Productivity Performance and International Competitiveness: A New Test of an Old Theory

Ehsan U. Choudhri and Lawrence L. Schembri

Department of Economics Carleton University 1125 Colonel By Drive Ottawa, Ontario, K1S 5B6

May 1998 Revised January 1999

Abstract The paper uses a modern adaptation of the Ricardian model which incorporates monopolistic competition and multiple factors to derive a MacDougall-type relation between a countrys international competitiveness at the industry level and its productivity performance. This relation is implemented empirically for Canada and the United States, using panel data for 25 years and 40 industries. A key finding is that Canadian-U.S. productivity ratio is a significant determinant of relative shares of Canadian firms in both Canadian and U.S. markets. Trade liberalization between Canada and the U.S. also plays an important role in influencing market shares. Key Words: International Competitiveness, Ricardian Model. JEL Code: F11, F12

Earlier versions of this paper were presented at the Meetings of the Canadian Economic Association, Ottawa, May 28-31, 1998, and the Conference on Empirical Investigations in International Trade, Purdue University, November 13-15, 1998. We are grateful to Keith Head, Doug May and John Ries for helpful comments. We would like to thank Mykyta Vesselovsky and Bei Ling Yan for excellent research assistance. This project is supported by the Social Sciences and Humanities Research Council of Canada under Grant No. 804-96-0036.

1.

INTRODUCTION Much attention has focused recently on the role of productivity performance in influencing a

countrys international competitiveness across sectors and over time.1 This paper explores the relationship between productivity and competitiveness within the framework of the Ricardian model. The Ricardian model has not led to much empirical analysis beyond the early studies by MacDougall (1951, 1952), which involved estimating a cross-sectional relation between the ratio of one countrys labor productivity to anothers and the relative exports of the two countries (to third country markets).2 Although the empirical evidence was favorable to these tests, two problems have discouraged further testing of the MacDougall relation. First, a McDougall-type relation cannot be rigorously derived from the Ricardian model given its assumption of homogeneous commodities and perfect competition.3 Second, labor is the only factor in the model and strict implementation of this assumption ignores information on other factors.4 The paper modifies the Ricardian model to address both of these problems. First, the paper introduces monopolistic competition with SDS preferences [based on Spence (1976), and Dixit and Stiglitz (1977)] in the Ricardian model. This extension provides a solid theoretical basis for the derivation of a relation in which an index of competitiveness based on relative shares of the two countries (in each countrys market) depends on the labor-productivity ratio.5 Although our main purpose in deriving such a relation is to perform new tests of the Ricardian model, the relation also includes elements of the new trade theory. For example, relative market shares in this relation are also influenced by the ratio of the number of firms in the two countries, a variable which represents potentially the home-market effect identified by Krugman (1980).

2 Second, the paper restates the Ricardian model in terms of a composite factor obtained by an aggregation (via a translog function) of labor and other factors. The paper then derives a modified relation explaining relative market shares where labor productivity is replaced by the productivity of a composite factor (i.e., total factor productivity). Two versions of this relation are considered. A basic version assumes the same factor shares for all industries and thus suppresses the role of inter-industry factor-intensity differences. An extended version allows factor shares to differ across industries and provides a potential framework in which factors emphasized by the Heckscher-Ohlin model can be added to the Ricardian explanation based on technological differences. This version is, in fact, compatible with recent empirical work on testing the Heckscher-Ohlin model, which allows technology to differ between countries in one form or another.6 The relative-market-share relation is tested for Canada and the United States. The tests employ a special panel data set which covers the 196690 period and consists of forty carefully matched Canadian and U. S. manufacturing industries at the three or four-digit classification level. Satisfactory indexes comparing absolute total factor productivity levels between countries are difficult to construct, especially for disaggregated industries. Therefore, the paper uses panel data to implement tests that make use of standard productivity data which report a countrys productivity for an industry as an index relative to some base year. To focus on the long-run implications of the Ricardian model, the paper uses an estimation procedure that removes the influence of short-run factors. Section 2 discusses the theoretical framework and derives the relation explaining relative market shares. Section 3 discusses the methodology and the data used to estimate this relation. Results of our empirical analysis are discussed in Section 4.

2. 2.1

THEORETICAL FRAMEWORK The Basic Model This section first develops a basic model that incorporates monopolistic competition in the

standard one-factor Ricardian framework and then extends the basic model to include more than one factor. The basic model assumes two countries, 1 and 2, with different technologies; one factor, labor which is freely mobile within each country; and many industries, each one characterized by monopolistic competition with a continuous variety space (i.e., a large number of identical firms) and SDS preferences. To allow for decreasing unit costs in a simple way, assume that each variety requires a fixed amount of headquarter services and is produced in a plant under constant returns to scale. At time t, industry is labor requirements at the plant and headquarters in the two countries are given by
Yj Lit

'

Yit

j Ait

, j ' 1, 2,

(1)

Lit '

Fj

Fi
j Ait

, j ' 1, 2,

(2)

where Lit

Yj

is the quantity of labor required to produce Yit amount of output; Lit

j

Fj

is the quantity of

labor needed to produce a fixed amount F i of headquarter services; and Ait is labor productivity assumed to be the same at the plant and headquarters. The two-country productivity ratio, assumed to vary across industries as well as over time. Ait
1 2 Ait

