International Economic Journal

ISSN: 1016-8737 (Print) 1743-517X (Online) Journal homepage: https://www.tandfonline.com/loi/riej20

Country and industry-level determinants of

vertical specialization-based trade

Don P. Clark

To cite this article: Don P. Clark (2006) Country and industry-level determinants of
vertical specialization-based trade, International Economic Journal, 20:2, 211-225, DOI:
10.1080/10168730600699515

To link to this article: https://doi.org/10.1080/10168730600699515

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International Economic Journal
Vol. 20, No. 2, 211– 225, June 2006

Country and Industry-Level

Determinants of Vertical
Specialization-Based Trade

DON P. CLARK

Department of Economics, University of Tennessee, Knoxville, USA

ABSTRACT This paper investigates country and industry-level determinants of vertical

specialization-based trade. Industries that engage in this pattern of trade are identified
through their use of offshore assembly provisions in the US tariff code. Findings
explain why industries engage in vertical specialization-based trade and shed light on
factors that enter production location decisions. Identifying factors that encourage
vertical specialization-based production and trade will enhance our understanding of
industry strategy and how trade patterns will evolve as the process of globalization
continues. Results suggest vertical specialization-based trade will continue to grow
relative to total trade.

KEY WORDS : Vertical specialization, production sharing, offshore assembly provisions

Introduction
The rapid pace of globalization has created new competitive challenges.
Firms have responded to these challenges by integrating production across
national boundaries. Rather than producing in a single country, stages of
the production process are performed in multiple countries to exploit
inherent locational advantages such as proximity to markets and access to
cheaper inputs. This practice gives rise to a sequential method of production
in which a country exports a component to another country that uses it to

Correspondence Address: Don P. Clark, Department of Economics, University of Tennessee,

Knoxville, TN 37996-0550, USA. Email: dclark3@utk.edu
1016-8737 Print=1743-517X Online/06/020211–15 # 2006 Korea International Economic Association
DOI: 10.1080=10168730600699515
212 Don P. Clark

produce a product that is subsequently shipped back to that country or is

exported to third country markets. Hummels et al. (1998) uses the term ‘ver-
tical specialization’ to describe this pattern of production and trade.1
According to Hummels et al. (2001), vertical specialization-based trade is
rapidly increasing relative to total trade. For example, a group of ten OECD
countries and four emerging market countries was found to have experienced
an increase in vertical specialization of about 30% between 1970 and 1990.
Growth in vertical specialization accounted for 30% of the growth in these
countries’ exports. Other countries are expected to have much higher vertical
trade shares, because larger countries are more likely than smaller ones to
conduct every stage of the production process. Despite the growing import-
ance of vertical specialization-based trade, there have been no attempts to
identify both country and industry-level determinants of such production
and trade.
The present study seeks to contribute to our understanding of vertical
specialization by identifying country and industry-level determinants of the
decision to conduct vertical specialization-based production and trade.
Industries that are engaged in vertical specialization across national bound-
aries are identified through their use of the offshore assembly provisions
(OAPs) in the US tariff code. OAPs encourage firms to transfer one or
more production stages abroad, export components for assembly, and sub-
sequently import more advanced stages of the product. US OAP statistics
are the only official source of information on the use of US-made components
in foreign assembly. Findings will explain why industries engage in vertical
specialization across national boundaries, and will shed light on factors
that enter production location decisions. Multinational firms must determine
where parts and components will be produced and where final products will
be manufactured. Understanding factors that influence the vertical speciali-
zation decision will assist in the formulation of global sourcing strategies
and in the design of global supply chains.
Three features of the present study represent improvements over earlier
attempts to identify determinants of OAP use. First, this study identifies
both country and industry-level determinants of OAP assembly activity.
Earlier studies focus only on a small number of industry-level determinants.2
Country characteristics will establish the relative importance of factors that
enter production location decisions. Second, the analysis will focus on verti-
cal specialization-based trade associated with foreign assembly, the value of
US-made components exported for assembly, and with all OAP imports.
Previous studies consider only the latter. Finally, the analysis focuses on
country and industry-level determinants of offshore assembly that conform

