Returning to the issue of how Chinese growth might affect workers in developed economies, it is important to recognise that vertical specialisation within product markets can also help insulate workers in developed countries from the low wages of workers in developing economies. Intuitively, the less substitutable goods of greater and less sophistication are, the weaker is the link between prices and wages and the more separated the workers in the two types of countries will be. Developed countries can move away from developing countries by climbing the quality ladder as well as by shifting the composition of their output.
Both of these forces appear to be at work. The widening price gap between Chinese and OECD varieties in some industries is consistent with quality upgrading: in reacting to China, firms in developed economies try to specialise in ever-more sophisticated versions of products to protect their sales. As a result, they drop their lowest price goods, raising their average price. Recent analyses of US manufacturing firms provide further evidence consistent with such a response. One study, for example, shows that even though US manufacturing firms are more likely to contract or fail as their industry?s exposure to imports from low-wage countries increases, this outcome is mitigated by the sophistication of the goods they produce within their industry. Firms that appear to be producing more sophisticated goods within industries have better outcomes. This study also suggests that firms move up as well as out in response to trade liberalisation by switching into industries that are more in line with US comparative advantage and that are therefore less exposed to low-wage country exports.
These behaviours provide intuition for why trade with developing countries will not lead to the elimination of manufacturing in the developed world, as some of the most extreme critics of globalisation contend. Even though increased trade with China may cause developed countries to abandon the production of their less-sophisticated goods, production of more-sophisticated goods, or the research and design services associated with them, is always waiting to take its place. Indeed, as is often pointed out, the creative destruction associated with these reallocations should be encouraged: allowing countries to produce according to their comparative advantage enhances the efficiency of production and encourages the availability of a wider variety of products at lower prices to consumers in all countries, thereby raising standards of living.
