Module 10

MODULE 10
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. (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 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 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 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 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. 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 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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