, is

4 Using the SDS utility function modified to allow for the possibility of a country bias in preferences, we express the demand in country ks market at time t for a variety produced by country js firm in industry i as

jk Dit

'
1 N it 1k C it

E it C it ( P it Bit )s (
1 P it 1k Bit

jk

jk

1s

2 N it

2k C it

2 P it

2k Bit

1&s

, s > 1, j , k ' 1, 2,

(3)

where, for industry i at time t; E it is the total expenditure in country k on all varieties; C it (with C it 1 C it , j k ) captures the effect of a possible country bias; Bit 1 (with Bit ' 1 for j 'k ) is country ks ad valorem tariff (or tariff equivalent of other trade barriers) on imports from country j; P it is the price of a variety produced in country j; N it represents the number of firms (each producing one variety) in country j; and finally, s represents the elasticity of substitution and the perceived elasticity of demand, assumed to be the same for all industries and both countries.7 Let Wit represent industry is wage in country j at time t and use (1) and (3) to obtain the following condition implied by profit maximization: Wit ' (1
j j j j jk kk jk jk

jk

1 j j ) P it A it , j ' 1, 2, s

(4)

where the right hand side of (4) represents the marginal revenue product of L it . Free entry of firms implies that price equals unit cost in each industry. Noting that for country j, industry is unit cost at time t equals Wit ( L it % L it )
j Yit j j Yj Fj

Yj

, setting it equal to P it , and using (1), (2) and (4), we obtain j ' 1, 2. (5)

Yit ' (s 1) F i ,

5 Free mobility of labor between industries implies that the wage rate is the same in each industry. Thus Wit ' Wt
j j

, j ' 1, 2,

(6)

where Wt is country js economy-wide wage rate at time t.

Next, define

k Rit

N it P it Dit N it P it Dit
2 2

1k 2k

, for k = 1, 2, as the relative share of country 1's firms in

each of the two national markets (at international prices). Use (3), (4) and (6) to obtain the following basic relationship:
k lnRit

k % s lnB k % ln( ' lnC it it

Nit Nit

1 2

) % (s &1) [ln(

Ait Ait

1 2

) & ln(

Wt Wt

1 2

)] , k ' 1, 2,

(7)

k / where C it

. 12 2k 1k Bit C it Bit Equation (7) is similar to the MacDougall relation in that it links an index of competitiveness based on relative market shares to the productivity ratio (via a log-linear relation).8 However, unlike the

C it

1k

k/ and B it

Bit

2k

1 1 C 2, B 1 ' B 21 and B 2 ' . Note that C it it it it it

MacDougall relation, (7) is derived from a well-specified theoretical model and includes additional variables. To test the Ricardian model, we focus on estimating (7). In a general equilibrium analysis of the model, however, both that N it
1

N it

can be linked to , and thus this variable reflects the influence of relative market size on 2 2 N it E it international competitiveness.10 In the Ricardian model, the productivity ratio is determined exogenously. Relation (7), however, would hold even if the productivity ratio were determined

2 N1 it E it

and

Wt

2 Wt

would be determined endogenously.9 It is interesting to note

6 endogenously. Indeed, a similar monopolistically-competitive framework can be used to develop a model of endogenous productivity growth [see Brecher, Choudhri and Schembri (1996), for example]. Letting Qit (/N it Yit ) denote total output of industry i in country j at time t, we can use (5) to express
j j j

N it N it

'

Qit Qit

1 2

(8)

As reliable data on the number of firms in an industry is often difficult to obtain, (8) suggests that in (7) can be replaced by (the easier-to-obtain) Qit
1 2 Qit

N it

1 2

N it .

2.2

The Multifactor Case We now examine how the basic relation (7) is modified if there is more than one factor.

Although our analysis below can accommodate any number of factors, we focus on the simple case where three factors, capital, labor and materials, are used to produce both output and headquarter services. The production relations for this case are also represented by (1) and (2) with Lit and Lit
Yj Fj

redefined as amounts of a composite factor given by the following linearly homogeneous aggregator function: Lit ' G i (Kit , Hit , Mit ), j ' 1, 2, Z ' Y, F,
Zj j Zj Zj Zj

(9)

where K it , Hit and Mit represent amounts of capital, labor and materials used to produce a variety in the ith industry of country j at time t; K it , Hit and Mit are the corresponding
Fj Fj Fj

Yj

Yj

Yj

7 quantities used to produce headquarter services of the variety; and for simplicity, the same function is used to aggregate factors employed at plants and headquarters. For each country, let Wit and Wit denote industry rental and wage rates and Wit the price of industry materials. Minimization of the cost of a given level of Lit subject to the constraint (9) implies the condition that MlnLit
Zj Zj Kj Hj Mj

'

Zj MlnXit

Xj a it ,

where

Xj a it

j
X

Wit Xit
Yj

Xj

Zj

Xj Zj Wit Xit

, for X = K, H,

M, and Z = Y, F. Using (1), (3) and the cost minimization condition for Lit , marginal-revenueproductivity conditions can be expressed as

(1 Wit '
Xj

1 j Xj j ) P it a it Yit s X it
Yj

, X ' K, H, M, j ' 1, 2,

(10)

Assume that (9) represents a (linearly-homogeneous) translog function. In this case the exact index for L it is given by
Zj

lnL it & lnLit& 1 ' j a it (lnX it & lnXit& 1 ), Z ' Y, F, j ' 1, 2,

Zj Zj Xj Zj Zj X

(11)

where a it ' (a it % a it& 1 ) / 2 .11 The index for the price of the composite factor, Wit , is given by12

Xj

Xj

Xj

j lnWit

&

j lnWit& 1

' j
X

a it j Using (1), (2) and (10)-(12), and making a suitable choice of the initial value of Wit , we can show that (4) and (5) hold for the multifactor case.

Xj Wit Xj ) a it [ln( Xj

& ln(

Wit& 1
Xj a it& 1

Xj

)], X ' K, H, M, j '1, 2.

