Vertical Specialization and the Changing Nature of World Trade

By Hummels, David; Rapaport, Dana et al. | Federal Reserve Bank of New York Economic Policy Review, June 1998 | Go to article overview

Vertical Specialization and the Changing Nature of World Trade


Hummels, David, Rapaport, Dana, Yi, Kei-Mu, Federal Reserve Bank of New York Economic Policy Review


The world's economies have become increasingly integrated and increasingly global. Among the most important and often cited features of the rise in globalization is the enormous growth in the export and import shares of GDP since World War II. In the United States, international trade-that is, exports plus imports--accounted for 23.9 percent of GDP in 1996, up from 9.2 percent in 1962.(1) Worldwide, the merchandise export share of production has more than doubled over the last forty-five years, while the manufactured export share of production has almost quadrupled (Chart 1). Most countries--emerging nations as well as highly developed economies--have experienced increases in their export share of GDP (Chart 2). Clearly, a greater number of countries are trading more today than in the past.

[Charts 1 and 2 OMITTED]

Another significant feature of increased globalization is the internationalization of production. Rather than concentrate production in a single country, the modern multinational firm uses production plants--operated either as subsidiaries or through arm's-length relationships--in several countries. By doing so, firms can exploit powerful locational advantages, such as proximity to markets and access to relatively inexpensive labor. There are currently more than 39,000 parent firms and 279,000 foreign affiliates worldwide, with a total foreign direct investment (FDI) stock equal to $2.7 trillion in 1995, compared with $1.0 trillion in 1987. Moreover, the value added of foreign affiliates--that is, their sales less materials costs-accounted for 6 percent of world GDP in 1991, a 300 percent increase from 1982 (United Nations Conference on Trade and Development 1996).

Increased international production, however, does not always lead to increased international trade, For instance, if a country's firms serve markets abroad through production facilities in each country--rather than through exports from the home country--trade may actually decrease as international production rises. International production will be associated with increased trade when countries are vertically linked--that is, when international production prompts countries to specialize in particular stages of a good's production. In that case, a sequential mode of production arises in which a country imports a good from another country, uses that good as an input in the production of its own good, and then exports its good to the next country; the sequence ends when the final good reaches its final destination. We use the term "vertical specialization" to describe this mode of production.(2) By comparison, in a horizontal-specialization scenario, countries trade goods that are produced from start to finish in just one country.

In this article, we shed light on the globalization of international production and trade by demonstrating the increasingly important role vertical specialization plays in international trade. We use case studies and input-output tables to calculate the level and growth of vertical-specialization-based trade, which we define as the amount of imported inputs embodied in goods that are exported. The case studies--the United States-Canada Auto Agreement of 1965, Mexico's maquiladora trade with the United States, electronics trade between Japan and Asia, and trade involving Opel's subsidiary in Spain--allow us to quantify the amount of vertical-specialization-based trade.(3) In all of the case studies, our findings indicate that vertical specialization has increased sharply in recent years: in the Japan-Asia electronics trade, for example, it increased 900 percent between 1986 and 1995.

To show that the results of our case studies can be generalized, we use input-output tables to calculate estimates of vertical-specialization-based trade in ten developed countries from the Organization for Economic Cooperation and Development (OECD). We find that by the beginning of the present decade, 14. …

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