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GLOBAL ALLOCATION OF PRODUCTION SEEN IN A DYNAMIC PERSPECTIVE.

INTRODUCTION

Due to the increasing globalization companies are competing and cooperating more and more across borders and continents. Companies can operate in a considerably larger marketplace than before and may relocate production to countries with fewer barriers. Because of this development the profitability of companies is determined by specialization in order to be able to compete effectively. In the economic reality, companies have to make strategic considerations as to the localization of production and where to sell the goods in the global context. Central to these considerations are the advantages of both foreign trade and locating production in a global context. Accordingly, one must focus on how these advantages depend on the economic development in a country.

This study provides an understanding of how the advantages of locating production in a global context change over time, and how a company should act in this context, which can be seen as recommendations. It is a theoretical study with messages seen in a general perspective so there are no concrete limitations.

In order to clarify the conditions that must be fulfilled before a company locates production in other countries, we present and elaborate on Dunning's OLI-model in section 2. In section 3, we clarify and discuss different strategies for locating production and, in this context, the motives of these strategies. How the advantages of locating production in a global context changes with the countries' economic development are explained and discussed in section 4. Furthermore, we clarify how cost savings seen in a dynamic perspective affect the choice of relocating production from one country to another. In section 5, the economic developments in China and Africa are used as illustrative cases.

BACKGROUND OF THIS STUDY

Dunning's Eclectic Paradigm: the OLI-model

If a company locates parts of the production in a foreign country by establishing a subsidiary, we have a global allocation of the production and thereby a multinational company. In order to clarify the conditions that must be fulfilled before a company locates production in other countries, we present and discuss Dunning's eclectic paradigm, the so-called OLI-model (e.g., Dunning, 1993; Dunning & Lundan, 2008). Dunning's OLI-model has long been the most influential framework for investigation of determinants in international production. The OLI-model was intended to provide an overall analytical framework that could include the most important theories for the problem at hand.

As an eclectic paradigm the OLI-model is a summary of various theories specifically related to the formation of multinational companies. According to Dunning's OLI-model, a global allocation of the production depends on the analysis and understanding of three advantages: Ownership-Specific Advantages, Location-Specific Advantages and Internalization-Incentive Advantages (Dunning & Lundan, 2008), thus the title OLI-model.

Ownership-specific advantages are advantages that the company has vis-a-vis companies in the particular markets in which it operates or plans to operate. These advantages largely take the form of the privileged possession of intangible assets and arise as a result of the common governance of cross-border value-added activities. According to Dunning there are three basic types of ownership-specific advantages (Dunning & Lundan, 2008).

The first type consists of property rights over e.g. raw materials and cheap inputs and/or intangible asset advantages as product innovations, production management, trade names, patents, organisational and marketing systems etc. The second type reflects the company's ability to manage and coordinate several geographically separated activities in various countries. Finally, the third type constitutes institutional assets, which means the formal and informal institutions that govern the value-added processes within the company, and between the company and its stakeholders.

Incentives for locating production in another country are to be found in the location-specific advantages. If it is not advantageous to locate parts of the production in another country, the total production is located in the company's home country. Otherwise, the production is split between the home country and a foreign country, and thereby the split productions are located in accordance with the location-specific advantages.

Finally, factors such as access to natural resources, producing close to final consumers or downstream customers and avoiding trade barriers, such as tariffs and import quotas, affect the location-specific advantages positively.

By internalization, i.e. offshoring where a subsidiary in a foreign country manages the production, the company is able to ensure product quality (forward integration) and stable supply of raw materials (backward integration). Furthermore, the company avoids problems with an agent who interrupts the contract and uses the technology to compete with the company.

Thereby the company keep the generated knowledge within the company and does not lose it through the market, and accordingly, the transfer of the knowledge generated by internal corporate channels sidesteps the market mechanisms. These internalization-incentive advantages are particularly relevant, if ownership-specific advantages have to be protected. Accordingly, key incentives for a company to internalize market are market imperfection and uncertainty.

Elaborations of Dunning's OLI-model

Some of the location-specific advantages are determined by the specialization and division of labor, known as comparative advantages (Ricardo, 1817), which means that the location-specific advantages are determined by the relation between the countries' factor endowment and hence by differences in wages and productivity and thus differences in unit labor costs.