(12)

8 To abstract initially from inter-industry differences in factor intensities, assume that factor shares are the same in all industries of each country so that a it ' a t , for X ' K, H, M . In this case, given the assumption that the price of each factor is the same for all industries, (6) would still hold with Wt now representing country js price of the composite factor at time t based on aggregate shares (i.e., a t , a t , and a t ). We can then use (3) and the multifactor versions of (4) and (6) to derive a multifactor version of (7), which is the same as before except that labor productivity is replaced by total factor productivity, and the wage rate by the price of the composite factor. As well, the multifactor version of (5) implies (8) and hence the two-country ratio of industry outputs can be used instead of the ratio of number of firms in estimating (7). The assumption that factor shares are the same in all industries can be relaxed to introduce a role for Heckscher-Ohlin considerations. If factor shares differ across countries, then (6) will not hold but we can still derive a modified (7), where ln( ln(
1 Wit 2 Kj Hj Mj j Xj Xj

) is replaced by an industry-specific index, 2 Wt ) , which incorporates the influence of both industry-level factor intensities and inter-country

Wt

Wit differences in factor prices. Note, however, that this index does not restrict the factor-intensity rankings of industries to be the same for both countries or invariant over time. 2. 3.1 EMPIRICAL IMPLEMENTATION Methodology To test our basic multifactor version of the Ricardian model, using (8), we express (7) as the following log-linear regression model: rit ' f i % f t % 1 b it % 2 q it% 3 ait % uit ,
k k k k k k k k

k ' 1, 2,

(13)

9 where rit / lnRit , f i and f t are fixed industry and time effects,
k bit k k k k

k , q / lnQ 1 lnQ 2 , a / ln( / lnB it it it it it

1

A it

A i0
2

) & ln(

A it

A i0
k

), and uit is a stochastic error term.

The theoretical relation (7) implies that 1 ' s , 1 ' & s , and for k ' 1, 2, 2 ' 1 and 3 ' s &1 . Note that ait is based on standard productivity indexes which measure each countrys total factor productivity in period t relative to that in base period 0. The fixed-industry effects reflect the industry-specific components of the (unobserved) homecountry-bias term as well as base-period differences in the productivity ratio (given our definition of ait ). The fixed-time effects capture the influence of the composite-factor price ratio [i.e., the term, ) ] common to all industries in each time period. These effects would also include possible time2 Wt specific components of the home-country-bias term. ln( Measured values of variables in (13) could temporarily deviate from their long-run equilibrium values [as specified in (7)] for a number of reasons.13 Measurement errors caused by these short-run deviations imply that OLS estimates of (13) would be biased. As it is difficult to find satisfactory instruments for these variables, we use a different approach to deal with the measurement-error problem. Our approach allows variables bit , qit and ait to be correlated with uit at finite lags and leads because of short-run effects. However, it assumes that (as implied by the theoretical model) permanent changes in these variables (i.e., changes in their long-run equilibrium values) have no longrun impact on uit . Under this assumption, it can be shown that the following equation, which
k k k k

Wt

10 augments (13) by introducing future, current and past values of the first differences of explanatory variables in this equation, would yield consistent estimates of its parameters:

rit ' f i % f t % 1 b it % 2 q it % 3 ait % d1 (L) ? bi,t% s %

k d2 (L) k ? qi,t% s % d3 (L)

(14)

? ai,t% s %

k eit

, k ' 1, 2,

where d1 (L) , d2 (L) and d3 (L) are lag polynomials of order p (>s) and eit is the error term in this equation.14 Note that in regressions in the form of (14), coefficients of bit , qit and ait also represent long-run multipliers in a dynamic relation between rit and the three variables. Our empirical relation is easily extended to estimate the modified form of the basic model that includes an industry-specific index of the composite-factor-price ratio. For this case, we simply add the variable ln( Wit Wit
1 2 k k

) and lags and leads of its first differences to the right hand side of (14).

3.2

Data We estimate (14) using a special data set for Canada (country 1) and the United States

(country 2). This set includes annual data from 1966 to 1990 for forty manufacturing industries. We briefly highlight certain features of our data set (further details and sources are given in the Data Appendix). Our sample of forty manufacturing industries is based on the Statistics Canada PL (Productivity Level) aggregation of the total factor productivity database (this level of industry aggregation is similar to the three-digit SIC, although it does include some four-digit industries as well). Each industry in the sample was selected on the condition that a relatively close match existed with a

11 similar three or four-digit U.S. industry based on a special concordance of Canadian and U.S. industries constructed by Statistics Canada. For both countries, the total factor productivity index for each industry, A it
j j A io

, measures output

per unit of a composite input consisting of capital, labor and intermediates, and expresses productivity in year t as a ratio of the level in the base year 0. Industry output and trade data is utilized to estimate relative shares. For each industry, the relative share of Canadian and U.S. firms in Canadian markets (Rit ) is estimated as the ratio of Canadian imports from the U.S. to domestic Canadian sales (Canadian nominal output minus total exports). Similarly, the relative share in the U.S. Market (Rit ) is estimated as the ratio of Canadian exports to the U.S. to domestic U.S. sales. The industry tariff rates for the two countries ( it & 1 and it &1) are calculated as the ratio of duties collected to the value of imports. To measure the industry-specific index of the composite-factor-price ratio, ln( estimate ? ln( Wit
1 12 21 2 1

Wit

2 Wit

) , we first

) using (12), and then obtain the index by integration (after normalizing its initial value 2 Wit to zero). As materials consist largely of traded intermediate goods that are subject to low trade barriers, the price of this factor is unlikely to differ substantially between the two countries. CanadaU.S. rental-rate differential is also not likely to change much over time because of capital mobility. We thus simplify the calculation of the composite-factor-price index by assuming that ? ln( Wt
M1 M2

) ' ? ln(

Wt

K1 K2

) ' 0 . Thus our measure of the index focuses on the Canada-U.S.