1
Hummels et al. (1998) describes outsourcing as the relocation of component production to
another country and subsequent importation of components from that country. Components
are then used to make a good that is not exported. If the final good is exported, both out-
sourcing and vertical specialization are said to have occurred. Vertical specialization-based
trade refers to the value of imported inputs embodied in goods that are exported.
2
See Clark et al. (1989), and Clark et al. (2000).
 Country and Industry-Level Determinants of Vertical Specialization 213

closely to the theoretical framework set out in Helleiner (1973), to case

studies presented in Grunwald & Flamm (1985), and to information
obtained from surveys of actual OAP users conducted by the US International
Trade Commission (1988, 1998).
This paper is organized as follows. The next section describes the offshore
assembly provisions. Factors that influence the decision to conduct vertical
specialization-based production and trade are discussed in the subsequent
section. The fourth section presents results of the analysis. Conclusions
are summarized in the final section.

Offshore Assembly Provisions

Data are not available to determine the extent of vertically specialized
production and trade conducted by individual US firms. However, indus-
tries engaging in vertical specialization across national boundaries can be
identified through their use of the offshore assembly provisions (OAPs) in
the US tariff code. OAPs technically refer to items HTS 9802 of the Tariff
Schedule of the United States. Under tariff item HTS 9802.00.60 (for-
merly 806.30), articles of metal that have been manufactured, or
subject to a process of manufacture in the US, exported for processing,
and then returned to the US for further processing, are subject to duty
only on the value of processing performed abroad. Item HTS
9802.00.80 (formerly 807.0) provides duty exemptions for US-made com-
ponents returned to the US as parts of articles assembled abroad. Duties
are levied on the value of the article less the value of the US-made
components.3
OAP production and trade entail vertical specialization across national
boundaries. A distinction is drawn between dutiable OAP imports and
non-dutiable imports. Dutiable OAP imports represent the value added
associated with foreign production.4 Non-dutiable imports measure the
value of US-made components and materials originally exported from
the US for assembly abroad that are returned to the US embodied in more
advanced stages of products. The distinction between dutiable and non-
dutiable OAP imports will provide new insights into country and industry-
level determinants of US production activities that engage in vertically
specialized production and trade.

3
Imports under both items 9802.00.60 and 9802.00.80 are included in the present study. The
latter accounts for 99% of all OAP imports. More than half of the 4-digit Standard Industrial
Classification (SIC) industries use the OAPs. For a list of countries and industries engaged in
OAP assembly and vertical specialization, see US International Trade Commission (1998,
1999).
4
A US International Trade Commission (1988) publication identified four types of offshore
operations that use OAPs: (a) foreign-based manufacturers that use US-based components;
(b) US producers that moved assembly to low wage countries; (c) US-based producers that
produce abroad to expand export markets, but send some goods back to the US; and (d) multi-
national firms that process metals.
214 Don P. Clark

Determinants of Vertical Specialization-based Trade

Country-level determinants of OAP use are characteristics that influence the
attractiveness of a foreign country as a production location.5 Many of these
characteristics are identified from surveys of OAP users conducted by the US
International Trade Commission (1988, 1998). Included here are influences
related to factor endowment differences between the US and foreign
countries, workforce quality and availability, foreign market size, domestic
federal tax burden, exchange rates, trade orientation, and proximity to
foreign countries.
Heckscher– Ohlin theory explains the pattern of trade in goods between
two countries based on their differences in relative factor endowments.
According to the Heckscher– Ohlin theorem, each country will export the
good that uses its abundant factor intensively and will import the good
that is intensive in its relatively scarce factor. Factor endowment differences
also influence the decision to engage in vertical specialization across national
boundaries. The US relative factor abundance, and hence comparative advan-
tage, lies in skilled labor. Unskilled labor is the true scarce US factor. The US
has a pronounced comparative disadvantage in unskilled labor intensive pro-
ducts. US-owned firms have reacted to this disadvantage by shifting simple
assembly operations to unskilled labor abundant countries to gain access to
low cost labor and improve their competitive position vis-à-vis foreign
countries. OAPs allow unskilled labor abundant countries to perform
segments of the production process in which they have a comparative advan-
tage (assembly). Because US-made components re-enter the US on a duty-free
basis, OAPs permit the US to perform parts of the production process in
which it has a comparative advantage (skilled labor and high-tech com-
ponents).6 Unskilled labor abundance is proxied by per capita GDP.7 OAP
use is expected to be negatively related to per capita GDP (PCGDP) of the
foreign country.
Many countries are potential candidates for offshore assembly operations.
When deciding on locations for offshore assembly, important considerations
include the quality and availability of the labor force. A quality labor force
is healthy and productive. Quality of the labor force is proxied by health
expenditures per capita. Availability of the workforce is measured by popu-
lation density. OAP use is expected to be positively related to both health
expenditures per capita (HEALTH) and population density (DENSITY).

