Is Intra-industry Trade driven by Comparative Advantage?
by
Eckhard Siggel, Department of Economics, Concordia University
This paper was written for the 2009 congress of the Société canadienne de science
économique, as well as for the annual meeting of the Canadian Economic Association. A
French version of the paper is in preparation.
Abstract
It is common in trade theory texts to differentiate trade based on comparative advantage
(CA) from other forms of trade, in particular, intra-industry trade. According to this
distinction Ricardian and Heckscher-Ohlin assumptions lead to comparative advantage
trade, whereas intra-industry trade is driven by other motives. This approach is incorrect,
in our view, because the comparative advantage principle is more wide-ranging than its
Ricardian and Heckscher-Ohlin specifications. The paper proceeds by restating first the
concept and measurements of comparative advantage in its most powerful and general
interpretation. The Krugman model, which is widely recognized to explain intra-industry
trade is then used to demonstrate that the driving force of intra-industry trade is a
comparative cost advantage, such that the distinction between CA-trade and non-CA
trade appears to be pointless and misleading.
I
Introduction
In the mainstream international trade literature it is common to distinguish between
comparative advantage trade and other trade not based on comparative advantage, in
particular intra-industry trade. This distinction derives, in our view, from an overly
narrow interpretation of the concept of comparative advantage and the failure to measure
it. Its consequence is not only academic but leads to potentially biased policy choices.
When policy makers ignore the distinction between competitiveness and comparative
advantage they tend to assume that all exports are proof of comparative advantage and
imply socio-economic gains. This assumption can lead to ill-advised industrial policies.
The present paper attempts to show that all trade needs to be based on
comparative advantage in order to benefit an economy. In particular it demonstrates that
in the true sense of comparative advantage intra-industry trade is no different from interindustry trade in that it leads to gains from trade only when it is based on comparative
advantage. In the following section the position taken by the majority of trade economists
is documented, including opposite views, which make a controversy evident. In section
III the concepts of comparative and competitive advantage are revisited and clarified as
they are the source of this unfortunate confusion. The fourth section discusses the
quantification of these concepts, which is important for their precise meaning. Section V
discusses economies of scale as a potential source of comparative advantage and section
VI attempts to demonstrate that intra-industry trade is in no way independent of
comparative advantage. In section VII we discuss the gains from trade and the crucial
importance of comparative advantage for generating gains from trade. Section VIII
assesses the limitations of the foregoing analysis, section IX shows some of the potential
policy implications and section X concludes.
II
A short survey of literature
Textbooks tend to reflect the mainstream views of authors as well as the generally
accepted approaches to various fields of specialization in economics. Therefore, we start
with a short review of how intra-industry trade, comparative advantage and the gains of
trade are related in the textbook literature.
2
In one of the leading textbooks it is stated that “Intra-industry trade (cloth for
cloth) does not reflect comparative advantage. Even if the countries had the same overall
capital-labour ratio, their firms would continue to produce differentiated products and the
demand of consumers for products made abroad would continue to generate intraindustry trade. It is economies of scale that keep each country from producing the full
range of products for itself; thus economies of scale can be an independent source of
international trade.” (Krugman & Obstfeld, 2009, p.131). This statement makes it clear
that the authors consider economies of scale as a source of intra-industry trade, but not as
a source of comparative advantage, and that comparative advantage has nothing to with
intra-industry trade.
Other authors that have adopted the same view of the comparative advantage
concept include Gerber (2005). In his otherwise lucidly written text the author introduces
the chapter on intra-industry trade with the heading ‘Beyond Comparative Advantage’.
He argues that “…a large share of international trade is not based on comparative
advantage” (p. 84). The reason for this conclusion is that comparative advantage is taken
strictly as an ex-ante concept that permits to predict the trade pattern of countries. In
other words, if trade results from a cost advantage based on economies of scale and
historic accident it cannot have comparative advantage.
In Caves et al., (2007), the authors comment on the prevalence of intra-industry
trade by writing: “The traditional theories of a nation’s comparative advantage in
international trade imply that a traded good is either imported or exported, but not both.”
At the surface, this sounds like one of the most convincing arguments for the
conventional position. At closer scrutiny, however, it is less convincing. In a given
product category different products may differ only in terms of some characteristics. The
fact that in one particular variety a country may have a lowest-cost producer, does not
prevent another country to have a lowest-cost producer in a different variety of the same
product category. In both cases the low costs may result from economies of scale.
