ITL - M4

MODULE 4
INTRA-INDUSTRY TRADE BETWEEN SIMILAR ECONOMIES

4.1 INTRODUCTION

Intra Industry trade refers to the exchange by way of import and export, of the same products
or similar products belonging to the same industry. Intra-trade is in explainable by classical
trade theories. An attempt was made to explain the phenomenon by Finger in 1975. Finger
relied on the existing classifications in place of goods that are based on heterogeneous factor
endowments in a particular industry. However, this argument ignores the fact that even when
industries are dis aggregated to fine levels, intra trade still occurs. The demand theory set forth
by Flavey and Kerzkowski in 1987 was also set aside. Their theory proposed that products are
not produced under identical technical conditions. Their model enumerated that on the demand
side goods are distinguished by the perceived quality of that good and high quality goods are
produced under conditions of high capital intensity. This theory was said to be faulty as it did
not address intra trade directly in those conditions where goods of similar factor endowments
were produced. The one theory however, that was widely accepted is that of the New Trade
Theory by Paul Krugman that focuses on the advantages that countries realise when they begin
to take into consideration the benefits accruing out of specialization. Specialization in a limited
area would help to realise the advantages of the increasing returns also known as ‘ economies
of scale’ without reducing the variety of goods available in the market for consumption.

Another theory was that of the Heckscher-Ohlin-Ricardo model by Donald Davis that
combined the Heckscher-Ohlin and Ricardian models to explain Intra-industry trade. Under
this model, it was shown that a country could still engage in the traditional method of intra
industry trading whilst benefiting from the constant returns to scale. This model imitated the
Ricardian model of Comparative Advantage and stated that trade would occur between
countries due to differences in technology, thus encouraging specialization and the benefits
accruing from it.

Intra Industry trade is the two-way exchange of goods within the same industry. A country uses
several determinants to measure such trade. However, one of the most conventional measures
of the intra-industry trade that takes place between countries is the Grubel-Lloyd (GL) index.

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(e.g. If a country only exports or imports good Y (e.g. rice) then the GL index for that sector is
equal to 0. On the other hand, if a country imports exactly as much of good Y as it exports,
then its GL score for sector would be 1.) This index sets the minimum value of zero when
there are no products in the same industry and maximum value of hundred when all trade is
intra industry trade. However, this measure is not absolute and may vary on the level of
disaggregation.

4.2 TYPES OF INTRA-INDUSTRY TRADE

The Organisation for Economic Cooperation and Development recognises two measures of
intra-industry trade. This relates to trade in similar products, known as horizontal trade and that
relating to vertically differentiated products which are differentiated between by quality and
price. For example, cars of a similar class and price range would fall under the first category.
Exports of high quality clothing and imports of lower quality clothing would fall under the
second category. A third type of intra industry trade is found to be practised in homogenous
goods. Conventionally, the theory and measurement of Intra Industry Trade, especially in the
case of industries, relates to goods. However, it has also seen a substantial inclusion of services
in recent times.
Horizontal trade in similar products with differentiated varieties equips countries with similar
factor endowments to benefit from economies of scale by specialising in a very narrow
category of products. Trade in vertically differentiated products may reflect different factor
endowments, skills and even costs associated. This is driven by comparative advantage. The
best example is the use of unskilled labour for assembly and line production or skilled and
specialized human resource for research and development. It has been noticed that intra
industry trade is far greater across manufactured goods than it is across non manufactured
goods. The highest intra industry trade is in the more specialised manufactured goods area such
as machinery, chemicals, transport and equipment. The data maintained by the OECD, shows
almost 60-70 percent for such goods whereas goods like food products or those that involve a
similar process of manufacturing are at 40-50 percent or even less in certain cases. This is due
to the benefits arising out of the specialisation and the benefits arising out of those products
which are more sophisticated than others and may even involve a more complex process of
manufacturing. The economies of scale are much higher in these processes and differentiation

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to the final consumer is also easier. Another trend that has hot the world ever since globalisation
is that of splitting up complex manufacturing processes into smaller components across
countries. this enables the manufacturing of such products easier, cost reduction and therefore
greater advantage to manufacturers. In fact, Paul Krugman expressly states in his theory that
those economies that are “super trading” economies rely on the breaking up of the chain of
manufacturing across boundaries and this in fact is the factor which helps the most to ensure
that these countries top the trade charts. Many of the countries that are the forerunners of trade
such as Belgium, Czech Republic etc. experience a dependency on their exports and imports
that account for a very high portion to their GDP.