5
Variable definitions and summary statistics are presented in the Appendix.
6
Feenstra et al. (2000) found goods exported from the US for further processing were more
skilled labor intensive than other goods US industries produce.
7
It is common practice to interpret differences in per capita income across countries as
differences in capital-labor endowment ratios. Unskilled labor abundant countries will have
relatively low levels of per capita income. See, for example, Helpman & Krugman (1985),
Helpman (1987), and Clark & Stanley (1999). A preferred approach would be to use the
actual capital – labor endowment ratio. These figures are unavailable for most countries in
the present study and are likely to be unreliable when available.
 Country and Industry-Level Determinants of Vertical Specialization 215

Distance between countries is an important determinant of plant location.

Closeness to the US affords greater management control, enables producers
to respond quickly to changing market conditions, facilitates just-in-time
inventory and production schedules, and speeds communications among sup-
pliers, managers, and customers. Proximity also reflects such factors as
regional economic integration, cultural and language differences, and
general market familiarity. OAP use will be negatively correlated with
distance (DISTANCE) between the US and a foreign country.
US-owned firms locate assembly operations abroad for reasons other than
reducing labor costs. Certain US firms produce abroad to gain greater access
to foreign markets. Motives for producing and selling abroad may include
such things as avoiding import barriers, minimizing exchange risk, increasing
foreign sales, or gaining greater product acceptance. Regardless of the
motive, the most important factor influencing the desire to penetrate
foreign markets is market size. GDP serves as a measure of market size.
OAP is expected to vary positively with GDP of the foreign country.
It is widely recognized that countries will attain higher growth rates and
will industrialize faster by adopting outward-oriented trade policies rather
than using inward-oriented policies.8 Outward-oriented strategies seek to
reduce trade barriers and other government regulations that favor production
for the domestic market over production for export. Economies that are open
to trade use outward-oriented policies that make them more attractive
locations for assembly operations. OAP use is expected to be positively cor-
related with the trade orientation (TO) of foreign countries.9
Surveys of OAP users conducted by the US International Trade Commis-
sion (1988) identified three additional factors often considered when deciding
among alternative production locations. Firms look for locations with a low
federal tax burden, a realistic exchange rate policy, and a stable government.
The tax burden is measured by tax revenue as a percentage of GDP. The black
market premium exchange rate reflects exchange rate distortion and macro-
economic stability in the host country. Institutions that foster civil liberties,
political freedoms, and government stability are proxied by an index of pol-
itical rights. OAP use is expected to be negatively related to the federal tax
rate (TAX). Countries with low levels of exchange rate distortion, as
measured by the black market premium (BMP) exchange rate, and those
enjoying political rights (RIGHTS) will be likely candidates for OAP activity.
Industry-level determinants of OAP use are well established in the
literature.10 Included here are factors related to comparative advantage,
characteristics of products produced by multinationals, trade barriers, and
import competition in the home market.

