Chapter 3: Factor Advantages

1. Chapter 3: Factor Advantages Keith Head Sauder School of Business

2. Objectives of this chapter • Show how factor abundance gives rise to comparative advantage • Identify sources of superior factor quality. • Show how changing factor intensities shifts comparative advantages over time.

3. Defining Factor Advantages A location has a factor advantage for a product if the unit factor costs are lower than alternative sites. A location (country, region) is more likely to offer factor advantages for producing X if • the factors used intensively to make product X • are relatively abundant there.

4. Factors and Products: What’s the difference? • Products: goods and services • Tradeable (in most cases) • Made by factors using intermediate inputs (i.e. non-final products).

5. Factors and Products: What’s the difference? • Factors of production: things that create products and earn incomes for their owners, namely labour (L) and capital (K). • Limited mobility across countries (in most cases) • Not incorporated into the products they make, a single factor makes a stream of products.

6. 5 Kinds of Capital • Natural capital: land and sub-soil resources. • Physical capital: machinery, buildings • Human capital: schooling, experience • Intellectual capital: patents, brands • Social capital: associations, relations Restaurant examples for all 5?

7. Factor Intensity • The relative importance of one factor versus others in production in an industry, usually compared across industries. • Measured as share of value-added going to a particular factor. (so excludes indirect factor use) • Indirect factor use is when intermediate inputs use a factor intensively (e.g. sawmills, wineries, tanneries, sweaters).

8. Examples of intensive use • Telephone apparatus and pharmaceuticals use high-skill workers (measured as “administrative employees”) intensively (37% and 21% of Value-added, respectively) • Footwear and furniture use low-skilled labour intensively (39%, 38%) • Aluminum and Petro-refining use other factors (mainly physical capital) intensively.

9. Factor Advantages depend on relative abundance! • Ratio test (2 countries, 2 factors): • Home is capital abundant when home’s K/L ratio is larger than the K/L ratio in the foreign country. • Relativity: K-abundance implies L-scarcity. • Shares test (Many countries, many factors): • Home is abundant in factor F when home’s share of the world supply of factor F exceeds home’s share of world income (GDP).

10. Example 1: Crop Land

11. Example: Crop Land • US has “absolute” abundance compared to Canada because 188 m hec > 45.5 m hec • If the second factor is labour, then Canada is relatively land-abundant: CaLand/CaLabour >USLand/USlabour 45.5/15 =3 > 188/136=1.4.

12. Example: Crop Land (cont’d) • Applying the shares test, Canada is crop-land abundant vs the world because its share of world crops, 3%, exceeds its share of world income, 2%. • US appears* crop-land scarce since 13%<26%. * But US crop-land is more productive (due to greater use of fertilizers and tractors than crop-land in less dev countries.

13. Example 2: Education

14. Factor abundance paradox • U of T economist Dan Trefler discovered rich countries seem to be scarce (by the shares test) in most factors. • How can this be? • Rich country factors have higher productivity. • Rich countries have complementary physical and social infrastructure. • What to do? Also apply ratio tests.

15. Factor Advantages Summary • Factor advantage is a “matching” process. • Choose the right country for each product • “Intensive user seeks abundant factor” • Absolute abundance is not enough: • Bigger isn’t better in the FA world. • Proportions are the key.

16. Michael Porter’s Critique • Traditional factor abundance won’t lead to sustained competitive advantage. • Abundance encourages wastefulness, scarcity induces effort and innovation • Innovations can offset problems caused by factor disadvantages • Basic factors are available in many places so having them doesn’t make you unique. • Competitive advantage in core firm activities arises from industry clusters that foster development of advanced, specialized factors.

17. Types of Factors

18. Examples of Factor Types • Type I (basic, general use) • Unskilled labour, pasture land • Type II (advanced, general use) • Bachelor of commerce degree • Type III (specific, basic) • Oil well ( specific to crude oil extraction industry) • Type IV (specific, advanced) • UC Davis enology dept., Danish diabetes treatment centres.

19. Factor Advantages, revisited • Porter is probably wrong when he argues that abundance is bad and scarcity is helpful. • Porter is certainly right to say that factor quality also matters. • Porter is also right to emphasize the special role of regional industry clusters: e.g. IT services in Bangalore.

20. International Product Life Cycles • Product produced and consumed in the (advanced) inventing country. Other advanced countries import it. • Production spreads to other advanced countries. • Production re-locates out of advanced countries into a low-wage nation. • Advanced countries import it. • Next generation product invented.

21. The International Product Life Cycle

22. Example: photocopiers STAGE I: New product • 1938: invented by Chester Carlson in Queens, NYC • 1949: First “xerographic” copier introduced by Haloid Company (later Xerox) • 1953: Sales subsidiary established in Canada.

23. Example: photocopiers STAGE II: Maturing product • 1956: Rank-Xerox joint venture established in UK. • 1962: Fuji-Xerox joint venture established in Japan. • 1965: Rank-Xerox opens manufacturing plant in the Netherlands. • 1974: Rank Xerox opens factories in Spain and France. • Various: Other companies such as Canon (Japan) and Olivetti (Italy) introduce photocopiers

24. Example: Photocopiers Stage III: Standardization • 1965: Xerox do Brasil founded (3 factories) • 1987: Xerox Shanghai J.V. formed to make copiers in China. • 1988: 2,000,000th Xerox copier is produced. • 1993: Xerox do Brasil Ltda. wins National Quality Award in Brazil. • 2000: all Asian operations sold to Fuji-Xerox.

25. Canadian Imports of Photocopiers

26. US Imports of Photocopiers

27. Understanding IPLCs What causes the move from stage I to stage II? That is, why does production spread to other advanced countries? • Inventing firm wants production closer to consumers • Rival firms license or imitate or wait for patent expiration

28. Understanding IPLCs What causes the move from stage II to stage III? That is why does production relocate to less developed countries? • Dubious answer: standardization makes demand curves more price-sensitive, competition “forces” inventing firms to seek low costs. • Good answer: standardization changes factor intensities. • skilled-labour (human capital) intensity falls as manufacturing process is “routinized” • unskilled-abundant (human capital-scarce) countries gain comparative advantage because of factor advantages for unskilled-intensive activities.