Thereby, capital-intensive parts of the production are located in a capital-abundant country and labor-intensive parts of the production are located in a labor-abundant country (Luthje, 2003, 2005, and 2006). Hence, split productions are located in accordance with factor endowment of the countries. As a result, the specialization across countries can be seen as a refinement of the conventional framework of comparative advantages (Ricardo, 1817).

When we deal with allocation of production between developed countries, there is a need for another cost incentive connected to foreign trade theory than comparative advantages. To set out this argument we have to look at the advantages in the final good production by intraindustry trade in intermediate goods between developed countries (Luthje, 2005). The greater the distance is between the closest and the ideal variety of the intermediate good, the relatively greater is the adaptation and hence, the relatively smaller is the productivity in the final good production. This is due to the fact that the adaptation of the intermediate good leads to less labor and capital available in the final good production. Because intra-industry trade increases the number of intermediate good varieties, the final good producer will be able to find an intermediate good variety that is closer to the ideal for a specific production process, which leads to an increase in the productivity in the final good production. Therefore, the incentive for allocation of production between developed countries is given by the need for a specific variety of the intermediate good.

The cost advantages in the production, when allocating split productions across countries, can be modified by transport costs and reduced utilization of increasing returns to scale in the split productions (Luthje, 2001; 2005). Furthermore, we have to take into account the disadvantages that derive from the fact that the conditions of production in a foreign country are not the same as in the home country. The more split the production is, the greater are the coordination problems and the control and managerial costs. Furthermore, the company does not have the same knowledge of the foreign country's legislation as in the home country. In a similar way, cultural differences, language barriers, corruption and bureaucracy may affect the location-specific advantages negatively.

Transaction costs can also explain internalization-incentive advantages and thus the forming of a multinational company. The theory of transaction cost economics dates back to Coase (1937), who identified a transaction cost as "a cost of using the price mechanism". Williamson (1975, 1985, and 1989) refined this analysis and located the sources of transaction costs in the characteristics of human nature. One characteristic is labelled opportunism and refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate or otherwise confuse. Other sources of transaction costs are market uncertainty and asset specificity. Forming of a multinational company prevents that each producer of a split product fears that the other producer will abuse the relation, and thereby the transaction costs are minimized.

There are many factors in the macro-environment that affect the location-specific advantages as e.g. tax changes, development of clusters, differences in language and culture, corruption, bureaucracy, new laws, trade barriers, demographic change and government policy. These factors can be categorized by using the PESTEL-model, which stands for Political, Economic, Social, Technological, Environmental and Law analysis. The original version was called the PEST-model and was created by Aguilar (1967). Political factors refer to the degree in which a government intervenes in the economy and include tax policy, labor law, environmental law, education, the quality of the infrastructure and political stability.

Economic factors include interest rates, taxation, exchange rates, inflation and economic growth. Social factors cover factors as cultural aspects, population, age distribution, religion and ethnicity. Technological factors refer to activities as innovation and research and development that create new products and new processes. Technology improvements may also lead to reduced costs and increased product quality. Environmental factors, especially the climate and the weather, have implications for industries such as farming, tourism and insurance.

Furthermore, the protection of the environment has an impact on industries such as travel and transportation, but also creates new business opportunities. Finally, legal factors affect a company's costs and the demand for its products and cover consumer law, antitrust law, employment law, discrimination law and health and safety law.

To analyze the level of competition within an industry and to develop business strategies Porters Five Forces (Porter, 1980) can be used. Porter draws upon industrial organization economics to derive the forces that determine the competitive intensity and consequently the attractiveness of an industry. The five forces are: (1) the threat of the entry of new competitors, (2) the intensity of competitive rivalry, (3) the threat of substitute products or services, (4) the bargaining power of customers (buyers), and (5) the bargaining power of suppliers. It is appropriate to combine Porter's Five Forces with the SWOT-model, where SWOT is an abbreviation of Strengths, Weaknesses, Opportunities and Threats (Panagiotou, 2003). Strengths and weaknesses should be seen as internal factors, whereas opportunities and threats are external factors.

Hence strengths and weaknesses are relevant in connection with analysing the ownership-specific advantages, and opportunities and threats are relevant in connection with analysing the location-specific advantages. The SWOT analysis is a tool for auditing an organization and its environment. It is the first stage of planning and helps marketers to focus on key issues. Strengths are resources and capabilities of the business that give it an advantage over others in the industry and include a strong brand name, patents, reputation, cost advantages, access to natural resources and distribution networks.

