Fragmentation in simple trade models

Abstract

This paper examines the effects of “fragmentation,” defined as the splitting of a production process into two or more steps that can be undertaken in different locations but that lead to the same final product. Introducing the possibility of fragmentation into simple theoretical models of international trade, the paper finds the effects of fragmentation on national welfare, on patterns of specialization and trade, and on factor prices. Models examined include the Ricardian Model and the Heckscher-Ohlin Model, both for small open economies and for a two-country world. Results are as follows: 1. If fragmentation does not change the prices of goods, then it must increase the value of output of any country where it occurs and that of the world. 2. If fragmentation does change prices, then fragmentation can lower the welfare of a country by turning its terms of trade against it. 3. Even in a country that gains from fragmentation, it is possible (but not necessary) that some factor owners within that country will lose. 4. To the extent that factor prices are not equalized internationally in the absence of fragmentation, fragmentation may be a force toward factor price equalization.

Introduction

The subject is fragmentation: the splitting of a production process into two or more steps that can be undertaken in different locations but that lead to the same final product. Also called “intraproduct specialization” by Arndt (1998) and by the more loaded term “outsourcing” in some economic literature as well as in the popular press, fragmentation occurs both within countries and across countries.¹ Within countries, if domestic factor markets are well integrated and markets are competitive, then fragmentation would be expected to occur only if the combined resources used by the fragmented steps were less than those used by the original process, in which case fragmentation would also represent a technological improvement. In this paper I will assume instead that fragmentation does not economize on resources, and therefore I will focus on fragmentation that occurs across countries.²

Internationally, fragmentation has become increasingly common in recent years as barriers to international trade and investment have fallen and as an increasingly competitive world environment has forced producers to look outside their own borders for ways to reduce costs. In the debate over the causes of increased wage inequality in the United States in the 1980s and 90s, “globalization” and technology have both been suggested as important causes of the increased wage differential paid to skilled labor, globalization being represented variously by international trade, foreign direct investment, factor mobility, and outsourcing.³ In fact, fragmentation may be thought of as a manifestation of globalization and technology combined, since in many industries it is only advances in technology that have made the splitting of production processes and the coordination of the resulting parts possible.

In any case, with the exception of Arndt (1997) and Jones and Kierzkowski (2001), the economic effects of fragmentation do not seem to have been given the theoretical treatment they deserve, and in this paper I will attempt to correct that.⁴ Using several familiar and simple models of international trade, I will examine the implications of fragmentation on trade, patterns of specialization, and factor markets, looking especially at its effects on factor prices and on the overall welfare of the countries involved.

I will examine the effects of fragmentation first in a Ricardian model in section 2, then in a Heckscher-Ohlin model in section 3. Section 4 concludes.