8
See Dollar (1992), and Clark (1997).
9
See Dunning (1979).
10
For example, Helleiner (1973) and Grunwald & Flamm (1985) discuss labor costs, trans-
portation costs, tariffs, scale economies, and the ability to segment production processes as
determinants of offshore activity.
216 Don P. Clark

Production cost differentials across countries influence the decision to

locate production operations in foreign countries. The US has a pronounced
comparative disadvantage in low-wage unskilled labor intensive production
activities. Low wage industries in the US would be likely candidates for
OAP use. According to a US International Trade Commission (1988)
study, labor cost is the most influential factor shaping the decision to conduct
offshore assembly. OAP use is expected to be negatively correlated with the
average US industry wage (WAGE).
Vertical specialization enables countries to perform certain stages of
production at home and shift other stages to foreign countries where they
can be performed at least cost. Cost savings from foreign production must
be compared to advantages inherent in home production. When firms
enjoy scale economies in home production, they will have less incentive to
geographically fragment production stages and locate some stages in
foreign countries than will firms without scale economies. Vertical specializ-
ation across national boundaries will become increasingly attractive as scale
economies become less pronounced. Minimum efficient scale measures scale
economies in each industry. OAP use is expected to be negatively correlated
with the minimum efficient scale (MES) of US production activities.11
Industries producing differentiated products are dominated by multina-
tionals. North–South trade models differentiate products and components
according to quality. Vertical specialization across national boundaries will
enable each product and component to be made where production conditions
are most favorable. High quality products and components will be produced
in the United States and low quality versions will be made in developing
countries. High-quality US components will be used in foreign assembly
operations to produce low quality products that are returned to the US, and
vice versa.12 The advertising-to-sales ratio is commonly used as a measure
of product differentiation. Advertising is intended to differentiate products
by exploiting quality differences. OAP use is expected to be positively
correlated with the degree of product differentiation as measured by the
advertising-to-sales ratio (AS).
Multinationals have high levels of R&D expenditures relative to sales.13
Firms producing technology intensive components can face intense compe-
tition in final product markets. OAPs enable these firms to retain product
design and production of high technology components. Shifting labor inten-
sive final assembly operations to low wage countries enhances their overall
competitive position and enables them to produce and export more high-
tech components than would otherwise be possible. R&D intensity is
measured by R&D expenditures as a percentage of net sales. OAP use is
expected to be positively related to R&D intensity (R&D).

11
See Helleiner (1973).
12
See Vernon (1974).
13
See Markusen (1995) and Helleiner & Lavergne (1979).
 Country and Industry-Level Determinants of Vertical Specialization 217

Government-imposed and natural barriers to trade will influence industry

participation in offshore assembly production. Most notable among these
barriers are tariffs, non-tariff measures, and international transportation
charges. Tariff duty savings are a recognized motive for conducting off-
shore assembly. High tariff industries will have a greater incentive to take
advantage of OAPs than low tariff industries.14 Non-tariff measures
(NTMs) such as quantitative import restrictions share a common purpose
with OAPs. Both are used to counter a comparative disadvantage in home
production. International transportation charges, a natural trade barrier,
will influence the decision to engage in offshore production. Industries assem-
bling products with high value-to-weight ratios will face low ad valorem
international transportation charges, making them likely candidates for
vertical specialization across national boundaries. OAP use is expected to
vary positively with both the US tariff rate (TARIFF) and the presence of
NTMs, and negatively with ad valorem international transport charges
(TRANS).15
Industries engage in offshore assembly to lower manufacturing costs in
order to become more competitive with foreign producers who sell in the
US market. According to a US International Trade Commission (1988)
study, industries using OAPs face high levels of import penetration in the
home market. OAP use is expected to be positively related to the intensity
of import competition at home as measured by the import penetration
ratio (PENETRATION).

Empirical Strategy and Results

A probit specification is first used to identify factors that influence the
decision to engage in vertical specialization-based trade. The dependent vari-
able takes on the value of one if a four-digit Standard Industrial Classification
(SIC) industry conducts offshore assembly, and zero otherwise. An industry is
classified as either conducting offshore assembly, or not, based on the pre-
sence of 1992 OAP imports. Sixty countries and up to 377 four-digit SIC
industries are included in the analysis.
A binary measure of offshore assembly participation is initially employed
as the dependent variable rather than using a continuous specification in
which the dependent variable is the share of offshore production in US
trade, because data on the full extent of offshore production are not available.
Employing a continuous dependent variable that measures OAP imports
relative to total US trade will not fully capture the extent of offshore
production activity because some industries assemble US components into
products that are sold in markets outside the United States. Such production