Weaknesses represent the absence of strengths and thereby the characteristics that place the company at a disadvantage relative to others. Consequently, the concept includes deficiencies or weaknesses in the above examples of strengths. Opportunities cover external factors as for instance new technologies, loosening of regulations, customer needs and reduction in international trade barriers.

Finally, threats are elements in the environment that could cause trouble for the business as for instance substitute products, regulations and loss of customers. By using the SWOT analysis the company can get an overview of its strengths and weaknesses and identify areas, in which strategic changes will give the greatest returns, and the areas in the industry, that provide the best opportunities and the greatest threats to the company.

STRATEGIES FOR LOCATING PRODUCTION IN A NATIONAL AND A GLOBAL CONTEXT

In this section we clarify different strategies for locating production in a national and a global context and the motives for choosing these strategies. Instead of keeping the production in-house and in the home country and then export the final goods, the production can be pulled out of the company in different ways. Allocation of production can take the form of sourcing, in which a subcontractor manages the production; this can be to either a national or a global subcontractor. If the company is relocating production, it has itself been responsible for, we have outsourcing and this is also to either a national or a global subcontractor. Consequently, outsourcing has to be seen as a proper subset of sourcing. In the case of a foreign subcontractor we term it global sourcing and global outsourcing respectively. National and global sourcing and outsourcing are illustrated in figure 1.

Sourcing, including outsourcing, is based on a contract-based solution as for instance licensing with a subcontractor. If there is no risk of product imitation or reduced market control, the company should choose sourcing or outsourcing. It may also be advantageous to choose sourcing or outsourcing, if the company cannot afford to set up a subsidiary.

Moving production from a subcontractor to the company is termed insourcing, whereas withdrawal of production, that the company earlier had outsourced, is termed backsourcing. This does not mean that the production takes place in the home country, but only that it takes place within the company; therefore the production is in house. The difference between insourcing and backsourcing is illustrated in figure 2.

If the company itself manages the relocated production, we are dealing with the establishment of subsidiaries, which also can be seen in a national and a global context. If the production in a subsidiary abroad previously took place in the home country, we have offshoring, as outlined above in the context of internalization connected to the OLI-model. So only the relocation of production to subsidiaries in foreign countries is termed offshoring, and therefore offshoring is part of the establishment of subsidiaries. Does the company choose to take the production back to the home country, we have backshoring.

In figure 3 these two concepts are illustrated. Between the two globalization strategies, on the one hand sourcing including outsourcing and on the other hand establishment of subsidiaries including offshoring, we have joint venture, which is a business agreement between two or more partners involved in an economic cooperation. In a joint venture the partners share the risk, cost, loss and gain.

Between the two globalization strategies, on the one hand sourcing including outsourcing and on the other hand establishment of subsidiaries including offshoring, we have joint venture, which is a business agreement between two or more partners involved in an economic cooperation. In a joint venture the partners share the risk, cost, loss and gain. The agreed distribution of power is vital to the advantages of this globalization strategy. In a joint venture the single partner will have more influence and control than in sourcing, and a joint venture does not lead to financial challenges in the same way as the establishment of subsidiaries.

So, by the choice of globalization strategy to move from export over sourcing and joint venture to the establishment of subsidiaries, the more control one gets over the production and associated with this, the greater the extent of new investments also will be. Hence we have four globalization strategies to choose among and these are export, sourcing including outsourcing, joint venture and the establishment of subsidiaries including offshoring.

Dunning's OLI-model can therefore be seen as part of the advantages of choosing a globalization strategy, and the name of an extended model could be the OLGS-model, where GS stands for the choice of Globalization Strategy. In figure 4 the advantages in the OLGS-model and the choice of globalization strategy are illustrated. It appears from the figure that the OLI-model is included in the OLGS-model, as offshoring (I) is part of the establishment of subsidiaries in foreign countries.

The choice of globalization strategy is also a relevant perspective for companies that are born globally, which is a new generation of growth companies that, from their birth, have sold worldwide. Born global produce specialized and customized products and they focus on improving the product quality.