4.3 INTRA-INDUSTRY TRADE IN THE GLOBAL ECONOMY

The significance of intra-industry trade can be best explained by its effect on the various types
of economies-developed, developing and least developed.

Developed economies and rapidly industrialising developing economies such as China,
Malaysia, Thailand etc. tend to engage more in intra industry trade. Resource rich developing
countries and less developed countries have a much lower ratio in comparison. Poorer
countries, with similar terms of income have a much lesser trade flow rate with each other
compared with their trade flows with rich countries. many of these countries are grossly reliant
on a small number of products. This gives rise to primary product dependency which is harmful
for their economies. The case of Arica is one such examples. Countries where overall labour
and capital productivity is low, have a much lower wage rate and produce less differentiated
goods and services as well. he sources of gains from intra-industry trade between similar
economies—namely, the learning that comes from a high degree of specialization and splitting
up the value chain and from economies of scale—do not contradict the earlier theory of
comparative advantage. Instead, they help to broaden the concept.

In intra-industry trade, climate or geography do not determine the level of worker productivity.
Even the general level of education or skill does not determine it. Instead, how firms engage in
specific learning about specialized products, including taking advantage of economies of scale
determine the level of worker productivity. Thus, the presence of skilled or unskilled labour in

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a developing or least developed country doesn’t matter as much as their willingness in the
engagement with this set up. There are various measures that have been taken by a number of
organisations to help promote projects in these countries. one such organisation is that of the
Multilateral Investment Guarantee Agency (MIGA). MIGA promotes the establishment of
projects by developed countries in developing or least developed countries by providing
guarantee against risks that could potentially occur. This in turn helps to raise the economy of
these countries so as to engage in trade and other measures that could increase their GDP and
uplift their economy, globally.
Intra Industry Trade is not bereft from comparative advantage theory. This theory can be
applicable in a number of ways to this form of trade. It can evolve and change over time as one
develops new skills and as manufacturers split the value chain in new ways. Countries are not
therefore, not destined to have the same comparative advantage forever, but must instead be
flexible in response to ongoing changes in comparative advantage.

A classic indication of the benefits of intra trade and world economy is The Stolper– Samuelson
theorem is named after Wolfgang Stolper and Nobel prize winner Paul Samuelson (Stolper and
Samuelson 1941) brings to light the various facets of Intra-Industry Trade. The theorem
indicates that an increase in the price of labor-intensive goods raises the real return to labour
independently of all considerations of how labor spends it income. If the price of labour-
intensive goods rises, resources will be drawn out of other industries into the labour-intensive
industries. But the other industries are not labour intensive; they may be land-intensive. If this
is the case, then, relative to demand, labor becomes more scarce and land less scarce, driving
up the price of labor and driving down the price of land. The cost of the product is made up of
both land and labor. If land falls in price and labor rises in price, the wage rate must rise by
more than the price of the labor-intensive good. a country imports labor-intensive goods,
international trade lowers the price of such goods and so makes laborers worse off. While the
economy as a whole gain, workers lose out. If a country exports labor-intensive goods, both
the economy as a whole and workers gain from more international trade. Therefore, this is the
biggest motivating force behind trade that exists and ensures that countries across the boarders
realize these benefits.