Ethier, in his fundamental text (1988), comments on intra-industry trade in the
following terms: “What makes it interesting is that, since roughly similar goods are
exchanged, comparative cost differences are unlikely to be large between countries. This
again suggests the possibility that something beyond comparative advantage is at work”.
3
This statement also reveals that the combination of product differentiation and scale
economies is not seen as a source of comparative advantage by Ethier.
One of the few exceptions to the narrowly based interpretation of comparative
advantage is the text of Markusen, Melvin, Kaempfer and Maskus (1995). According to
these authors “Economists generally agree that relative labour productivity, factor
endowments, tastes and product differentiation with scale economies all seem to provide
important sources of comparative advantage” (p. 237). In spite of their assurance of
agreement among economists, it is clear that their view of what constitutes the sources of
comparative advantage differs from that of most authors.
This short review reveals that the origin of this controversy is the very concept of
comparative advantage. While Krugman and others define comparative advantage as a
principle, which is strictly tied to the sources of the Ricardian and Heckscher-Ohlin kind,
it is in our view a more far-reaching and important concept. Rather than driving trade,
which is what competitiveness does, it determines whether trade leads to net benefits
(gains from trade) or not and it applies in that sense to all forms of trade. The origin of
this disagreement is the distinction between comparative advantage and competitiveness,
to which we now turn.
III
Competitiveness and comparative advantage revisited
The first question to be clarified is what is meant by “trade being driven by comparative
advantage”. It is a somewhat colloquial statement, which probably is supposed to mean
that trade leads to gains for the economy when based on comparative advantage. Clearly,
firms or industries are exporting products and services when they are able to compete
with foreign suppliers. In other words, competitiveness is what drives trade, not
comparative advantage; but competitiveness does not necessarily lead to gains from
trade, because exports may be profitable due to subsidies or other beneficial distortions.
In that case the gains from trade may be completely or partially cancelled.
Since the seminal paper of Dornbusch, Fisher and Samuelson (1977) we know
that the extension of the comparative advantage paradigm from the two-good to the ngood case requires the introduction of prices and monetary costs. We also know that the
notion of opportunity cost is ambiguous in the real world of multiple products and that in
4
the presence of multiple products it needs to be replaced by the requirement of
equilibrium prices. When the observable prices are not equilibrium prices a cost
advantage can only be described as cost competitiveness, not comparative advantage.
This follows from the following argument concerning the Ricardian model. When in a
country the general wage level rises beyond its equilibrium level it would be possible that
the country loses comparative advantage in all activities. That, however, is incompatible
with the very concept of comparative advantage. But it is possible that all activities are,
temporarily, non-competitive. In other words, the nominal changes of prices, wages or
the exchange rate out of equilibrium affect only competitive but not comparative
advantage.
Most basic books on international trade theory proceed by showing how the
equilibrium factor prices can be determined in open economies. In the Ricadian trade
model extended to n products it is the relative equilibrium wage that represents the
dividing line between activities that have comparative advantage and those that have not.
When applying the condition that relative labour productivity (relative to the foreign one)
needs to exceed the relative wage it is silently assumed that the wages need to be
equilibrium wages; otherwise the condition can only be called cost competitiveness:
(1)
a w < a* w*
or a*/a > w/w*
(2)
a we < a* we* or a*/a > we/we*
(competitiveness)
(comparative advantage),
where a and a* are domestic and foreign (*) labour input per unit of output, w and w* are
domestic and foreign wage rates and we is the corresponding equilibrium wage.
In the Heckscher-Ohlin model it is the direct correspondence between relative product
and factor prices in equilibrium that allows us to determine the equilibrium factor prices
which lead to gains from trade. The fact that the equilibrium nature of factor prices is
often not underlined derives from the nature of reasoning, which is based on the twosector general equilibrium model. It needs to be stated, however, that in the real world
product and factor prices are not necessarily equilibrium prices and need to be adjusted in
order to be usable for the determination of comparative advantage. This leads to a further
5
source of controversy, the neglect of measurement of comparative and competitive
advantage.