Because the choice of globalization strategy will affect the degree of control and management and thus the utilization of location-specific advantages, the chosen globalization strategy may affect the choice of location. If a company chooses sourcing or outsourcing, it may have to choose a country that is characterized by a trustworthy business environment with minimal risk of imitation and failure of agreements, even though labor costs are not as low as in other countries. It may also be advantageous for a company to choose sourcing or outsourcing instead of establishing subsidiaries, if the company wants to wait and see which opportunities the location can offer. Hence, the chosen globalization strategy may also affect the choice of locality, for example to find the most appropriate partner even though wages are higher. Both the advantages of the chosen globalization strategy and the location-specific advantages have an effect on the ownership-specific advantages, for example experience and competence. It thus appears that the OLGS-advantages have to be seen in an interactive perspective because of the interdependence between the single advantages. Consequently, it is not the way that one first identifies the ownership-specific advantages, then the location-specific advantages, and finally the globalization strategy.

IMPACT OF ECONOMIC DEVELOPMENT ON THE ADVANTAGES OF LOCATING PRODUCTION IN A GLOBAL CONTEXT

Nothing is static, nor are the OLGS-advantages. When a company wants to find a country to locate production in, it must focus on the fact that the advantages of locating production in a country depend on the country's economic stage and that these advantages change with the country's economic growth. Furthermore, developed countries are contributing to economic growth in developing countries, partly by locating production in these countries and partly by trading with these countries. Economic growth in a developing country will have an impact on the production as well as the demand in the country and therefore on the advantages of locating production in this country.

The developing country's supply of production factors becomes more capital intensive and is lifted to a higher level of technology, whereby the production possibilities in the country become more advanced. This implies that, in terms of production, the country increasingly will resemble the developed countries. As wages in the developing countries increase, demand in these countries will increase and lead to products at a higher quality level where developed countries have a strong position. This change in the purchasing power helps reinforce proximity to market as a key factor. Economic growth in the developing countries also increases these countries' educational level, which partly makes it possible to draw on knowledge in these countries and partly enables their consumers to achieve the skills needed to be able to use the developed countries advanced products. This should be seen as the advantage of economic development in the country, where the company has located its production. Accordingly, it is essential to get a foothold in a rapidly growing market in order to be at the forefront of development. Higher levels of education and improved technology and new knowledge gives developed countries further advantage by locating production in developing countries. So there may also be a strategic reason for moving business functions out of the home country.

Small and medium-sized companies are extra sensitive to how the economic development affects the advantages by locating production in a global context, since they are not in possession of the same financial opportunities as large companies. Moreover, they may also be exposed to increased competition in line with the increasing globalization all over the world. A central solution to these problems may be to cooperate with companies in the country where they want to locate production. By entering into or build a network in the country concerned, a company can make themselves known and familiarize themselves with the market and culture.

Consequently, we have to look at the OLGS-advantages in a dynamic way and to consider how the economic growth in the developing countries affects the advantages of locating production in a global context and thus the implications for strategic decision making. The economic growth in the developing countries has an impact on the countries production and demand side and thereby the advantages of locating production in these countries. Hence, there are two main advantages of locating production in a global context that economic growth over time affects in opposite directions:

1. Cost Savings

Versus

2. Proximity to Market and/or Drawing on Knowledge

The two main groups are connected and the weight between them changes with economic growth and consequently they must be seen in a dynamic way. This means that economic growth makes proximity to the market and/or drawing on the knowledge being developed in the country concerned more important, while the benefits of cost savings, including wage savings, are reduced. As mentioned above, the positive effect connected to reduced wage benefits in a country is that the population of the country can afford to buy the company's products and develops skills partly to use these products and partly to engage in the production of them at a more advanced level. Hence economic growth leads to main group 2 becoming more important relative to main group 1.

So the main groups' significance must be seen in relation to the motive of locating production in a global context. Companies that relocate production with focus on cost savings will typically move standardized production away from a country where wages are increasing to another low-wage country. This takes place for example by relocating production from China to Vietnam, but in this case there will over time also occur wage increases in Vietnam similar to the experience of China, so it should be seen as a temporary solution. Hence, companies, that are relocating production to another country particular to save costs, should be aware of the country's economic level as well as the way in which the economic development in the country is likely to be.

