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Economy

Dale W. Jorgenson -- The more global value chains expand, the more the TPP makes sense

The Trans-Pacific Partnership is an international trade agreement that would substantially reduce tariffs among the 12 participating countries bordering the Pacific. The participants, including the U.S. and Japan but not China, signed the accord on Feb. 4. The TPP is often described as the largest free trade agreement in history -- the participating countries generate more than 40% of world gross national product and originate more than a third of world trade.

To take effect, the TPP would have to be ratified by the participating governments. In the U.S., this would require legislation by Congress. President Barack Obama has expressed strong support for the deal, for example, in a recent joint statement with Prime Minister Lee Hsien Loong of Singapore, one of the participating countries. Obama has called on Congressional leaders to ratify the agreement during his remaining term of office, which ends on Jan. 20 next year. However, his support for the TPP has been called into question by both leading candidates for the U.S. presidency -- Hillary Clinton and Donald Trump.

Whatever the outcome of the U.S. election, ratification of the TPP by the U.S. during Obama's remaining time in office will require extraordinary leadership by the president and Congress. Fortunately, Congress has already passed the Trade Promotion Authority, so-called "fast track" legislation to require a simple up-or-down vote on the TPP with no possibility of amendments or a filibuster to block the legislation. Obama signed this into law on June 29, 2015.

A big deal

The TPP has been accurately described as the most important U.S. trade agreement since the North American Free Trade Agreement of 1995, which liberalized trade among Canada, Mexico and the U.S. Another possible analogue to the TPP is the European Single Market, which eliminated barriers to the movement of goods and services within the European Union. While both of these free trade agreements have led to substantial liberalization of trade, the participating countries are located much closer to each other than the participating countries of the TPP.

Perhaps the closest analogue to the TPP is the Information Technology Agreement, which eliminates all tariffs and taxes on information technology products like computers and communications equipment among the participating countries. This agreement originally involved 29 participants when it went into force in 1997, but it now involves 82 members, including the U.S., Japan and China. The ITA was recently expanded to include many more products and new tariff reductions began on July 1, 2016.

The economic case for the TPP is usually expressed in terms of the theory of comparative advantage. By assigning each product to the country where it can be made with a comparative advantage, trade produces the most efficient international division of labor. While this theory is at the core of international free trade agreements, many of the 30 chapters of the TPP are concerned with subsidiary issues like workers' rights and environmental policy. These issues are also the primary focus of politicians supporting or opposing trade agreements.

The theory of comparative advantage has been greatly expanded to deal with the rapidly growing importance of global value chains in international trade. A GVC involves the fragmentation of production into a series of stages that make up the value chain. Value is added to the final product at each stage of the production process. Value chains have spread across international boundaries and involve hundreds of stages in dozens of countries, becoming global in the process.

GVCs are feasible because of the rapid development of information and communication technologies. Managers rely on information transmitted and stored electronically to coordinate production and distribution across the many stages of a GVC. The recent proliferation of these chains is also a response to the lowering of tariff and nontariff trade barriers through the World Trade Organization, established in 1995. The WTO provides an institutional home for the ITA.

More than a phone

A leading example of a global value chain is the production of the iPhone, designed by Apple in Cupertino, California. The iPhone is covered by the ITA, so that exports of the product and imports of components and production facilities are not subject to tariffs or taxes by the 82 participating countries. The iPhone is assembled in China from components originating around the world by Foxconn, a Taiwanese company. Foxconn specializes in subcontracting production from companies like Apple and has more than a million employees in China.

It is tempting to think of exports of the iPhone from China as an appropriate focus for trade policy. However, the proportion of the value added by assembly in China is less than 7% of the total value of the iPhone. The video processor that resides at the heart of the iPhone is produced in Singapore by Samsung, the South Korean electronics company. The case for the iPhone is produced in the U.S., and the digital camera is made in Taiwan. All of these economies are participants in the ITA.

While Apple designs the iPhone, along with the iPad, the iWatch and so on, it also designs and manages the GVCs for these products. The theory of comparative advantage applies at each stage of the GVC. Multiple suppliers compete for Apple's business by bidding for the components that make up the iPhone or for processing these components into subassemblies. Apple provides a list of its 200 most important suppliers on the corporation's website. However, Apple actually has more than 700 suppliers.

Apple provides research and development, product design and software for the iPhone. In addition, the company plays an important role in the distribution of the iPhone to final consumers through Apple stores around the globe. However, much of the value added in production is through the design and management of the GVC that begins with electronic components and ends with delivery of the iPhone to the ultimate consumer. More than half the value of the production and distribution of the iPhone is added by Apple.

Production processes all over the world are fragmenting into complex streams of individual tasks. Some tasks involve production of components, others combine these into subassemblies, and the sub-assemblies are assembled into a product like the iPhone. Since the components and subassemblies that make up the iPhone cross international borders many times, trade policy must provide the institutional framework for integrating the activities of hundreds of suppliers in dozens of countries. The ITA provides a highly successful example of an international free trade agreement that has succeeded in meeting these exacting requirements.

At the risk of oversimplification, the purpose of the TPP is to enable the participating Pacific Rim countries to take advantage of the increasing importance of GVCs. The reduction of barriers to trade by reducing and removing tariffs and eliminating nontariff barriers has created many new opportunities. These opportunities are especially important to the U.S., home to many of the multinational corporations that design and manage GVCs.

Productivity boost

Prime Minister Shinzo Abe of Japan has actively promoted the TPP, for example, in his well-received speech to the U.S. Congress in April 2015, emphasizing the economic and strategic benefits to the U.S., Japan and the other participants. Japan's multinationals are active in the development and management of GVCs and provide many of the highly sophisticated technologies that are required. At the same time, the Japanese labor force is shrinking. Through greater participation in GVCs, Japan could revive productivity growth, which has languished for more than two decades.

The importance of the principle of comparative advantage that underlies the TPP has vastly increased as a consequence of the proliferation of GVCs. The growing advantages of a more elaborate international division of labor have made the economic rationale for international agreements like the TPP far more compelling. This is already reflected in the strong support of the TPP by the governments of the participating countries. It is also reflected in the recent expansion of the ITA to include a wider range of products and many more participants. Ratification of the TPP by Washington will provide a legacy for Obama and will lead to many further steps to advance free trade around the world.

Dale W. Jorgenson is a professor of economics at Harvard University.

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