Wt Wt difference in the wage rate, which is measured for each country by the average labor compensation for all manufacturing industries. Industries in our data set are identified in Table 1, which summarizes the behavior of the models key variables over the sample period. For each industry, the table shows the average annual

12 percentage rate of change of the Canadian and U.S. productivity indexes and of the relative shares of Canadian firms in Canadian and U.S. markets, and the average annual change in the percentage Canadian and U.S. tariff rates for the 1966-1990 period. The table shows wide variation in average productivity growth across industries in each country. It is also clear from the table that Canadian firms have generally lost market shares in Canada and gained market shares in the U.S. The extent of these losses and gains, however, differs considerably from one industry to another. The importance of trade liberalization between Canada and the U.S. is also highlighted in the table which shows that Canadian and U.S. tariff rates fell for all industries with one minor exception (misc. food products in Canada).

4.

EMPIRICAL RESULTS We estimate the basic relation (14) by OLS separately for the Canadian and U.S. markets

using panel data for 40 industries from 1966 to 1990.15 Newey-West weighting is used to obtain heteroskedasticity- and autocorrelation-consistent standard errors. Estimates of key parameters are presented in Table 2. These estimates are based on two leads and lags of the first-difference terms. This number of lags and leads seems to be adequate for removing the influence of short-term factors without significantly reducing the length of the time series for each industry. Nevertheless, we also tried a greater and smaller numbers of leads and lags but the estimates were not very sensitive to this variation.16 As Table 2 shows, coefficients of all three explanatory variables have the right signs in the regressions for both Canada and the U.S., and are all significantly different from zero (at the 10 % or

13 lower level). Thus, as the model predicts, both the Canada-U.S. productivity ratio and the industryoutput ratio have a positive and significant impact on the relative share of Canadian firms in the Canadian as well as the U.S. market. Trade barriers are also significant determinants of the competitiveness of Canadian firms with Canadian barriers exerting a positive effect in the Canadian market and the U.S. barriers a negative effect in the U.S. market. Magnitudes of the estimated coefficients, however, do not fully conform to the model. In particular, the coefficients of bit and ait equal s and s & 1 , respectively, and hence the predicted difference between these coefficients equals one. Estimates of these coefficients in the Canadian regression, however, imply a significantly greater difference. A similar discrepancy arises in the U.S. regression (where the difference between the absolute value of the coefficient of bit and the coefficient of ait is significantly greater than the predicted value of one). Another inconsistency is that the coefficient of qit is significantly less than one in the Canadian regression. These departures could reflect certain biases in our empirical measures. For example, as discuss further below, our trade barrier index does not fully capture all impediments to international trade. As well, indicator of the ratio,
1 N it 2 N it 2 1

, if (8) does not hold exactly.17

could be an imperfect 2 Qit The departures could also be caused by

Qit

heterogeneity of parameters (such as s ) across industries. Our time-series data are not sufficiently long to estimate all parameters of the model separately for each industry.18 However, we explore below how well the model (based on the assumption of homogeneous parameters across industries) fits individual industries. Our trade barrier index is based only on tariff rates and does not account for changes in transport costs and other non-tariff barriers that may have occurred during the sample period. If tariff

14 and non-tariff barriers in an industry tend to move together, the omission of the latter may overstate the estimated effect of the former in our regressions. In addition, it could be argued that trade liberalization between Canadian and the U.S. may have improved information in each country about the other country's products and thus may have reduced over time the trade barriers created by the own-country bias in preferences. Such changes, if correlated with reduction in industry tariffs, could also produce a bias in the coefficients of bit and bit . Economy-wide changes in home-country bias as well as in all other types of trade barriers would be captured by time dummies in the regression. These dummy variables would also represent the effect of changes in the composite-factor-price ratio over time (which are common to all industries). These two types of effects, however, imply a different pattern of time effects in the two markets. For example, a decrease in trade barriers would decrease relative Canadian share in the Canadian market but increase it in the U.S. market. A decrease in the factor-price ratio, on the other hand, would increase the share in both markets. For both Canadian and U.S. regressions, Table 3 shows the estimated effect of each years time dummy as a difference from the effect of the time dummy for 1969 (which is the first year in our sample). Over time, these effects tend to decrease for Canada but increase for the U.S. These results suggest that time effects represent largely the influence of declining trade barriers. Trade liberalization thus appears to have been a major source of change in relative market shares over time (via time effects as well as the trade-barrier index ). To explore the performance of the model for individual industries, Table 4 shows the correlation coefficient between actual and fitted values of rit (using the basic model in Table 2) for each industry. The industry means and standard deviations of rit are also shown in the table. For most
1 2

15 industries, values predicted by the model are strongly correlated with actual values for both Canadian and U.S. markets. The table, however, also identifies a number of industries in each market where the model does not fit the data well. For example, the correlation coefficient is less than 0.5 for 9 industries in the Canadian regression and 8 industries in the U.S. regression (correlation coefficients for these industries are shown in bold). There are, however, only two industries (iron foundries and aircrafts and aircraft parts) where the model performs poorly in both markets. Thus factors specific to a particular market rather than an industry appear to be generally responsible for cases where the model does not explain the data well. We also estimate an extended relation which relaxes the assumption of constant factor shares across industries and adds an index of the composite-factor-price ratio, which is industry-specific because it depends on the interaction of (the two-country) factor-price ratios with industry factor shares. As discussed above, our measure of this index assumes that trade in materials and capital mobility eliminate variation in the Canada-U.S. ratios for the price of materials and the rental rate, and thus the measure reflects essentially the Canada-U.S. wage ratio weighted by industry labor shares. Letting w it[/ln( Wit
1 2 Wit

)] denote the composite-factor-price index, the results for the extended relation

are also shown in Table 2. The model predicts that the coefficient of w it equals & (s & 1) . The estimated coefficient of w it is negative in both Canadian and U.S. regressions and is significantly different from zero in the U.S. regression. The results thus provide some support for the extended relation. As in the basic relation, however, estimated coefficients in the extended relation do not satisfy cross-parameter constraints implied by the model.