What seems to be a location-specific cost advantage in the short run, may decrease over time and finally disappear. Alternatively, production can be concentrated in a country close to the home country e.g. to save tariffs and transport expenses. It has turned out that companies that locate production in neighboring countries achieve greater advantage than companies that locate production in distant countries (Science, 2014). There are also advantages related to quality and culture, which more than offset the higher wages in neighboring countries. Finally, by concentrating production on fewer localities there will be better opportunities to utilize economies of scale.

There are also companies that draws production home in order to achieve a shorter reaction time, if sudden changes occur for example in the market. Moreover, it becomes easier to build up the organizational structure, and to exercise control and management, including managing the entire value chain (Arlbjorn & Luthje, 2012). In addition, employees in Western countries are characterized by being independent thinkers, loyal, innovative, possess a high work ethics and take initiatives. This compensates for the fact that the domestic wages might be higher than the foreign wages.

Furthermore, another reason why a number of companies choose to draw production home is the increased efficiency and advanced technology that have taken place in the home country (Luthje, 2015). Technological development has, among other things, led to significant development in robotic technology. The price of a robot has decreased by 25% in recent years, and robots are much more flexible, faster to program and can be used for many more things than in the past.

This means that the costs by automating the production are quickly recouped, and that even smaller companies can afford to invest in robots. It has also led to several companies needing to shift work to utilize robots as much as possible, so there must also be hired people for evening and night shifts and weekends. Companies must naturally only take the production home, they have the competence to perform, and they have to consider what needs to be invested in means of production. Hiring the right employees is of course also a necessary precondition and central to this are both professional qualifications and personality. In addition, a product may be marketed with the label "Made in USA", which gives credibility of quality, fashion and design etc. Furthermore, the consumer may create a prestige effect because one can profile oneself as having purchased a product that is "Made in USA".

Hence, for cost savings seen in a dynamic perspective there are three strategies to focus on when relocating production from one country to another country: (1) The production is relocated to another distant low-wage country, (2) The production is concentrated in a country close to the home country, where the wages are higher than in a distant low-wage country or (3) The production is moved back to the home country and is subject to automation including the use of robots (op. cit.).

THE ECONOMIC DEVELOPMENT IN CHINA AND AFRICA AS ILLUSTRATIVE CASES

The economic development in China has led to wage increases of over 10 percent per year, which has reduced the cost advantages by locating production in the country (Morrison, 2014). But derived from the rising wages, the Chinese middle and upper classes to a greater extent demand Western brands such as vehicles, clothes, bags, food and wine. The same situation applies for e.g. the wind power industry. The rapidly growing Chinese middle class may create a market for products that are "good enough" to be sold at a price that the Chinese middle class can afford. Such products need central attention in order to enter a fast growing market and to establish contacts in the immediate environment.

This trend in consumption is typically followed by lifestyle diseases and consequently pharmaceutical products also come into consideration. Therefore, the above considerations regarding the advantages of withdrawing production from, for example, China do not apply to companies that locates production in a country with the purpose to be close to the market or draw on knowledge.

Africa is the second largest continent and the economic growth in Africa has also led to a higher standard of living (Danish Industry, 2014) and thus a greater demand for more advanced products, where western companies have the opportunity to focus. One-third of Africa's population is today middle class and is real consumers. The start of the economic growth in Africa can be attributed to demand for Africa's natural resources such as oil, diamonds and minerals as well as the comprehensive debt relief. The economic growth also plays a role in the technological development in Africa.

Among other things, Kenya's information and communication sector represents five percent of the total gross domestic product, and in Kenya and other parts of East Africa the use of mobile banking has developed the banking sector, which has provided access to new customers. This has also led to the fact that the growth of, for example Nigeria, is no longer only determined by oil exports, but also by export within the communication, bank and retail sectors.

One of Africa's largest trade and investment partners is China (Danish Industry, 2014). The trade between Africa and China has been strongly increasing in recent years, and the greatest part of Chinese investment in Africa is directed towards the service sector and also towards agriculture and industry. It is expected that the development is reinforced by the construction of industrial parks in countries such as Nigeria, Ghana, Kenya and South Africa, for the purpose of attracting manufacturing companies. When establishing business in Africa it is advantageous to make contact with a network of people with knowledge of the African firms and the local areas. Moreover, it is well-advised to be present in person

Due to the economic growth in developing countries, companies in these countries also invest in Western countries. The outward investments from Singapore, Hong Kong and China to the Western countries are increasing, though still lower than the inward investments from the Western countries (OECD). For example, China is investing in health and environmental technology and Chinese investors also go for shipping, machinery, IT, real estate, food, and clothing and industrial design.

