In the case of education, international
limits on the migration of people make the educational attainment of the adult population a
country-specific feature.
c. Domestic transport infrastructure
Internationally immobile factors of production should also include the extent and quality of
domestic infrastructure. Since industries have different transport-intensities for delivering
their products to the main export markets, these factors have the potential of affecting the
composition of net exports and comparative advantage.
2.1.3.3. Availability of credit
Financial development has been established as a pre-condition for economic development.
A study by Rajan and Zingales (1998) established that industrial sectors that are relatively

more in need of external finance develop faster in countries with more developed financial
markets. Beck (2003) and Manova (2008) built on this idea and demonstrated that financial
development translates into a comparative advantage in industries that use more external
finance. Beck (2003) demonstrated this effect using data for 36 industries and 56 countries.
Manova (2008) showed how such an effect may arise in a theoretical trade model with
heterogeneous firms where larger, more productive firms have an advantage in obtaining
external finance. She also found empirical evidence for this effect using data on bilateral
exports for 107 countries and 27 industries during the period 1985-1995. More recently
Chor (2010) confirmed the importance of credit constraints as determinant of international
trade patterns using a sample of 83 countries and 20 industries and data for 1990.
2.1.3.4. Economies of scale
Economies of scale can provide comparative advantage by lowering production costs.
External economies that operate by shifting the average cost of firms downward can in fact
occur due to an industrial policy or a proactive role of the government in providing better
infrastructure and/or a better educated or trained labor force. Such economies of scale are
consistent with Ricardian model. Economies of scale (internal) achieved through the
existence of a large home market and/or some policy-induced accessibility to a larger
market outside the nation (say due to a customs union) also imply lower production costs.
CHAPTER 2: LITERATURE REVIEW

17

This may boost or create a comparative advantage for the industry experiencing such
economies of scale.
2.1.3.5. Technological Gap (Benefits of an Early Start) and Product Cycle
Industrially advanced nations in general had an early start in most manufactured products
and services, which allowed them to enjoy large national and international markets.
Industrially advanced nations were thus able to export new products until such time that the
products were produced by other low factor cost countries. Vernon’s (1966) Product Cycle
hypothesis emphasizes the importance of the nature and size of home demand for new

products in highly industrialized countries. Since, initially, the new product involves
experimentation of the features of the product as well as the production process, the
countries that have sufficient home demand for such products produce and export them. As
the specific nature of demand becomes more universal and the technology more easily
available to others, the nation loses comparative advantage in that product. Meanwhile, the
firms are likely to have developed another product that enables the nation to gain
comparative advantage in that product.
2.1.3.6. Demand Patterns: Demand Considerations
The role of demand and the size of the home market for products are already evident in (1)
establishing the equilibrium terms of trade and therefore the division of gains from trade; (2)
economies of scale; and (3) product cycle hypothesis. In addition, Linder (1961)
emphasized the role of demand in the home market as a stepping stone towards success in
international markets. According to Linder, manufacturers initiate the production of a new
product to satisfy the local market. In this step, they learn the necessary skills for making
the product by more efficient techniques, which in turn, give these nations comparative
advantage in the product vis-à-vis other countries. Linder’s study postulates exporting the
product to countries with similar tastes/demand patterns. The theory, coupled with market
imperfections and product differentiation can explain a large portion of intra-industry trade
among the industrialized nations.
2.1.3.7. National and International Policies
National policies towards infrastructure, export promotion, education and training, R&D
policy related to export industries can go a long way in creating and sustaining comparative
advantage. The policies that do not target any particular sectors but rather reflect broad
public choices or seek to enhance general resource endowments, even though they may
indirectly favor some of the sectors, are a potential source of comparative advantage and
CHAPTER 2: LITERATURE REVIEW

18

thus of welfare gains from trade. For example, capital accumulation can be encouraged by

well developed financial markets and this can create favorable conditions for development
of a competitive capital-intensive activity, but financial market reforms are not principally
designed to favor any particular industry. Similarly, a good education system may boost the
endowment of human capital thus favoring human-capital intensive activities, but good
education policy does not directly favor production of any particular good or service.
Industrial policies such as production subsidies, tax preferences, restricted tendering of
Government contracts, anti-trust policy, and a number of other means are often used to
provide an advantage to domestic industries. Likewise, the commercial policies aimed at
restricting imports through tariffs, quotas, voluntary export restraints, import licensing, local
content rules, restriction on outsourcing, escape clauses, etc. have been used to the
advantage of domestic import competing industries. Policy driven benefits realized by the
industries through internal and/or external economies, in the long run, may become a source
of comparative advantage to these industries. The 1965 Auto-Pact between Canada and the
USA is a good example of targeting individual industries to influence production and trade
through national policies. Chang in Lin and Chang (2009) described the four decades long
protection of the Japanese car industry by high tariffs, direct and indirect subsidies and
restrictions on foreign direct investment before it became competitive in the world markets.
Nokia group was cross-subsidized by its sister companies before it started making profits
(Lin and Chang, 2009). Korean state owned firm POSCO benefited from import
substitution-type of policies and the Brazilian aircraft company Embraer was established
and developed into a global competitor through state ownership and export subsidies
(Rodrik, 2009).
The trade creation and trade diversion effects of customs unions/free trade areas are well
known in the literature. Further, the policies pursued by international organizations such as
the World Bank, the IMF and the WTO can also become a source of comparative
advantage/disadvantage to some industries in countries affected by such policies.
2.1.3.8. Factors affecting export performance
As comparative advantage is normalized by dividing the export-import ratio of a country for
a given industry by that for the world, factors affecting export performance also affect
comparative advantage of a country in a given industry. Determinants of export

performance can be divided into internal and external components. External components
include market access/entry conditions and a country’s location regarding international
markets. Internal components are related to supply-side conditions (Fugazza, 2004).