The productivity effects of Australia’s withdrawing from supply chains

Australian trade is concentrated at both the beginning and end of international supply chains. Australia mostly exports commodities — raw materials for transformation into industrial goods — and imports finished products, some of which are inputs into domestic production processes.

Beyond supplying raw materials and consuming finished products, Australia’s low economic complexity means it does not play a significant role beyond the beginning of supply chains. Australia’s withdrawal of commodities would disrupt other countries to the extent that they cannot find alternative sources of raw materials. With the exception of iron ore, the widespread availability of export commodities means Australia has little scope to use the threat of decoupling as a deterrent to other countries weaponising trade. Similarly, the small scale of the Australian market means a threat to ban imports is unlikely to be a major loss for most of its trading partners.

Given the inability to use the threat of decoupling as a deterrent, the justification for decoupling must be that it improves Australia’s resilience to disruptions in trade — for any reason. But Australia’s low levels of economic complexity means that import replacement will take time and require considerable investment.

Given the extent to which China is integrated into global value chains, does replacing international supply with domestic production that still needs imported inputs improve economic resillence? And what would be the cost to productivity?

Productivity rises when inputs are combined more efficiently, producing more output for the same level of inputs. For large fixed investments, such as mines, productivity rises due to economies of scale. Production ramps up until capacity is reached. But more important for productivity is how scale enables new technology and innovation in the production and delivery of output to market.

Adopting new technologies often involves a changing mix of inputs. This is mostly via a rise in capital inputs — including intangible capital, such as skills from learning by doing — relative to labour. Scale allows labour and capital to be combined more efficiently.

A classic example is the labour-saving technology of backhoes replacing shovels. A person and shovel are the most efficient approach to digging one hole, but the backhoe and skilled driver are much more efficient at digging many holes. Scale justifies increased investment in more sophisticated technology and in the skilled labour required to apply it.

The returns to scale from rising utilisation of capital and labour, and from adopting better technology, are the source of improvement in productivity. Technology applied at scale in mining, along with rich ore deposits, has made Australia one of the world’s most efficient producers. The same narrative applies to agriculture, where scale has justified investment in new production techniques, plant varieties and animal genetics.

These returns to scale apply even more to digital technologies than to physical equipment. Unlike investing in bigger and more automated backhoes, it is almost costless to scale up digital technologies. While productivity gains from mass production remain important, largescale data processing systems that support tailored design are an increasing source of productivity growth.

Connectivity that is embedded in products and improves performance — such as software updates in electric vehicles — is a new source of productivity growth, albeit one reflected in quality more than directly in productivity statistics. Here, too, scale matters. The unit cost of a software update — that is, productivity improvement — falls with the number of connected products.

Withdrawing from international supply chains reverses the productivity gains from scale through lower utilisation rates and adopting less efficient, smaller scale technologies. These effects are direct when replacing efficient imported products with less efficient domestic production and indirect when part of a broader protectionist trend that reduces demand for exports.

Australia’s small market means that production scale, and consequently productivity, will be lower even with the best technology at that scale. Withdrawing from international supply chains should be limited to products where technology is less scale dependent or there is export potential. If import bans are used to support domestic production, the forces of competition are also dampened. This only reduces firms’ incentives to improve their technology. Ways to expose firms to competition need to be devised. Unlike many other countries, Australian governments have resisted the temptation to use import tariffs or bans to promote domestic production.

For domestic production to improve resilience, any essential imported inputs — and the inputs into these products — must also not be at risk. The impact of import replacement on resilience is product dependent. What matters is themarket concentration in any of the essential inputs in domestic production that are vulnerable to disruption. This risk must be assessed before any decoupling is justified.

There is an additional cost to decoupling — gains to trade come from comparative advantage, as well as the scale and specialisation that scale enables. Comparative advantage harnesses differences in the relative abundance of resources to make trade mutually beneficial. Countries with surplus labour have a comparative advantage in labour-intensive production. Those with abundant mineral deposits have a comparative advantage in mining.

Withdrawing from international supply chains reverses gains from comparative advantage. As with trade agreements that provide tariff concessions to selected trading partners, onshoring and friend shoring imposes a net loss through trade diversion, by buying from a less efficient and more expensive producer.

To the extent that Australia’s withdrawal encourages other countries to take more protectionist stances, this also indirectly impacts productivity. Australia has benefited enormously from rapid economic growth in Asia, which has driven demand for products where Australia has a strong comparative advantage. The erosion of open trade and investment will slow both global growth and the demand for commodities.

It is in Australia’s interest to push back against this kind of protectionism. It is not only costly to domestic productivity for an uncertain improvement in economic resilience but also harms the development prospects of countries that deserve to prosper by harnessing their comparative advantages. The WTO Director General Okonjo-Iweala has expressed this concern in her calls for reglobalisation.

The productivity cost of onshoring will vary by product. So will the extent to which onshoring reduces the risk of supply chain disruption relative to other approaches, such as stockpiles. With little strategic leverage to gain from deterrence, Australia’s calculus must be on the value of improved resilience relative to the higher costs imposed on consumers and taxpayers through lost productivity.