The Standard trade theory also seeks to highlight the importance of Intra-Industry Trade. This
type of trade involves trade in homogeneous products as well. This is a requisite for perfect

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competition and thus, an economy seeks to attain perfect competition when there is intra
industry trade. David Ricardo (1817) introduced standard trade theory when he formulated
what is also known as the theory of comparative advantage which has been described in great
length in the previous module. Ricardo highlighted the key ingredient of the theory: goods are
more mobile across international boundaries than are resources (land, labor, and capital). This
assumption applies to the theory of intra-industry trade.

The theory of comparative advantage deals with all those causes of international trade that are
generated by the differences among countries. The basic principle of the model is to realize
those differences and to make them work to the advantage of the countries that engage in
international trade. One such method is that of intra-trade which is best suited and explained
by the Ricardo Model which takes into consideration the differences between the economies
of the world. In fact, he realized that it is these that resulted in all countries being internationally
competitive even though they might have higher wages (for developed countries) or lower
productivity (for developing countries or least developed countries) than other economies. He
proposed that trade is conducted in terms of prices: people buy homogeneous goods where they
are the cheapest. The Ricardian model of trade is designed to show that every country can
profitably take advantage of any differences among countries. Whether one country has higher
wages or lower productivity, the competitive wage rates that prevail in a country ensure that
every country will specialize in the good in which it has a comparative advantage

4.4 GAINS FROM SPECIALISATION

Specialization is a method of production whereby an entity focuses on the production of a
limited scope of goods to gain a greater degree of efficiency. Many countries, for example,
specialize in producing the goods and services that are native to their part of the world, and
they trade for other goods and services. This specialization is, therefore, the basis of global
trade, as complete self-reliance in international trade is seemingly a myth.

The pattern of specialisation is deeply embedded in international trade theory. A consequence
of international trade is that countries do not need to produce all their goods; instead they can
specialise in the production of goods that they are relatively good at producing and import those
goods that they are relatively less good at producing. Countries will experience welfare gains

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from trade as this process requires the reallocation of production towards sectors that are more
efficient.

Analysing the determinants of specialisation is crucial since it not only allows us to measure
the gains from trade but also informs us on how trade affects the structure of an economy.
Specialization can be at both micro and macro-economic levels. Micro specialization relates to
the individual level, where specialization usually comes in the form of career or labour
specialization. Each member of an organization or economy, for example, has a unique set of
talents, abilities, skills, and interests that make her uniquely able to perform a set of tasks.
Labour specialization exploits these talents and helps to draw attention to the human resource
asset, helping both the individual, as well as the overall economy.
Macro level specialisation occurs on a larger, more global sphere. Economies that realize
specialization have a comparative advantage in the production of a good or service. When an
economy can specialize in production, it benefits from international trade and has a greater
advantage of trade.

Many trends have come about to help enumerate the benefits of specialization. One of the most
popular trends that has come about in the recent years is called the ‘splitting up the value chain.’
Specialization in the world economy can be very finely split. The value chain describes how a
good is produced in stages. Thanks to a great deal of improvements in communication
technology, sharing information, and transportation, it has become easier to split up the value
chain. International trade often does not involve nations trading whole finished products like
automobiles or refrigerators. Instead, it involves shipping more specialized goods like a part or
a component which adds to the finishing good. Intra-industry trade between similar countries
produces economic gains because it allows workers and firms to learn and innovate on
particular products—and often to focus on very particular parts of the value chain. These
economic gains are further realized by the realization of the economies of scale which is
discussed in the next section.

4.5 ECONOMIES OF SCALE
Another major advantage that arises out of intra industry trade is the existence of economies of
scale in production. This may also be referred to as increasing returns to scale. Economies of
scale means that production at a larger scale (more output) can be achieved at a lower cost (i.e.

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with economies or savings). When production within an industry has this characteristic,
specialization and trade can result in improvements in world productive efficiency and welfare
benefits that accrue to all trading countries.

Trade between countries need not depend upon country differences under the assumption of
economies of scale.