14
See Grunwald & Flamm (1985: 240).
15
Foreign tariffs and non-tariff measures also influence the location of production. These
data are unavailable on a disaggregated basis for the countries included in the present
study.
218 Don P. Clark

will not be reflected in the numerator of this dependent variable. For

example, dutiable OAP import values will understate the true value of
foreign production when offshore operations assemble components into
products for sale in either local or third markets.16 The binary dependent
variable will serve as a general measure of vertical specialization-based
trade by indicating whether or not an industry engages in OAP activity.
Probit estimates identify determinants of vertical specialization-based
trade. A random effects model is used to control for unobservable industry-
level factors that may vary across observations.17 Such intangibles as
managerial know-how, industry-specific border-related hindrances, or tech-
nological developments that facilitate separation of production stages
might be important determinants of vertical specialization.18 Figures
shown in column 1 of Table 1 represent marginal effects on the probability
of conducting vertical specialization-based trade given a one-unit change in
each explanatory variable, holding all other variables constant at their
mean values. Results are generally consistent with our expectations. Nearly
all of the country-level characteristics are found to exert significant influences
on the probability of engaging in vertical specialization-based trade. Coeffi-
cients on per capita GDP (proxy for the capital-to-labor endowment ratio),
population density, workforce health, distance, GDP (market size), trade
orientation, and the black market premium exchange rate have the expected
signs and differ significantly from zero. The significant negative coefficient on
PCGDP suggests OAPs enable US firms to reduce their comparative disadvan-
tage in unskilled labor intensive production by moving these activities to
labor abundant countries. Factors to be considered when locating segments
of the production process abroad include workforce quality (HEALTH)
and availability (DENSITY). DISTANCE exerts a negative effect on the prob-
ability of engaging in offshore production. Some firms produce abroad to
gain greater access to foreign markets. The significant positive coefficient
on GDP highlights the importance of foreign market size in the decision to
produce abroad. Results also show that trade orientation and the degree of
exchange rate distortion (BMP) are important determinants of the decision
to engage in vertical specialization-based trade.19 The tax burden (TAX)
coefficient is positive and significant. This finding is not consistent with our

16
See Grunwald & Flamm (1985: 34– 37) for a discussion of this issue and other important
exclusions from OAP data.
17
A likelihood ratio test is used to compare random effects models with a model that does not
include random effects. We reject the null hypothesis that random effects do not contribute to
the model at all standard levels of significance. Fixed effect probit and tobit models are not
readily available.
18
Factors that influence the availability to search for a partner and establish relationship-
specific investments in an environment of incomplete contracts influence the success of out-
sourcing. See Grossman & Helpman (2005).
19
The black market premium exchange rate measures the deviation of the black market
exchange rate from the official rate. A negative coefficient is consistent with the hypothesis
that greater exchange rate distortion reduces the likelihood of vertical specialization.
 Country and Industry-Level Determinants of Vertical Specialization 219