16 It would be interesting to explore how alternative measures of w it affect the results. Although our data set did not permit a thorough investigation of this question, we did experiment with a measure that relaxes the assumption that the rental-rate ratio is constant and estimates each country's rental rate by the user cost of capital. This measure, however produced anomalous results for the coefficient of w it , which was found to be insignificant in the U.S. regression and significantly greater than zero in the Canadian regression.19

5.

CONCLUSION To explore the link between productivity performance and international competitiveness, the

paper uses a modern adaptation of the Ricardian model that incorporates monopolistic competition and multiple factors. This adaptation provides a strong theoretical foundation for deriving a relation determining a countrys international competitiveness at the industry level as measured by relative shares of its firms in the home and foreign markets. Given trade barriers, relative productivity performance is a key determinant of international competitiveness in this relation. The paper empirically implements the productivity-competitiveness relation for Canada and the United States, using a special database consisting of about 25 years of data for 40 carefully matched Canadian and U.S. industries. Our empirical analysis indicates that, although the modern version of the Ricardian model does not fit the data exactly, it provides a useful framework for identifying key sources of international competitiveness. Our results show that there is a robust link between productivity performance and international competitiveness the Canadian-U.S. productivity ratio is a significant determinant of relative shares of Canadian firms in both Canadian and U.S. markets. Our empirical

17 analysis also suggests that trade liberalization between Canada and the U.S. has exerted an important influence on the behavior of market shares over time. The multifactor framework of the model enables us to explore whether competitiveness of Canadian firms is also influenced by an industry-specific index of the composite-factor-price ratio. This index represents a potential channel for the effect of the interaction between factor-price differences and factor intensities. As factor-price differences between Canada and the U.S. are not likely to be substantial, especially for traded materials and capital, the composite-factor-price index may not play an important role in Canada-U.S. trade. We do find, however, that a measure of this index, based mainly on industry shares and the relative cost of labor, does significantly affect relative shares in the U.S. market.

Page 18 Table 1: Summary of Industry Data - (1966-1990)*

Rate of Productivity Change (%) Rate of Change of Rel. Mkt. Shares of Cdn. Firms (%) Tariff Rate Changes**

Industry Name

Canada 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Fish products Feed Misc. food products Bread & other bakery prod. Beverages Rubber & leather Man-made fibre & cloth Wool yarn & woven cloth Carpet, mat & rug Clothing Hosiery Sawmills, planing & shingles Veneer and plywood Furniture Pulp & paper Paper box & bag Printing & publishing Primary steel Iron foundries Aluminum rolling & casting Power boiler & struct. metal Machinery & equipment Aircraft & aircraft parts Motor vehicles Motor vehicle parts Electrical appliances Radio & TV Electronic equipment Office & store machines Electrical wire & cable Other elect. & electronic prod. Concrete products Glass & glass products Refined petroleum & coal prod. Chemicals Pharmaceutical & medicine Paint and varnish Soap & cleaning compounds Toilet preparations Sporting goods & toys -0.67 0.47 0.05 0.11 0.25 0.73 2.54 0.37 1.60 2.67 2.87 1.13 1.14 -0.08 -0.39 0.41 0.34 0.12 0.91 0.77 0.24 -0.08 -0.01 1.05 1.69 1.41 2.64 1.84 3.03 0.58 0.65 1.09 1.19 0.27 1.14 1.82 0.25 0.14 0.13

U.S.

Canada

U.S.

Canada

U.S.

-0.52 -7.03 1.64 -0.37 -0.31 1.68 -11.23 5.38 -0.23 -0.21 0.65 -2.30 6.16 0.01 -0.16 0.15 -5.98 4.49 -0.08 -0.22 1.37 -3.78 -1.48 -0.59 -0.61 0.33 -7.54 19.46 -0.34 -0.40 1.29 -2.86 14.17 -0.17 -0.36 2.00 -6.51 14.02 -0.19 -1.01 1.48 -13.88 33.39 -0.17 -0.48 0.49 -4.59 15.07 -0.05 -0.40 2.04 -7.83 10.66 -0.01 -0.64 0.62 -2.23 9.96 -0.06 -0.04 0.58 -14.86 18.49 -0.25 -0.53 0.20 -5.78 15.51 0.35 -0.40 0.62 -4.21 1.17 -0.28 -0.01 0.17 -6.61 9.38 -0.32 -0.50 -0.18 -0.64 8.12 -0.13 -0.14 0.09 -3.74 6.61 -0.09 -0.17 -0.72 3.23 -0.88 -0.13 -0.21 -0.09 -3.73 10.27 -0.13 -0.32 0.02 -3.34 5.91 -0.16 -0.30 -0.86 -2.88 9.21 -0.21 -0.39 -0.10 -2.00 2.39 -0.08 -0.27 1.50 -6.41 9.21 -0.08 -0.19 -0.46 -2.85 8.79 -0.05 -0.08 1.68 -4.99 6.91 -0.24 -0.41 3.41 -8.60 28.18 -0.42 -0.35 1.37 -4.92 12.81 -0.41 -0.30 7.39 -10.07 12.21 -0.33 -0.30 0.05 -6.97 7.47 -0.24 -0.40 -0.25 -4.00 14.00 -0.32 -0.39 0.62 -4.23 19.52 -0.15 -0.73 -0.14 -2.41 15.09 -0.14 -0.92 -0.55 -2.55 12.35 -0.18 -0.07 0.71 -2.04 5.73 -0.10 -0.47 0.43 -5.07 5.56 -0.26 -0.40 0.33 -3.61 14.90 -0.19 -0.24 0.82 -2.48 13.71 -0.20 -0.12 0.10 -12.58 16.35 -0.25 -0.45 1.35 0.50 -4.82 11.63 -0.35 -0.5 3

Note:

* The summary data are annual averages calculated over the sample period. ** The percentage point change in the tariff rate.

