Small Countries and Risks of Deindustrialization

Ai-Ting Goh, Professor of Economics and Decision Science and Tomasz Michalski, Professor of Economics - Decision Sciences - July 10th, 2010
Small Countries and Risks of Deindustrialization  - abandonned industry

Should small countries that have opened their markets worry about deindustrialization? Sometimes, yes. However, according to HEC economists Ai-Ting Goh and Tomaz Michalski, this risk can be kept to a minimum. They advise small countries to specialize in the production of intermediate goods that can then be exported to meet the needs of secondary industry. 

Ai-Ting Goh ©HEC Paris

Ai-Ting Goh joined HEC Paris in 2002 and is a professor of economics as well as co-director of the school’s master’s degree in economics program. She holds a PhD from the (...)

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Tomasz Michalski ©HEC Paris

Tomasz Michalski has been professor of economics at HEC Paris since 2006. Previously, he was a researcher at the National Bank of Poland and at the European Central Bank. He holds (...)

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In recent years, the work of 2008 Nobel Prize winning economist Paul Krugman on increasing returns to scale and monopolistic competition (the new theories of international trade) has inspired many economists to increasingly focus on the economic effects of trade liberalization. In particular, they are interested in finding out how free trade influences companies’ location choices. Ai-Ting Goh and Tomaz Michalski have asked the following question. Will opened markets cause industrial companies in small countries to delocalize? To respond, they have developed a brand new model, the first ever to take intermediate goods into account. 

MAYBE SIZE REALLY DOES MATTER!

Using a two-country model, recent theories on international trade showthat for reasons of economies of scale, industrial companies should establish production activities in the larger of the two countries to limit transportation costs. Small countries are consequently likely to specialize in the production of primary goods and to therefore end up deindustrializing. This phenomenon is known as the “home market effect”, yet it only proves accurate when transportation costs for primary goods are significantly lower than those for secondary goods. Economist Donald Davis* points out that he has never seen this theory translate into reality. Does this mean that small countries have no reason to fear deindustrialization? Not necessarily, say Goh and Michalski. They have introduced the notion of intermediate goods to show that under certain conditions, small 

INTERMEDIATE GOODS

Goh and Michalski have created an economic model where two types of intermediate goods are both used to manufacturer secondary goods and products in one of two countries (re: the theory of comparative advantage). They show that in this context, two opposing forces come into play. On one hand, secondary good manufacturers want to set up in the larger country to gain access to this market while also limiting shipping costs. On the other, the larger country needs more intermediate goods to supply its industry, so it must import from the smaller country. 


article 15 - david ricardo - eng

DEINDUSTRIALIZATION VS. INDUSTRIALIZATION

As a result of these circumstances, two different things may occur.

• The “home market effect” enters into the picture, and as the larger country’s economic strength increases, that of the smaller country diminishes. When the difference in strength between the two countries becomes sufficiently large, the small country starts specializing in primary goods production and the large country, in producing secondary goods. The small country is then likely to deindustrialize.

• If secondary goods production moves entirely to the larger country, this country will need more of the intermediate goods produced in the small country. The small country is therefore unlikely to run any risk of deindustrialization. For example, in the automobile industry, many components (i.e., seats, windows, dashboards, motors, tires, body parts, etc.) are needed to produce the final product. Automobile manufacturers can therefore choose to make these goods themselves, or to outsource their production (and generally, to import such components). If a large country like China has to import large quantities of intermediate goods, it will contribute to growth in the countries that export them. 

FROM THEORY TO REALITY

Goh and Michalski believe that small countries are only likely to deindustrialize under two conditions.  The first is when the production of primary goods requires less intermediate goods than the production of secondary goods. The second is when the small country needs to import more intermediate goods than the large country to produce secondary goods. To test this hypothesis, they studied statistics from the 36 OECD countries. They found that on the average, it takes at least two times more intermediate goods to produce secondary goods than to produce primary goods. This ratio is even greater in very small countries (like Belgium or Luxembourg), and it shows that small countries may indeed be faced with risks of deindustrialization. 

Based on an interview with Ai-Ting Goh and on the article, “Should Small Countries Fear Deindustrialization?” by Ai-Ting Goh and Tomaz Michalski, Review of International Economics . * Donald Davis, “The Home Market, Trade, and Industrial Structure”, American Economic Review , Vol. 88, pp.1264-76, 1998.   

APPLICATIONS FOR GOVERNMENT
APPLICATIONS FOR GOVERNMENT

This study can help governments design trade policies in ways that minimize risks of deindustrialization. For example, developing countries (which Goh points out can be considered to be the same as small countries because of the relatively small size of their domestic markets in comparison to those of developed countries) should promote free trade rather than protectionism and establish government policies aimed at developing a comparative advantage in terms of intermediate good production. Many Eastern European countries have successfully pursued this type of strategy. Once they have opened to international trade, they have become sub-contractors for Western European industrial manufacturers.

METHODOLOGY
METHODOLOGY

Goh and Michalski considered a model of two-countries with different-sized economies. Both countries produce three types of goods—primary, secondary, and intermediate (goods that are required for the production of secondary goods)—all of which they can freely trade. Transport costs are “iceberg” in nature (a portion of the goods traded disappears during shipping).