The failure to distinguish the two concepts, of competitive and comparative
advantage, has had several consequences. With respect to competitiveness, the absence of
a well established concept has led to a multitude of definitions in the literature, which we
have surveyed recently (Siggel, 2006). Many indicators have been proposed and those of
a macro-economic perspective, such as the method used by the World Economic Forum
in its annual World Competitiveness Report (cf, WEF/IMD, 1995), differ distinctly from
the original meaning of competitive advantage or cost competitiveness in the
microeconomic sense. With regard to comparative advantage, the official discourse of
trade theory has continued to explain the concept strictly in Ricardian terms, i.e. with
reference to two goods and one factor of production. The extension to more than two
products and to more than one factor, in the framework of the Heckscher-Ohlin trade
theory, is acknowledged but not pursued in terms of measurement. The comparative
advantage principle applied to the Heckscher-Ohlin model requires that in autarchy the
domestic prices differ from foreign or international ones. Since trade leads to the
equalization of prices this difference disappears and comparative advantage becomes
supposedly unmeasurable. But does it mean that comparative advantage does not exist
once trade takes place? An is it really unmeasurable in a post-trade context?
IV
Indicators of competitiveness and comparative advantage
Bela Balassa recognized in his often quoted paper on “Revealed Comparative Advantage,
or RCA”(1965), that the measurement of a comparative cost advantage by comparison
between domestic and foreign prices under autarchy was impossible in reality, since
autarchy prices are usually not observable. He proposed therefore to measure
comparative advantage by help of the export performance of different activities. This
proposal contributed to perpetuate the confusion between competitiveness and
comparative advantage. Clearly, export performance in the context of distorted prices
reflects cost competitiveness, but says nothing about gains from trade to the economy.
Therefore, it measures competitive, but not comparative advantage.
6
The only serious measure of comparative advantage that has survived over time is
the Domestic Resource Cost (DRC) ratio, proposed first by Michael Bruno (1965). It
compares the cost of primary factor inputs with the corresponding value added, all
computed at shadow prices. Its only disadvantage is that it enters the potential price
advantage of intermediate inputs only indirectly through the denominator. Clearly,
intermediate inputs can be a source of comparative advantage. For tradable inputs it can
be argued that their equilibrium prices are international prices and therefore the
abundance of tradable raw materials cannot constitute a source of comparative advantage.
This is debatable, but for non-tradable intermediate inputs the argument clearly applies.
For instance, abundant and low-cost domestic electricity supply can be a source of
comparative advantage, especially in energy-intensive industries.
The preceding argument has led us to propose a full-cost measure of comparative
advantage, which divides total cost of production by the output value (or price), both at
shadow prices, and which we have called Unit Cost ratio at shadow prices (UCs) (cf.
Siggel, 2006 and earlier empirical studies referred to therein)1. This indicator lends itself
also to a decomposition of the corresponding measure of domestic cost competitiveness
(UCd) into components of comparative advantage and various sources of distortion, in
particular exchange rate misalignment, rates of protection of output and input prices, as
well as various distortions of primary input prices (i.e. wage rates and the cost of capital).
While these indicators are often difficult to apply, given their extensive data requirements
and the necessity to estimate shadow prices of all inputs and outputs that are prone to
price distortions, they highlight the crucial difference between competitiveness under
protection, subsidies and/or other distortions on the one hand, and comparative advantage
on the other hand. The distinction is of great importance, when it comes to the discussion
of industrial policies, public investment criteria and especially in the context of policies
in favour of sustainable development.
One often wonders why the measurement of comparative advantage has not
attracted more interest in the past and has not led to the establishment of generally
accepted indicators for the use in econometric studies of trade. The reason is probably the
1
The indicator was first proposed by Cockburn et al. in (1999) and used in several applied studies of
industry competitiveness and comparative advantage in India, Kenya and Uganda (cf. references in Siggel,
2006)
7
philosophy that underlies most works in mainstream economic theory. It places much
confidence in markets, even when markets are possibly imperfect or failing.
Governments are rightly said to be not competent in “picking winners”, which means
identifying those activities that have potential comparative advantage. But it is also true
that de facto all governments engage in some forms of industrial policy. This means that
better information about distortions of all kinds, about competitiveness and comparative
advantage would help in choosing better policies, especially in the context of
globalization and the pursuit of socio-economic objectives.
V
Economies of scale and comparative advantage
As shown above, economies of scale (EoS) are not generally recognized as a source of
comparative advantage. The reason for this may be the fact that EoS represent an industry
characteristic and not a country characteristic. Since large markets tend to attract large
plants and industries with EoS, Tybout argued, “…bigger economies have bigger plants,
so large domestic markets may confer a competitive advantage on potential exporters
through internal increasing returns to scale” (Tybout, 1993, p.441). As the author also
reports gains from trade through specialization in large-scale production it follows that
the increased competitiveness may translate into comparative advantage. Other authors
who describe economies of scale as a source of comparative advantage are Markusen et
al. (1995) as reported earlier.
