Us Trade Sanctions and Global Outsourcing to China

Abstract

In his 1995 paper for the twenty-fifth anniversary of the Brookings Papers on Economic Activity, Krugman identifies several new aspects of modern world trade. One of them is the ability of producers to "slice up the value chain", breaking the production process into many geographically separated steps. This phenomenon is commonly known as "foreign outsourcing" and it is the outcome of globalization of the world economy in the last two decades.

This paper develops a general equilibrium model that features the North's outsourcing to the South, with 3 countries (2 in the North and 1 in the South) and three goods (labor intensive good, intermediates and capital intensive good). The North-South trade patterns are characterized by the North's export of capital intensive good to the South and its import of intermediates and labor consumer good from the South. The intermediates enter the production of the capital-intensive good.

The policy issue that motivated this study is the debate on China's MFN ("most favored nations" and now called normal trade relations) in the US in the past 10 years. While the US threats to revoke MFN, its competitors, namely, EU, Japan and NICs (EJN) do not. These countries compete in the world high-tech marketplace and at the same time outsource heavily to China. This paper applies the above model to analyze the price, output and welfare effects of tariffs on Chinese imports to the US.

The first part of the paper sets up a perfect competition benchmark framework. It gives the conventional results of the tariffs. As a large country, the US tariffs on import from China change the terms of trade to its favor and its welfare improvement comes solely from its terms of trade gains. The same is true for EJN. China suffers a welfare loss due to the worsening of its terms of trade. It also shows that the tariffs contribute to the further integration between the EJN and China in production of the capital-intensive good, with more EJN outsourcing to China. The opposite happens to the US and China. As a result, EJN takes more comparative advantage of China and its own and therefore has a bigger market share in the world market place for the capital-intensive good.

The second part of the paper extends the analysis to the imperfect competition in the capital-intensive good production. By so doing, some of the results obtained in the PC case are altered and others are not. Like in PC case, the tariffs improve the terms of trade for the US and EJN. It also reduces the US market share and increases the EJN market share in the capital-intensive good sector. For China, it allocates more resource from labor-intensive good sector to intermediates sector, and exports more intermediates to the EJN but less to the US. It also reduces the US real profit and increases the ENJ's real profit in capital-intensive good sector. The real profit term is equivalent to an efficiency term and it makes ambiguous. This leaves open the possibility of a welfare loss for the US. The world economy as a whole, however, suffers an unambiguous welfare loss.

Keywords: globalization, economic integration, trade

JEL Classification: F10, F15