Page 19
Source: See Data Appendix

Page 20

Table 2: Estimates of Key Parameters Basic Relation Canada United States Extended Relation Canada United States

bit

6.457*** (1.733) 7.119** (2.806) 0.266* (0.144) 0.703*** (0.184) 0.729*** (0.221) 0.647** (0.299)

6.679*** (1.897) -8.133*** (2.875) 0.219 (0.144) 0.844*** (0.189) -0.251 (0.996) 0.734*** (0.215) 0.550* (0.294) -2.778** (1.210) 0.889

bit

qit

ait

w it 2 R

0.953

0.887

0.954

Note: The dependent variable is rit with j = 1 for Canada and j = 2 for the U.S. Newey-West heteroskedasticity- and autocorrelation-consistent standard errors are shown in parentheses. The regressions also include industry and time dummies (to allow for fixed industry and time effects) as well as current, 2 future and 2 past values of the first differences of all explanatory variables. *indicates that the coefficient is significantly different from zero at the 10% level, ** at the 5% level, and *** at the 1% level.

Page 21 Table 3: The Patterns of Fixed Time Effects in the Basic Model

Canada

U.S.

Canada

U.S.

1970

- 0.043 (0.077) -0.165 (0.098) -0.254 (0.107) -0.313 (0.104) -0.460 (0.107) -0.556 (0.112) -0.368 (0.114) -0.386 (0.106) -0.640 (0.102) -0.687 (0.100)

0.303 (0.163) 0.405 (0.183) 0.331 (0.210) 0.677 (0.176) 0.661 (0.183) 0.356 (0.195) 0.413 (0.198) 0.510 (0.206) 0.562 (0.200) 0.663 (0.206)

1980

-0.739 (0.104) -0.729 (0.104) -0.649 (0.106) -0.675 (0.110) -0.710 (0.108) -0.696 (0.113) -0.737 (0.116) -0.682 (0.121) -0.733 (0.129)

0.692 (0.208) 0.811 (0.195) 0.846 (0.195) 0.917 (0.198) 0.971 (0.198) 1.019 (0.207) 1.123 (0.216) 1.176 (0.219) 1.163 (0.230)

1971

1981

1972

1982

1973

1983

1974

1984

1975

1985

1976

1986

1977

1987

1978

1988

1979

Note: This table shows fixed time effects of regressions reported for the basic model in Table 2. The regression equations are estimated for the 1969-88 period because of the inclusion of two leads and lags of the first difference terms. Each coefficient shows the effect of the given year minus

Page 22 that of the first year (1969) included in the regression. Standard errors (estimated as in Table 2) are shown in parentheses.

Page 23 Table 4: Performance of the Basic Model in Individual Industries

CANADA Corr. Coeff. between Mean UNITED STATES Corr. Coeff. between Mean

Industry Name

Std. Dev. of rit

rit and r it
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Fish products Feed Misc. food products Bread & other bakery prod. Beverages Rubber & leather Man-made fibre & cloth Wool yarn & woven cloth Carpet, mat & rug Clothing Hosiery Sawmills, planing & shingles Veneer and plywood Furniture Pulp & paper Paper box & bag Printing & publishing Primary steel Iron foundries Aluminum rolling & casting Power boiler & struct. metal Machinery & equipment Aircraft & aircraft parts Motor vehicles Motor vehicle parts Electrical appliances Radio & TV Electronic equipment Office & store machines Electrical wire & cable Other elect. & electronic prod. Concrete products Glass & glass products Refined petroleum & coal prod. Chemicals Pharmaceutical & medicine Paint and varnish Soap & cleaning compounds Toilet preparations Sporting goods & toys

of rit

rit and r it of rit

Std. Dev. of rit

0.929 1.443 0.474 0.665 -1.805 0.152 0.830 4.108 0.499 0.456 -6.111 0.336 0.880 2.360 0.162 0.940 -5.793 0.496 0.880 4.113 0.277 0.813 -5.935 0.264 0.752 4.479 0.324 -0.926 -4.314 0.219 0.927 1.544 0.369 0.933 -4.340 0.959 0.920 1.323 0.250 0.965 -6.271 0.732 0.827 2.297 0.486 0.877 -5.147 0.652 0.813 2.101 0.475 0.942 -7.687 2.396 0.786 3.459 0.231 0.506 -5.587 0.380 0.808 3.457 0.882 0.243 -7.899 0.812 0.875 2.240 0.224 0.851 -2.454 1.085 0.636 2.684 1.170 0.463 -4.125 0.863 0.728 2.503 0.219 0.917 -4.886 0.598 0.865 1.987 0.280 0.104 -1.764 0.185 0.896 2.900 0.311 0.941 -6.514 0.835 0.221 1.960 0.081 0.823 -6.023 0.516 0.271 2.205 0.257 0.959 -4.383 0.642 0.215 1.367 0.474 -0.033 -4.566 0.333 0.784 0.778 0.464 0.921 -4.607 0.565 0.685 2.254 0.301 0.729 -4.904 0.249 0.840 0.062 0.155 0.976 -4.312 0.349 0.254 -0.808 0.346 -0.053 -3.722 0.198 0.684 -0.368 0.437 0.770 -2.339 0.283 0.471 -1.408 0.301 0.854 -3.174 1.012 0.893 1.174 0.199 0.776 -5.481 0.569 0.962 0.196 0.683 0.779 -4.397 0.659 0.923 0.646 0.403 0.435 -4.695 0.450 0.926 -1.344 0.676 0.634 -3.868 0.350 0.962 2.247 0.602 0.682 -4.753 0.584 0.813 0.922 0.194 0.904 -5.095 0.516 0.093 4.882 0.451 0.907 -6.484 1.889 0.395 1.448 0.185 0.928 -5.651 0.897 0160 3.661 0.382 0.926 -5.063 0.614 0.073 1.386 0.078 0.972 -4.475 0.383 0.643 2.299 0.553 0.804 -6.851 0.386 0.801 2.080 0.201 0.929 -7.271 0.861 0.345 2.514 0.166 0.945 -6.733 0.905 0.910 2.867 0.659 0.964 -7.120 0.662 0.812 1.155 0.230 0.838 -5.546 0.55 7

Page 24
Note:

r it is the fitted value of rit based on the basic model in Table 2. Correlation coefficients less than 0.5 are
shown in bold.