Table 1. Determinants of vertical specialization-based trade

Tobit models

OAP Dutiable Non-dutiable

Variable Probit model trade Share trade Share trade share

PCGDP 20.0120a 20.4008a 20.2342a 20.1622a

(0.0021) (0.0594) (0.0366) (0.0256)
HEALTH 0.0043b 0.1525a 0.1001a 0.0488b
(0.0019) (0.0571) (0.0358) (0.0261)
DENSITY 0.0048a 0.2294a 0.0930a 0.1130a
(0.0011) (0.0341) (0.0195) (0.0146)
DISTANCE 20.0179a 20.5132a 20.2710a 20.2251a
(0.0019) (0.0464) (0.0248) (0.0176)
GDP 0.0094a 0.1166a 0.1064a 0.0236a
(0.0011) (0.0211) (0.0145) (0.0088)
TO 0.0214a 0.4204a 0.3393a 0.1606a
(0.0029) (0.0670) (0.0447) (0.0286)
TAX 0.0001a 0.0024a 0.0010a 0.0011a
(0.00001) (0.0003) (0.0002) (0.0001)
BMP 20.0308a 20.7660a 20.4227a 20.2865a
(0.0051) (0.1307) (0.0776) (0.0535)
RIGHTS 20.0005 20.0843a 20.0328b 20.0369a
(0.0008) (0.0239) (0.0148) (0.0109)
WAGE 25.75e-07b 20.00002a 21.20e-05a 23.02e-06b
(2.43e-07) (0.00001) (3.93e-06) (1.52e-06)
MES 20.0825b 22.0347b 21.1467b 21.6265a
(0.0334) (0.8932) (0.5525) (0.3121)
AS 0.0033a 0.1056a 0.0613a 0.0394a
(0.0013) (0.3777) (0.0207) (0.0071)
R&D 0.0055a 0.1445a 0.0884a 0.0399a
(0.0008) (0.0222) (0.0132) (0.0054)
TARIFF 0.0018a 0.0728a 0.0336a 0.0332a
(0.0003) (0.0105) (0.00055) (0.0031)
NTM 0.0003a 0.0056a 0.0031a 0.0029a
(0.00005) (0.0012) (0.0007) (0.0005)
TRANS 20.0046a 20.1486a 20.0835a 20.0839a
(0.0005) (0.0113) (0.0066) (0.0041)
PENETRATION 0.0006a 0.0092a 0.0067a 0.0057a
(0.0001) (0.0028) (0.0018) (0.0010)
Predicted 0.0203
probability
Predicted 0.7015 0.4397 0.2758
trade share
r 0.2787 0.2451 0.2307 0.0028
(0.0223) (0.0201) (0.0194) (0.0000)
N 13,803 13,803 13,803 13,803

Note: Entries are marginal effects coefficients with standard errors in parentheses. All models include
industry-level random effects. r is the share of the variation in the dependent variable that is explained
by the random effects.
a
Significant at the 1% level (two-tail test).
b
Significant at the 5% level.
220 Don P. Clark

expectations.20 Only the coefficient on the index of political rights (RIGHTS)

is not significantly different from zero.
All of the coefficients on industry-level characteristics have the hypo-
thesized signs and are significantly different from zero. The probability of
conducting vertical specialization-based trade is negatively related to the
average industry wage, extent of scale economies, and the ad valorem inter-
national transportation charge. The significant negative coefficient on WAGE
reflects the intention of low wage industries to reduce their degree of
comparative disadvantage by shifting assembly to labor abundant countries.
Product differentiation (advertising intensity), R&D expenditures as a
share of sales, the tariff rate, non-tariff measure trade coverage ratio, and
the degree of import penetration in the US market all exert positive effects
on the probability of conducting vertical specialization-based trade. R&D
intensity exerts a positive influence on vertical specialization-based trade
because many US components shipped abroad for assembly are skilled
labor and technology intensive. The significant positive coefficient on
TARIFF reminds us that tariff savings are a recognized motive for taking
advantage of the OAPs. Significant positive coefficients on TARIFF and
NTM reflect the practice of using OAPs to counter a comparative disadvan-
tage in home production. All of these findings are consistent with infor-
mation obtained from surveys of OAP users conducted by the US
International Trade Commission (1988), and are consistent with expec-
tations from theoretical discussions in Helleiner (1973) and Grunwald &
Flamm (1985).
Many country and industry-level variables are found to exert significant
influences on the decision to conduct vertical specialization-based trade.
When the scale of each variable is taken into account, most variables are
found to exert a relatively small impact on the predicted probability of con-
ducting vertical specialization-based trade. Variables with the relatively
largest impacts include PCGDP, DISTANCE, TRANS and TARIFF. The
change in each variable required for a 1% increase in the predicted prob-
ability is as follows: a $216 decline in PCGDP, an 88 km reduction in
DISTANCE, a 4.4% reduction in TRANS, and an 11% increase in TARIFF.
The second stage of the analysis takes a more narrow view and focuses on
vertical specialization-based trade involving US-made components returned
to the US as parts of products assembled abroad. Unlike the probit specifi-
cation, this analysis does not account for US components used in foreign
assembly to make products that are consumed locally or shipped to third
countries. Determinants of vertical specialization-based trade are identified
for all OAP imports, dutiable OAP imports (foreign production), and for
non-dutiable OAP imports (US components embodied in goods returned to
the US) relative to total trade. Dependent variables are values of OAP