Economies of scale can arise in several ways. First, they can be internal or
external to the firm. Both are likely to play a role in intra-industry trade, but in the
present context we shall focus on internal increasing returns to scale. Second, the decline
of unit costs with increased production can arise simply from the bulkiness of capital
equipment, which generates fixed costs that spread more thinly as the scale of production
increases. This is perfectly compatible with constant returns to scale. The second way
internal economies of scale arise is through increasing returns to scale, i.e. increasing
returns when all factor inputs are increased proportionally. This assumption is of course
less plausible and more difficult to observe since all factors are rarely expandable
proportionately. It can be defended only for limited sections of the production function.
8
We shall therefore limit the present discussion to the first and more plausible case of
scale economies based on fixed start-up costs.
As scale economies of this kind are a characteristic of industries in the same sense
as capital intensity or labour intensity, they apply to industries independent of their
location. In combination with country-specific attributes, such as country size or taste
biases, they can generate comparative advantage. It must be conceded that as a source of
comparative advantage EoS act differently from labour or capital abundance in that they
are less ex-ante. They become actual only once the producers have chosen the location of
production and the plant size. Let us now see how comparative advantage arises in intraindustry trade.
VI
Intra-industry trade and comparative advantage
The model on which Krugman bases his claim that intra-industry trade is not based on
comparative advantage is precisely the intra-industry trade model developed by Helpman
and Krugman (1985). This model is based on two important assumptions, those of
differentiated (brand-named) products implying monopolistic competition, and of
economies of scale, which in turn derive from fixed costs. Intra-industry trade arises in
this model when firms producing brand-name products will rather produce in large scale
factories in one country and supply other countries by exporting than producing in
smaller factories in all countries. Countries can therefore be exporters and importers of
the same type of product if the homes of different brands are not all located in one
country. Where the home base of each brand is located is not explained by the model; nor
does the model explain the location of the surviving plants when markets become
integrated. There are other theories, however, which can supply an explanation of this
problem, which go beyond historical accident. Taste patterns or preferences can
determine the origin of certain product brands and this approach has been further
extended into a determinants- of-trade theory by Linder (1961).
The essence of the intra-industry trade model is that the production of
differentiated products will take place where the average cost is lowest and at the largest
possible scale. Countries that either develop such industries or succeed in attracting them,
can therefore derive comparative advantage based on scale economies, as long as
9
comparative advantage is measured as a cost advantage, as it should be, in line with the
principle of comparative advantage. The model also reflects monopolistic competition,
which results from product differentiation into brand-name products. The competition
between the producers of different brands of similar products takes the form of mixed
price/attribute competition. This raises the question whether comparative costs and,
thereby, comparative advantage apply to differentiated products. It is possible that some
of the authors’ rejection of comparative advantage in intra-industry trade may be based
on a negative answer to this question. In our view, the comparison of costs of
differentiated products poses no particular problem as it exists in inter-industry trade as
well. Quality differences exist even in so-called homogeneous products; in other words,
perfect homogeneity is rarely observable. Quality differences are then overcome by
assuming that they are taken into account by product prices. In the measurement of
competitiveness and comparative advantage discussed earlier differences in product
quality are taken into account by the particular definition of unit cost ratios, which divide
total costs by the value of output. Higher quality or additional product attributes tend to
increase both costs and the price. Therefore, unit cost ratios are comparable across
differentiated products.
VII
Comparative advantage and the gains from trade
The question that remains to be addressed is whether comparative advantage is necessary
for the attainment of gains from trade. First, the concept of gains from trade itself needs
to be defined more precisely. We understand the gains from trade as a welfare increase
through trade that takes the form of increased consumption possibilities. In twodimensional geometry we usually demonstrate these gains by allowing a country to
consume outside its production possibilities frontier and to reach a consumption point on
a higher community indifference curve. In the socio-economic context it is necessary,
however, to extend this difinition by including other benefits that lie outside the typical
two-goods space and are not easily measurable. For instance the goal of environmental
sustainability needs to be integrated in any modern discussion of trade benefits.