Page 25

Data Appendix
The industry classification used in this study is Statistics Canadas Input-Output classification at PL level of aggregation, which roughly corresponds to the three-digit SIC. The Canadian industrylevel TFP, output, value added, wage payments, labor and capital are provided by Statistics Canada on this basis. The corresponding U.S. industry level data were provided by the National Bureau of Economic Research at the four-digit SIC industry level. Statistics Canada also supplied all the CanadaU.S. trade data on bilateral and total exports by industry. The U.S. data are aggregated to the PL classification using the concordance developed by Allard-Saulnier (1993). The PL classification consists of eighty-five manufacturing industries; thirty-three of them are excluded from our sample because a close match with a U.S. SIC industry group could not be obtained. Another sixteen PL industries are further aggregated into six industry groups to improve the comparability with U.S. SIC industry groups. Of the forty-two remaining industry groups, two are omitted Fruit & Vegetables and Tobacco Products because of the existence of significant nontariff barriers to bilateral trade. The Canadian tariff rate for each PL industry was calculated from data on duties collected and imports provided by Statistics Canada. The U.S. tariff data at the four-digit SIC industry level were obtained from two sources. For the period of 1978-1987, tariff rates are constructed from the corresponding U.S. series on calculated import duty and the value of imports from Canada. Both series were provided by the Foreign Trade Division of the U.S. Bureau of Census. For the period of 1961-1977, the calculated duty and value of imports series are not available on a detailed industry level by country of origin. However, in the U.S. Bureau of Census publication U.S. Commodity Exports and Imports as Related to Output, these series are available aggregated over all source countries. Since the bulk of the imports come from GATT members, the tariff rates computed from the aggregate

Page 26 series would be a reasonable approximation for the rates applying to imports from Canada. Even the aggregate series on imports and calculated duty were not published in the years 1973 and 1974, and these omissions were filled by straight-line interpolation. The exchange rate used to convert Canadian and U.S. dollars into common currencies for the purpose of constructing the market shares was the annual average noon spot exchange rate published in the Bank of Canada Review.

Page 27

Footnotes
1. For example, Dollar and Wolff (1993, pp. 144-48) find some evidence that relative productivity growth influences changes in revealed comparative advantage (based on export performance). In related work, Bernard and Jensen (1995) find evidence that U.S. exporting plants exhibit higher productivity than non-exporters. 2. For further empirical analysis of this relation, see Balassa (1963), McDougall et al. (1962) and Stern (1962). 3. The model does imply a relation between ratios of the two countrys labor productivities and unit costs. However, as Bhagwati (1964) has noted, there is no theoretical basis for relating unit-cost (or price) ratios to relative exports of the two countries. 4. In fact, a two-factor framework could provide an alternative explanation of the McDougall relation. For example, Deardorff (1984) points out that in a multi-commodity Heckscher-Ohlin model with unequal factor prices between countries and the same elasticity of substitution for all goods, both the labor-productivity and unit-cost ratios for a good would be positively related to its capital intensity and hence (as in the Ricardian model) these ratios would be related to each other. 5. For an alternative approach, see Eaton and Kortum (1998), who examine the role of technology in determining bilateral volumes of trade in terms of a model which assumes that each industry is a CES aggregate of a continuum of differentiated goods with stochastic technology. 6. Trefler (1995) and Davis and Weinstein (1998), for example, explore the role of international technology differences in explaining the factor content of international trade. Harrigan (1997)

Page 28 incorporates cross-country differences in total factor productivity in a model that determines the international pattern of production.. 7. The modified SDS utility function can be expressed as U it ' j (C it )1/s j [Dit (v )](s & 1)/s
k 2 jk jk j' 1 v jk ) s /(1 & s )

, where at time t , U it is the utility for

industry i s varieties in country k and Dit (v ) is the demand in country k )s market for variety v produced by country j )s firms. The demand function (3) can be derived by maximizing this utility function subject to the budget constraint. 8. The MacDougall index of competitiveness, in fact, represents the ratio of the two countries exports to (or equivalently their relative share in the market for) a third country. Our model is based on a two-country setup, but it can be easily extended to include a third country and derive a relation [similar to (7)] that would determine the MacDougall index. 9. A complete model would also include a relationship linking aggregate utility to industry-level utility as well as an endowment constraint for each country and a balance of trade condition. 10. Expressing the two-country ratio of firm outputs as Yit
1

'

Dit % Dit
21 Dit

11

12

2 Yit 1

22 Dit

, multiplying both

sides by

P it N it

2 2 P it N it 1

, and using (3)-(6), we can solve for

N it

2 N it

as a function of

E it

2 E it

for given

values of

Wt

2 Wt

A it

2 A it

, Bit and Bit . Such a relation is derived by Head and Ries (1998) in a

12

21

monopolistic-competition model which is similar to ours but assumes no technological differences between the two countries. 11. Such an index is discussed by Diewart (1976).