20
Perhaps our tax measure reflects the ability of a foreign country to support the infrastructure
necessary to attract and sustain offshore assembly.
 Country and Industry-Level Determinants of Vertical Specialization 221

imports, dutiable OAP imports, and non-dutiable OAP imports, each

expressed as a share of total US imports. Values for these dependent variables
are restricted to the interval between zero and 100%. Consequently, we esti-
mate a two-limit random industry-effects tobit model that accounts for clus-
tering at zero and 100, and allows us to examine the continuous variation in
each OAP trade share. All of our measures have observed minima at zero for
approximately 89% of the 13,803 observations. The OAP import share has
observed maxima of 100 for 43 observations, while the dutiable OAP
share has one observation with the upper limit value.
Marginal effects coefficients from the tobit analysis are reported in
columns 2 through 4 of Table 1. The non-dutiable OAP trade share con-
forms most closely to the definition of vertical specialization-based trade
used by Hummels et al. (1998) that includes the value of imported inputs
embodied in goods that are exported. Findings are generally consistent
with our expectations. Results reported in columns 2 through 4 are extre-
mely similar, and are remarkably consistent with those in column 1. Regard-
less of the OAP-based measure used, the same country and industry-level
characteristics emerge as important determinants of vertical specialization.21
The main difference between the two sets of results is that tobit estimates in
columns 2– 4 confirm the importance of political freedom as a determinant
of production location and vertical specialization-based trade. The coeffi-
cient on political RIGHTS has the expected sign and is significantly different
from zero.22
Marginal effects coefficients reported in columns 2– 4 are statistically
significant, but most variables are found to exert a relatively small impact
on the predicted trade shares. Variables with the greatest impacts on the
OAP trade share include DISTANCE, TRANS and WAGE. The change in
each variable required for a 1% increase in the predicted OAP trade share
is as follows: a 106 km decline in DISTANCE, a 4.7% reduction in
TRANS, and a $365 decline in WAGE. The same three variables exert the
largest impacts on the dutiable OAP (foreign production) trade share.
Here, the change in each variable required for a 1% increase in the predicted
dutiable OAP trade share is a 126 km decline in DISTANCE, a 5.3%
reduction in TRANS and a $366 decline in WAGE. DISTANCE, TRANS
and TARIFF exert the largest impacts on the non-dutiable OAP trade
share. The change in each variable required for a 1% increase in the predicted
non-dutiable OAP trade share is a 95 km decline in DISTANCE, a 3.3%
reduction in TRANS, and an 8.3% point decline in TARIFF.

21
Swenson’s (2004) study of OAP determinants found the OAP import share was positively
related to a country’s production costs and negatively related to competitor costs. Negative
relationships were established between the OAP share and GDP, per capita GDP, and
distance.
22
The Barro & Lee (1994) index of political rights varies from 1 to 7, with ‘1’ indicating ‘most
free.’ A negative coefficient is expected for this variable because we hypothesize that greater
political rights will raise the likelihood of vertical specialization-based trade.
222 Don P. Clark

Conclusions
This paper investigates country and industry-level determinants of vertical
specialization-based trade. Industries that engage in this pattern of
production and trade are identified through their use of offshore assembly
provisions in the US tariff code. Findings explain why industries engage
in vertical specialization-based trade and shed light on factors that enter
production location decisions.
US industries engage in vertical specialization-based trade to counter a
comparative disadvantage in home production by shifting simple assembly
operations to unskilled labor abundant countries. Other motives include pro-
ducing and exporting more R&D intensive components than would other-
wise be possible, gaining greater access to foreign markets, enjoying tariff
duty savings, and becoming more competitive with foreign producers who
sell in the US market.
Factors that enter production location decisions include labor force avail-
ability and quality, foreign market size, proximity to foreign countries, politi-
cal rights, degree of exchange rate distortion, and the trade policy orientation
of host countries. Industries that engage in vertical specialization-based trade
have relatively low wages, less pronounced scale economies, high tariffs and
non-tariff measures, relatively low ad valorem international transport costs,
differentiated and R&D intensive products, and have high levels of import
penetration at home.
Identifying factors that encourage vertical specialization-based production
and trade will enhance our understanding of industry strategy and how trade
patterns will evolve as the process of globalization continues. Globalization
will continue to force many industries to lower overall production costs by
shifting segments of the production process to locations where they can be
conducted more efficiently. This trend leads to the expectation that vertical
specialization-based trade will continue to grow relative to total trade.