The Chinese interest is no longer limited to purchases of foreign companies with rights to natural resources such as mining and oil, which can be explained by their rapidly growing domestic market. Through Chinese investments, Western companies may obtain technology and new knowledge from China, technology that can be built upon and thereby also create growth and jobs.

CONCLUSION

This article provides an understanding of how the advantages of locating production in a global context change over time. In order to clarify the conditions that must be fulfilled before a company locates production in other countries, Dunning's eclectic paradigm, the so-called OLI-model, was presented and both extended and elaborated upon. In addition, we clarified and discussed four different globalization strategies: export, sourcing including outsourcing, joint venture, and establishment of subsidiaries including offshoring. The name of the extended model was the OLGS-model, where GS stands for the choice of Globalization Strategy. Dunning's OLI-model is included in the OLGS-model as offshoring (I) is part of the establishment of subsidiaries in foreign countries, which is one of the four globalization strategies.

It was also pointed out that the choice of globalization strategy may affect the choice of location. This is due to the fact that the choice of globalization strategy has an impact on the degree of control and management and thus the utilization of location-specific advantages. If a company chooses sourcing or outsourcing, it may have to choose a country that is characterized by a trustworthy business environment with minimal risk of imitation and failure of agreements. It may also be advantageous for a company to choose sourcing or outsourcing instead of establishing subsidiaries, if the company wants to wait and see what opportunities the location can offer. The chosen globalization strategy may also affect the choice of locality to find the most appropriate partner.

These arguments can be more important than wage differences and thereby a location may be chosen even though wages are higher than in other countries. Both the advantages of the chosen globalization strategy and the location-specific advantages have an impact on the ownership-specific advantages by affecting for example experience and competence. It thus appears that the OLGS-advantages have to be seen in an interactive perspective, because there is interdependence between the single advantages. It is not the way that one first identifies the ownership-specific advantages, then the location-specific advantages and finally the globalization strategy.

Thereafter, we explained how the advantages of locating production in a country depend on the country's economic stage and that these advantages change with the country's economic development. Consequently, the main motive of locating production in a global context is gaining proximity to the market and/or drawing on knowledge. These arguments can be more important than wage differences and therefore a location may be chosen even though wages are higher than in other countries. In this context, automation is also increasingly important to match the rising wages in these countries. This is also the reason for some of the challenges that companies encounter in this context. Furthermore, we clarified how cost savings seen in a dynamic perspective affect the choice of relocating production from one country to another country. As a result, production is moved either to another distant low-wage country, or is concentrated in a country close to the home country, or is withdrawn to the home country, where it is increasingly subject to automation.

So a company should have focus on what kind of advantages it will make use of by locating production in a global context and how the economic development in a country affects these advantages. Seen in relation to the motive for location of production in a global context, the advantages have different weights and the importance of economic development should be seen in relation to this. Accordingly, it could be interesting in a following study to make a statistical analysis of how the economic development affects the advantages of locating production in a global context. In this context it is important to have focus on the motive of locating production.

In recent years, automation is associated with a significant rise in robot technology. Furthermore, the price of a robot has decreased and robots are far more flexible, easily programmed and can be used for far more tasks than earlier. In the short run, automation may lead to a decrease in employment due to a higher productivity, which implies a reduced need for unskilled labour. However, in the long run, employment may increase due to the improved competition, leading to an increased need for skilled workers and engineers.

Eventually, productivity gained from automation will be even greater, as it is expected that a significant proportion of the industries will automate and thereby improve competitiveness. Therefore, countries with focus on research and development as well as innovation are, in the long run, well equipped for the challenges of the global economy.

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About the Author:

Teit Luthje is Associate Professor at the University of Southern Denmark. Central for Dr. Luthjes research area is development of theory related to global production and he has published several articles of this topic in international journals and has contributed to several books. An article in "Open Economies Review" was reprinted in a publication in honour of Paul A. Samuelson.

Teit Luthje

University of Southern Denmark
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