INTRA-INDUSTRY TRADE AND THE SCALE
EFFECTS OF ECONOMIC INTEGRATION
Elisa Riihimäki
Statistics Finland, Business Structures
September 2005
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Objective of this presentation is to analyse the scale effects of
economic integration in the framework of intra-industry trade



Approach in two steps:
1) In a theoretical model of intra-industry trade, I determine
two major scale effects through which integration might
affect
2) And how to determine these scale effects in the econometric
analysis
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The progress of integration increase competition in the
international product market but also the wider market
enables to expand sales and production


a) The wider trade and capital flows increase the international pricecompetition between countries
b) On the other hand, firms with access to the wider market were
expected to take better advantage of economies of scale

Thus, market power may arise from specialisation in production and
differentiation of products to establish segmented markets (e.g.
increased international trade in services)
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Theoretical model of intra-industry trade


I consider an open economy where there are many firms at industry
level producing differentiated good
Supposing that product markets are imperfectly competitive, there is
monopolistic competition in good markets

Extension of the model of Dixit and Stiglitz (1977): Monopolistic
Competition and Optimum Product Diversity. American Economic
Review 67, 297-308
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

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Definition
Intra-industry trade can be defined as the two-way exchange of goods in
which neither country seems to have a comparative cost advantage
This approximates a situation in which there are a large number of
varieties and each firm has some power over the pricing of its product



 I suppose that international integration
a) increase the price competition
b) and enables better advantage of economies of scale
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Together with interaction between number of products/firms and degree of
price competition, intra-industry trade and economic integration can be
seen as the result of the interaction between product differentiation and
economies of scale
=> Each industry contains a large, but limited because of economies of scale,
number of potential differentiated products that consumers regard as imperfect
substitutes
 Representative consumer’s tastes are assumed represented by the utility function

V   jbj
where
1
j
Dj
j
D j  in1D ji
bj
an index of consumption of the
differentiated products at industry j
positive constant
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By imposing the symmetry assumption a consumer maximising
will set an index of consumption of the differentiated products
at industry j
 Pj * 

Dj  
 bj 


where
1
1 j
1
j 
 1 product-demand elasticity
1 j

j
P
an index of the price level in
terms of international integration
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The product-demand elasticity can be thought as an increasing
function of the number of products
 j   j n j 
where
 j n j   0
nj
number of products/firms
An increase in the number of firms leads to an increase in the degree of
competition
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We get then the demand of products type i
 p ji 
D ji  D j  * 
P 
 j 
 aj p
 j
ji
 j
Pj
* j  j
where
 j1
p ji
the price of variety i
the elasticity of substitution between
any two products types
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The industry’s elasticity of substitution among differentiated
goods can be thought as a decreasing function of the advantage
of economies of scale
 j   j a j 
 j a j   0
where
aj 

Aj
*
j
A
an exogenous comparative productivity for
domestic industry relative to foreign
A growth in the advantage of economies of scale in industry leads to a
decrease in the degree of substitution among differentiated goods within
industry
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Impact of a reduction in trade costs ( ) on product
markets



Let consider the impact of a reduction in marginal trade costs on product
markets due to transactions costs and other trade barriers related to
foreign trade
For simplicity, it is assumed that the trade costs of import and export
outputs are equal
The effects on imperfectly competitive product markets of increased
integration via declining trade costs are basically of two counteracting
sorts
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1) Firstly, assuming that firms were expected to be able to
expand production taking better advantage of economies of
scale (a) it follows that product-substitutability () decrease
 j a j
a j  j

0
This has associated to reduced market imperfection and to
increased incentive of product-differentiating
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2) Secondly, market entry becomes easier or less costly
implying that more goods become traded goods (n)

Higher price competition makes product-demand () more
elastic
 j n j
n j  j

0
The higher the degree of price competition is, i.e., the closer substitutes
the good sale on the world market is, the more elastic with respect to
own price output demand becomes
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=> In the imperfect competition, we have then the condition of
pricing rule for products types at industry j
n 1   

1 j 
j
*
Pj  
p ji 
 i 1 a j

1
1 j
 With in optimum, the price equals to the marginal revenue from
exporting, where we must have that relative trade cost equals to mark-up
factor
1 j
aj
j  j

 j   j 1
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Proposition for the characterisation of the optimal pricing rule:

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Lower trade costs with increased integration, higher number of firms and
in consequence of its higher elasticity of product demand will reduce the
mark-up price,
 whereas better advantage of economies of scale and in consequence of
its lower elasticity of substitution between differentiated products will
raise it
=> Product demand becomes more price elastic when product markets are
more integrated,
 but is the effect of product market integration on the price sensitivity
of the market share larger than its direct effect on the market share
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Econometric analysis

1) Constant scale returns

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To estimate constant-output ( = 1) price-relation () it can
be used restricted generalized least squares estimation
(GLS) with constant scale returns
2) Scale effects of integration

 1
To estimate scale effects price-relation ( ) it can be used
instrumental variables estimation (G2SLS) with scale
returns
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
There are two possible different control variables:
a) the share of country’s exports to the other countries in production
 b) and the share of the country’s output in production of other countries
 which are deflated by country’s real competitiveness indicator (where
country weights are based on country’s bilateral exports)

a) The first attempts to measure foreign demand for country’s products
 b) and the second attempts to measure the overall demand of other
countries
 furthermore, a real competitiveness indicator measures the
international product market competition
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=> The scale effects of integration () measures the impact of international
demand shock on the demand of factors
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a) A rise in exports increases the production of industry, which is supposed
to increase the demand of factors
 The assumption is that higher export signals better scale economies (or
less foreign competition)
 This makes all factor demands less elastic with own price via the scale
effect of integration
 b) On the other hand, the more the rest of the other countries accounts for
the output of industry, the more competitive that industry is for country’s
firms and thus the more elastic all factor demands will be

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An increase in the real competitiveness indicator means that an industry’s
price competitive ability decrease is supposed to decrease the product
demand and thus the demand of factors
 Thus, declining competitiveness indicator should make international
product markets more competitive; this should make all factor
demands more elastic
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 If both scale () and constant-output () pricerelations are consistently estimated, then the
difference between these two is an estimate of the
scale effects,
and it would provide indirect evidence about the
competitiveness of product market,
and thus it can be determined the impact of
integration’s scale effects
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Statistical example
For example, international trade in services (ITS) have increased last
years
 Trade in services is often, in fact, trade with trade of goods, not pure
services
 This is good example, how firms specialised within industry
 Increased competition could also reinforce pressures to specialise and
differentiate goods increasing tradable services

Average annual change of ITS in OECD-countries, 1997-2002
Exports
Imports
3.3 %
4.1 %
Source: OECD/Eurostat, 2004
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