Chapter 3: Factor Advantages

Keith HeadSauder School of

Business

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.

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.

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).

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.

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?

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).

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.

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).

Example 1: Crop Land

Country Crop LandM hec

LabourM

IncomeTr$

Canada 45.5 16 .57

USA 188 136 7.1

World 1465 2784 27.7

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/USlabour45.5/15 =3 > 188/136=1.4.

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.

Example 2: Education

Univ-edWorkers

Share of WldUni-ed

U-ed/Non U

Shareof Wld Inc

China 18m 8% .02 3%

India 16m 7% .03 1.5%

France 3.8m 2% .10 4%

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.

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.

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.

Types of Factors

Specificity to individual industries

Origin of factor

Basic (endowed)

Advanced(man-made)

General-use I II

Industry-specific III IV

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.

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.

International Product Life Cycles

I. Product produced and consumed in the (advanced) inventing country. Other advanced countries import it.

II. Production spreads to other advanced countries.

III. Production re-locates out of advanced countries into a low-wage nation.

Advanced countries import it. Next generation product invented.

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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.

Example: photocopiersSTAGE 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

Example: PhotocopiersStage 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.

Canadian Imports of Photocopiers

US Imports of Photocopiers

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

Understanding IPLCsWhat 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.