Acknowledgments
The author is grateful to Donald Bruce and two anonymous reviewers for
providing many helpful comments.

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Appendix
Data Definitions and Sources
Offshore Assembly Provision (OAP) imports, dutiable OAP imports, and
non-dutiable OAP import values pertain to 1992, and are taken from a US
Bureau of the Census (1995b) publication.
Figures on Gross Domestic Product (GDP) and Per Capita Gross Domestic
Product (PCGDP) pertain to 1992 and are taken from United Nations (1997).
Population DENSITY, expressed in people per square kilometer, and
HEALTH expenditures per capita are taken from a World Bank (2001) pub-
lication. DISTANCE, in kilometers, is from Fitzpatric & Modlin (1986).
These variables are expressed in natural logarithms. Following Stone &
Lee (1995), trade orientation (TO) is proxied by the residuals from a
regression of per capita merchandise trade (exports plus imports) on per
capita income and population. Data are from United Nations (1997). TAX
revenue as a percentage of GDP is from a World Bank (2001) publication.
The black market premium (BMP) exchange rate expresses the deviation of
the black market exchange rate from the official exchange rate. BMP rates,
taken from Barro & Lee (1994), are averaged over the 1985– 98 period.
The index of political rights (RIGHTS) is from Barro & Lee (1994). This
index varies from 1– 7, with ‘1’ indicating most free.
The average wage (WAGE) is total employee compensation per worker.
Minimum efficient scale (MES), our scale economy measure, is defined as
average sales per firm for firms in the midpoint class size (defined by
product shipments) as a percentage of shipment values. These figures
pertain to 1992 and are from the US Bureau of the Census (1995a). The
advertising-to-sales ratio (AS) pertains to 1987 and is calculated from a US
Department of Commerce (1994) publication. R&D expenditures as a per-
centage of sales (R&D) in 1992 is taken from a National Science Foundation
(1993) publication. These figures are available only at the 2 and 3-digit SIC
level.
Ad valorem tariff rates (TARIFF) are from the US Bureau of the Census
(1993). The non-tariff measure trade coverage ratio (NTM) expresses the
share of imports (by value) subject to one or more non-tariff measures.
Non-tariff measures include para-tariff measures (such as tariff-rate
quotas), import licensing schemes, antidumping duty actions, price actions,
import quotas and voluntary export restraint agreements. NTM trade cover-
age ratios pertain to 1992, and are from the United Nations Conference on
Trade and Development (UNCTAD) database on Trade Control Measures.
Ad valorem international transport charges (TRANS), and the total value
of US imports are from the US Bureau of the Census (1993). Import PEN-
ETRATION expresses the 1992 total value of imports as a share of total
 Country and Industry-Level Determinants of Vertical Specialization 225

domestic market supply (shipments plus imports). This variable measures

intensity of foreign competition in the home market.

Summary Statistics

Standard
Variable Mean deviation Minimum Maximum
OAP Share 2.558 13.055 0.000 100.000
Dutiable OAP Share 1.279 6.954 0.000 100.000
Non-dutiable OAP share 1.278 7.896 0.000 93.811
PCGDP 8.787 1.416 5.370 10.450
HEALTH 4.987 1.024 2.054 6.763
DENSITY 4.688 1.107 2.398 6.778
DISTANCE 8.636 1.259 2.302 9.676
GDP 11.772 1.683 7.392 15.130
TO 0.007 0.524 21.506 1.325
TAX 41.421 101.515 10.000 960.000
BMP 0.186 0.531 0.000 3.731
RIGHTS 2.602 1.692 1.000 6.500
WAGE 33024.230 9887.152 14092.000 65036.000
MES 0.027 0.075 0.000 1.000
AS 1.886 1.759 0.000 15.000
R&D 2.304 2.580 0.500 13.800
TARIFF 4.454 5.611 0.000 153.800
NTM 6.681 23.137 0.000 100.000
TRANS 8.273 11.787 0.000 498.9
PENETRATION 9.144 12.019 0.000 91.123