Controlled and Uncontrolled Exports of Knowledge Capital

This post is me simply thinking out loud. So if you like tidy posts with a beginning and an end, just skip this one.

I’m thinking about cross-border flows of knowledge capital, which really screw up our interpretation of the trade statistics. In particular, the cross-border flows of knowledge capital make it really hard to understand the real meaning of our trade deficit with China.

Take this situation. An unnamed U.S. manufacturer, with fairly advanced technology,  wants to produce airplane parts in China where the manufacturing costs are cheaper. In order to do this, the manufacturer must transfer proprietary knowledge about the design of the parts, the materials, and the manufacturing process to the Chinese factory.  The parts are then shipped back to the U.S. , showing up as an import of airplane parts.

There are two extreme  possibilities (and plenty in between)

a) The factory is owned by the U.S. manufacturer. The knowledge capital is exported to the Chinese factory, and then imported again, as embodied in the airplane parts. There is no spillover of knowledge capital to the broader China economy.

b) The factory is owned by a Chinese manufacturer who is sophisticated enough to learn from the knowledge capital, and apply it to the production of other aerospace parts, to be sold on the broader export market. Moreover, the knowledge capital becomes part of the knowledge set of all the companies in the region. In this case, the imported knowledge capital fully spills over to the Chinese economy.

In case (a), call this a controlled export of knowledge capital. It looks like we are importing airplane parts, but in fact we are mostly importing our own knowledge capital. If we correctly accounted for knowledge capital in the trade accounts–i.e. if the Chinese factory paid full royalties for all the U.S. knowledge capital being used–it would look like our trade deficit was a lot smaller. The difference would also show up as a combination of a higher profit margin for  domestic airplane manufacturers, higher profit margins for airlines, and lower costs for air travellers. Presuming perfect competition in China, all of the gains from the shift overseas are captured by the downstream members of the supply chain.

In case (b), call it an uncontrolled export of knowledge capital. The imports of airplane parts would look exactly the same, but the rest of the economic system would be very different. Chinese manufacturers would become effective competitors to U.S. manufacturers in the market for airplane parts. This would drive down the prices that U.S. manufacturers could charge–not just for the original part, but for other parts as well.

In case (b), we would still have the original flow of knowledge capital to the factory, and the flow back in imports. Additionally,  it’s as if we gave a gift of knowledge capital to the Chinese economy for which we were not paid.

What happens when you give a gift of knowledge capital? In a world of monopolistic competition, if you give a gift of knowledge capital to one of your competitors, your profit margin unambiguously falls. In this case, the sum of corporate profits and improvements in consumer welfare would drop.

So in order to assess the true trade deficit  with China, we need to know (1) the value of the goods we are importing, (2) the exports  of knowledge capital from the U.S. to China necessary to produce those goods, and (3) whether those exports of knowledge capital are controlled or uncontrolled.

The iPhone is probably an extreme case, where Apple does a good job of keeping its exports of knowledge capital under control. Other companies? Not so much.

I welcome any and all comments and criticisms. My goal is to build up a more sophisticated framework for thinking about global trade, including knowledge capital flows.

 

 

Comments

  1. “The iPhone is probably an extreme case, where Apple does a good job of keeping its exports of knowledge capital under control.”

    Well, and a major element of the knowledge capital that comprises the iPhone is in the software that runs on the platform, and not in the hardware to make the iPhone. The iPhone hardware is easily duplicated: witness the number of near perfect hardware knockoffs of the iPhone hardware in the Chinese marketplace. But the software is nearly impossible to imitate.

    For other manufacturers, where the software comes from a third party supplier (such as a Microsoft Windows based computer tablet), it is far easier for a Chinese knock-off to work as well as, and sometimes even better than, the original product from which the knowledge capital was taken.

    Also, one wonders how lower prototyping costs and lower short-run manufacturing costs (such as represented by the MakerBot, http://makerbot.com/, a $1,000 3D prototyping printer) will affect the overall marketplace, as it significantly reduces the cost in iterating through prototypes, making it easier and cheaper to close gaps in incomplete knowledge–thus making it easier for knowledge capital to escape.

    Sorry for butting in, but I’m extremely fascinated by these developments. I believe we’re on the cusp of a new industrial revolution, but I don’t know what it may look like.

  2. Michael – Here’s the very complex dilemma we face:

    Innovation generally comes through collaboration and sharing knowledge. So protecting knowledge can actually impede innovation. The question becomes how to ensure that your organization is in the middle of and will benefit from the innovations that come out of any collaboration. Walling ourselves off from China is not the answer.

    What should be of concern to everyone in the U.S. is not that we are sharing some of our knowledge with China, it is that we are not even considering the flow of knowledge as important. This, I believe, is one of the many dangerous consequences of our failure to create measurement and reporting systems for knowledge intangibles.

  3. Stephen McCracken says:

    Mike, can you elaborate on why consumer welfare would suffer in case (b)? It’s not clear to me.

    • Mike Mandel says:

      This is what perplexed me for a while too. But suppose we have a situation where the U.S. can charge a premium for its products globally because of its knowledge capital. Then if the U.S. makes a gift of its knowledge capital to China, the premium disappears and global market prices fall, even though nothing has changed about the U.S. production process. Then U.S. consumers can be worse off.

    • So the idea is that U.S. consumers are worse off because U.S. companies and U.S. workers have made a gift of producer surplus to the Chinese, not that all consumers in all parts of the world are worse off?

      • Mike Mandel says:

        Obviously the Chinese are better off. And collectively consumers worldwide are better off. Generally, I think, the benefits would accrue to the non-owners of knowledge capital because the premium would fall.

      • But wouldn’t the uncontrolled transfer of knowledge disincentivize further creation of knowledge capital, if the original creators of it were not able to fully realize the value of their creation? And wouldn’t that lead to a long term decline in the creation of such knowledge capital, thus leaving everyone worse off?

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