At the first stage we shall address the question in the traditional format using twodimensional geometry and then examine whether the conclusion needs to be modified for
10
a more complete view of welfare gains. Can exporting firms or industries that have no
comparative advantage, but derive competitiveness from export subsidies, nevertheless,
generate welfare gains?
To answer this question let us assume that in the following diagram A and M are
two sectors of the economy, agriculture and manufacturing, and that the country is too
small to influence international prices, which are taken to be equilibrium prices. We also
assume that under free trade and in the absence of any distortions agriculture has
comparative advantage since in autarchy the domestic relative prices of agriculture (not
shown) would be below the international price. This leads to exports of (Aq-Ac) and
imports of (Mc-Mq).
Q’
(Pm/Pa)w
Aq’
Q
Aq
C
Ac
Ac’
C’
(Pm/Pa)d
Mq’
Mq
Mc Mc’
M
Figure 1: Welfare implications of an export subsidy
When agricultural exports are subsidized by an export subsidy s the domestic price ratio
declines to (Pm/Pa)d = (Pm/Pa(1+s)), resources flow into agriculture, exports and imports
are increased, but the gains from trade are strongly reduced and potentially negative. This
11
is shown by the location of the new consumption point (C’), in comparison with
consumption under non-distorted trade (C), or potential consumption in autarchy.
VIII
Limitations of the analysis
This demonstration corresponds to the conventional analysis of tariffs and subsidies in a
static general-equilibrium framework. It excludes dynamic effects and therefore dynamic
gains from trade, which may possibly outweigh the potential welfare losses from export
subsidization. Three kinds of dynamic gains can occur from exports: (a) diminished cost
due to larger-scale production, (b) diminished cost through learning and (c) access to new
technology gained by way of increased imports, which in turn are made possible through
increased exports. On the other hand, the gains from trade are likely to be reduced when
other objectives are factored into the social welfare function, such as environmental
protection. The quantification of such effects is known to be difficult.
The arguments above apply of course to trade creation in general, but they need to
be considered in a complete evaluation of the gains from trade. In the present context
they only modify but do not reverse our argument that without comparative advantage
there cannot be gains from trade. Using the method of measuring comparative advantage
that we have championed in the past, an industry in which the total cost at shadow prices
exceeds the sum of private and social benefits, and which is made competitive by way of
subsidies, cannot have positive net benefits, as demonstrated above. Let us now get back
to the case of intra-industry trade and examine whether it can lead to positive net gains in
the absence of comparative advantage.
IX
Policy implications
The distinction and measurement of competitive and comparative advantage are not only
important from an academic point of view; they are important for the rational design of
industrial policies. It is often argued that industrial policies have no place in marketdriven economies. Nevertheless, in nearly all countries governments de facto engage in
industrial policies, either purposefully or accidentally by pursuing other goals. Often the
outcome of such policy choices is a set of policies that is sub-optimal with regard to
longer-term sustainable development. The pursuit of socio-economic objectives requires
12
evaluation of benefits and costs, and in the area of industries in international competition
this amounts to information on competitiveness and comparative advantage.
In the context of present government policies in Canada we observe a marked
decline of manufacturing industries and a return to a natural resource-based and exportdriven economy typical of developing countries. At the same time we observe various
forms of industrial policies, which seem to be applied in an ad-hoc fashion and with
regard to achievement of export competitiveness. In the case of some industries one
wonders whether they result in net benefits to the country when all socio-economic
benefits and costs are considered. Only empirical research can answer this question and
the concepts of competitive and comparative advantage measured in terms of unit costs,
can provide a useful framework for this analysis.
X
Conclusion
The present paper is motivated by the observation that in mainstream trade theory, as
reflected by several standard textbooks, there is a division between comparative
advantage trade and other trade not based on comparative advantage, in particular intraindustry trade. This division is based on an overly narrow interpretation of the
comparative advantage principle, which links it only with Ricardian and Heckscher-Ohlin
type trade. In other words, comparative advantage is widely viewed as having only two
kinds of sources, differences in technology and differences in factor endowment. We
have argued and demonstrated that the comparative advantage principle applies to all
kinds of trade and represents the dividing line between trade that is beneficial from a
socio-economic point of view and trade that has no positive net benefits. In particular it
was shown that intra-industry trade can be and should be evaluated from the same
perspective as inter-industry trade. In that perspective it can be assured that intra-industry
trade is determined by comparative advantage as well, although what this means is that it
can lead to positive gains from trade only if it is based on comparative advantage.
13
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