Page 29 12. This index is equivalent to the implicit price index, lnWit & lnWit& 1 ' lnj Wit X it & lnj Wit& 1 Xit& 1 & (lnL it & lnLit& 1 ) ,
j j Xj Zj Xj Zj Zj Zj X X

X ' K, H, M, j ' 1, 2, and Z = Y, F. Expression (12) for the index is convenient as it allows us to easily incorporate the Ricardian assumption that the price of every factor is the same for all industries in each country (i.e. Wit ' Wt ). 13. These deviations could arise, for example, because of short-run departures from the free-entry and free-factor-mobility conditions as well as stickiness in wages and other prices. 14. Consider the following linear projection: uit ' 1 (L)bi,t% s % 2 (L)qi,t% s % 3 (L)ai,t% s % eit , k ' 1, 2 where 1 (L), 2 (L) and 3 (L) are lag polynomials of order p (>s). Assume that correlation of it with b it , q it and ait is zero at leads greater than s and lags greater than p-s. The assumption that permanent changes in these variables have no long-run impact on u it implies that the long-run multipliers, j (1), j ' 1, 2, 3, equal zero. Using the above projection, we can express (13) as rit ' f i % f t % p1 (L)bi,t% s % p2 (L)qi,t% s % p3 (L)ai,t% s % eit , k ' 1, 2, where p1 (L), p2 (L) and p3 (L) are lag polynomials of order p (>s). Since pj (1) ' j % j (1) ' j , for j ' 1, 2, 3, (13) can be expressed as (14) with eit
k k k k k k k k k k k k k k k k k k k k k k k k k k k k k Xj Xj

orthogonal (by construction) to the three variables at all leads and lags. For use of such a procedure and additional references, see Brecher, Choudhri and Schembri (1996). 15. Separate estimation for Canada and the U.S. allows short-run dynamics (captured by firstdifference terms) to differ between the two countries.

Page 30 16. We tried 1 to 3 lags and leads. For Canada, estimates of b it ranged from 5.7 to 6.9, of a it from 0.7 to 0.8, and of q it from 0.2 to 0.3. For the U.S., the range of estimates was - 6.5 to 7.6 for bit , 0.5 to 0.8 for a it , and 0.6 to 0.8 for q it . 17. The key assumptions underlying (8) [and (5) on which it is based] are a large number of firms and free entry (needed to obtain zero-profit condition), and the same fixed amount of headquarter services in the two countries. Departures from these assumptions would introduce an error in (8). 18. For the regressions based on 2 lags and 2 leads, for example, we have only 20 observations to estimate 19 parameters (1 constant, 3 level and 15 first-difference terms). 19. The user cost of capital is estimated simply as the interest rate plus the depreciation rate (for all manufacturing) minus the inflation rate. This measure uses ex-post inflation rate and ignores the influence of the tax system. These limitations may account for the unsatisfactory results obtained for the index based on this measure.
2 1

Page 31

References
Allard-Saulnier, M., Comparability of Multifactor Productivity Estimates in Canada and the United States in Statistics Canada, Aggregate Productivity Measures 1991, 1993 (Catalogue no. 15-204E). Balassa, B., An Empirical Demonstration of Classical Comparative Cost Theory, Review of Economics and Statistics, 45 (August 1963). Bhagwati, Jagdish, Pure Theory of International Trade: A Survey, Economic Journal, 74 (March 1964), 1-84. Bernard, Andrew B., and J. Bradford Jensen, Exporters, Jobs, and Wages in U.S. Manufacturing: 1976-1987", Brookings Papers on Economic Activity: Microeconomics, (1995), 66-119. Brecher, Richard A., Ehsan U. Choudhri and Lawrence L. Schembri, International Spillovers of Knowledge and Sectoral Productivity Growth: Some Evidence for Canada and the United States, Journal of International Economics, 40 (1996), 299321. Davis, Donald R., and David E, Weinstein, "An Account of Global Factor Trade", mimeo, University of Michigan Business School, September, 1998. Deardorff, Alan V., Testing Trade Theories and Predicting Trade Flows in R.W. Jones and P.B. Kenen (eds.), Handbook of International Economics, Vol. I. Amsterdam: Elsevier Science Publishers B.V., 1984. Diewart, W.E., Exact and Superlative Index Numbers, Journal of Econometrics, 4 (1976), 115145. Dixit, Avinash and Joseph E. Stiglitz, Monopolistic Competition and Optimum Product Diversity, American Economic Review, 67 (June 1977), 297-308.

Page 32 Dollar, David and Edward N. Wolff, Competitiveness, Convergence and International Specialization, Cambridge, Mass.: The MIT Press, 1993. Eaton, Jonathan and Samuel Kortum, "Technology and Comparative Advantage", mimeo, Department of Economics, Boston University, October, 1998. Harrigan, James, "Technology, Factor Supplies and International Specialization: Estimating the Neoclassical Model", American Economic Review, 87 (September 1997), 475-494. Head, Keith and John Ries, "Armington Versus Krugman: An Empirical Test", mimeo, Faculty of Commerce and Business Administration, University of British Columbia, 1998. Krugman, Paul, Scale Economies, Product Differentiation, and the Pattern of Trade, American Economic Review, 70 (December 1980), 950-959. MacDougall, G.D.A., British and American Exports: A Study Suggested by the Theory of Comparative Costs, Part I, Economic Journal, 61 (December 1951). MacDougall, G.D.A., British and American Exports: A Study Suggested by the Theory of Comparative Costs, Part II, Economic Journal, 62 (September 1952). MacDougall, G.D.A., M. Downley, P. Fox and S. Pugh, British and American Productivity, Prices and Exports: An addendum, Oxford Economic Papers, 14 (October 1962). Spence, Michael E., Production Selection, Fixed Costs and Monopolistic Competition, Review of Economic Studies, 43(1976), 217-236. Stern, Robert M., British and American Productivity and Comparative Costs in International Trade, Oxford Economic Papers, 14 (October 1962). Trefler, Daniel, "The Case of the Missing Trade and Other Mysteries", American Economic Review, 87 (December 1995), 1029-1046.