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.