The benefits of economies of scale are enjoyed by intra industry trade. This phenomenon occurs
because intra-industry trade arises because many different types of products are aggregated
into one category. For example, many different types of chemicals can be produced. It may be
that production of some types of chemicals require certain resources or technologies in which
one country has a comparative advantage. Another country may have the comparative
advantage in another type of steel. However, since all of these types are generally aggregated
into one export/import category, it could appear as if the countries are exporting and importing
identical products when in actuality they are exporting one type of chemicals and importing
another type. The best suited explanation for the engagement of countries in intra industry trade
lies in the benefits realisation of the economies of scale. As the scale of output goes up, average
costs of production decline which ultimately is highly profitable to the nation state. Intra
industry trade thus provides a way to combine the lower average production costs that come
from economies of scale and still have competition and variety for consumers.

4.6 SIGNIFICANCE OF INTRA INDUSTRY TRADE

A large part of intra-industry trade reflects trade in “similar” but highly differentiated products.
As the world maintains a global trading platform, foreign direct investment has come about to
become one of the major contributors to the development of economies. This is specially for
those countries that are developing and least developed. The increasing number of super
trading economies and the benefits that arise from international trade, add up to the need of
engagement of these economies in the global trading regime.

The splitting up of the value change was a trend which made use of this realization. Intra
industry trade differs from country to country. The splitting up of the value chain of production
may mean that the initial consequences for value added of any shock to demand are more

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dispersed across countries. The concentration of intra-industry is indicative of how soon this
trend is catching up due to the multiple benefits that arise from it. Intra-industry trade represents
international trade within industries rather than between industries. Such trade is more
beneficial than inter-industry trade because it stimulates innovation and exploits economies of
scale. Moreover, since productive factors do not switch from one industry to another, but only
within industries, intra-industry trade is less disruptive than inter-industry trade.
4.7 CONCLUSION
International trade is traditionally thought to consist of each country exporting the goods most
suited to its factor endowment, technology, and climate while importing the goods least suited
for its national characteristics. Such trade is called inter-industry trade because countries export
and import the products of different industries. Cross-border trade between multinational
companies and their affiliates, often referred to as intra-firm or sometimes related party trade,
accounts for a large share of international trade in goods. The main aspects to engage in intra
industry trade rests in the realization of the returns to scale and the benefits accruing from
specialization. These benefits thus help to draw a country closer to attaining the balance of
trade. Every country seeks to maintain this balance of trade. This will be discussed in the next
module.

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REFERENCES

1. Grimwade, Nigel (2000). International Trade: New Patterns of Trade, Production &
Investment (Second ed.). New York: Routledge. p. 71. ISBN 978-0-415-15626-4.

2. Krugman, Paul; Obstfeld, Maurice (1991). International Economics: Theory and
Policy (Second ed.). New York: Harper Collins. ISBN 978-0-673-52151-4.

3. Brander, James A. (1987). "Book Review of Greenaway and Milner (1986)". Journal of
International Economics. 23 .

4. Davis, D. R. (1995). "Intra-industry trade: A Heckscher-Ohlin-Ricardo approach". Journal
of International Economics. 39 (3/4): 201–226.

5. Shelburne, Robert C. ; Gonzales, Jorge (2004). "The Role of Intra-Industry Trade in the
Service Sector", in Michael Plummer (ed.) Empirical Methods in International Trade: Essays
in Honor of Mordechai Kreinin, Edward Elgar Press, 110-128, 2004.

6. Kadar, Bela (1981). "Review of Herbert Giersch, On the economics of intra-industry
trade". Journal of Economic Literature. 19 (3): 1109.

7. HUMMELS, D., J. ISHII and K. YI (2001), “The nature and growth of vertical specialisation
in world trade”, Journal of International Economics, Vol. 54, No. 1.

8. OECD (1994), “Trends in international trade”, OECD Economic Outlook, No. 56, Paris.
9. Dixit, A., and V. Norman (1980), Theory of International Trade (Cambridge: Cambridge

University Press).
10. Marvel, H. P., and E. Ray (1987), “Intra-industry Trade: Sources and Effects on Protection,”

Journal of Political Economy 95 (December): 1278–91.

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