CHAPTER 5
ALTERNATIVE
THEORIES OF TRADE
Intra-industry trade
 One major set of facts about actual trade
that may require theory beyond
comparative advantage is the substantial
trade among industrialized countries,
much of which involves exchanges of
very similar products.
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Intra-industry trade
 Inter-industry trade ─ a country’s
exports and imports are in different
product classification categories.
Traditional trade theory dealt only with
inter-industry trade, but intra-industry
trade clearly constitutes an important
segment of international trade.
 Countries that export and import items in
the same product classification are
engaging in intra-industry trade.
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Intra-industry trade
 A country’s trade can be divided into the
part that is net trade (or inter-industry
trade) and the part that is intra-industry
trade.
 Net trade is the value of the difference
between exports and imports for the
product.
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Intra-industry trade
Intra-industry trade is the part of total
trade that is not net trade ─ the part that
is matched exports and imports.
X M

IITshare  1 
 X  M 
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Intra-industry trade
 If all trade is inter-industry, the IIT share is 0.
 If all trade involves matched exports and
imports (X=M) for each industry, the IIT share is
1.
 If some trade is net trade and some trade is
intra-industry trade, the IIT share will have a
value between 0 and 1.
 The size of IIT share indicates the importance
of the intra-industry trade.
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The Significance of Intraindustry Trade


About one-fourth of world trade consists of
intra-industry trade.
Intra-industry trade plays a particularly
large role in the trade in manufactured
goods among advanced industrial nations,
which accounts for most of world trade.
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Intra-industry trade
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Intra-industry trade
 The major explanation for intra-industry
trade is product differentiation.
 Product differentiation refers to
products that are seemingly the same
good but which are perceived by the
consumer to have real or imagined
differences.
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Inter-industry trade & intraindustry trade

Main differences between inter-industry
and intra-industry trade:
 Inter-industry
trade reflects comparative
advantage, whereas intra-industry trade does
not.
 The pattern of intra-industry trade itself is
unpredictable, whereas that of inter-industry
trade is determined by underlying differences
between countries.
 The relative importance of intra-industry and
inter-industry trade depends on how similar
countries are.
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Why Intra-industry Trade
Matters


Intra-industry trade allows countries to
benefit from larger markets.
Gains from intra-industry trade will be large
when economies of scale are strong and
products are highly differentiated.
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Economies of scale
 Economies of scale, or increasing
returns to scale, exist if increasing
expenditures on all inputs (with input
prices constant) increases the output
quantity by a larger percentage.
Therefore, the average cost of producing
each unit of output declines, as output
increases.
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Economies of scale
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Economies of scale
 Scale economies are internal if the
expansion of the size of the firm itself is
the basis for the decline in its average
cost.
 Scale economies external to the
individual firm relate to the size of the
entire industry within a specific
geographic area. The average cost of
the typical firm declines as the output of
the industry within this area is larger.
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Economies of scale
 Economies of scale can be either:

External



The cost per unit depends on the size of the industry
but not necessarily on the size of any one firm.
An industry will typically consist of many small firms and
be perfectly competitive.
Internal
The cost per unit depends on the size of an individual
firm but not necessarily on that of the industry.
 The market structure will be imperfectly competitive with
large firms having a cost advantage over small.
Both types of scale economies are important causes of
international trade.


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Monopolistic competition and
trade
 The monopolistic competition model can
be used to show how trade leads to:



A lower average price due to scale
economies
The availability of a greater variety of
goods due to product differentiation
Imports and exports within each industry
(intra-industry trade)
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Monopolistic competition and trade
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Monopolistic competition and trade
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The basis of trade
 Product differentiation ( intra-industry
trade )
 Comparative advantage ( inter-industry
trade )
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Trade gains with intra-industry
trade
 The increase in varieties
 Lower prices for the domestic varieties
 Modifying the well-being of different
groups in the country
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Trade gains with intra-industry trade
The implications of trade for the well-being of
different groups in one country:
 If most trade is intra-industry, then there may
be little pressure on factor prices caused by
inter-industry shifts in factor demand.
 The gains from increased variety reduce the
loss to factors that suffer income losses due to
Stolper-Samuelson effects.
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External scale economies
 Economies of scale that occur at the
level of the industry instead of the firm
are called external economies.
 There are three main reasons why a
cluster of firms may be more efficient
than an individual firm in isolation:



Specialized suppliers
Labor market pooling
Knowledge spillovers
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The Theory of External
Economies
 Specialized Suppliers
 In many industries, the production of goods and
services and the development of new products
requires the use of specialized equipment or
support services.
 An individual company does not provide a large
enough market for these services to keep the
suppliers in business.
 A localized industrial cluster can solve this
problem by bringing together many firms that
provide a large enough market to support
specialized suppliers.

This phenomenon has been extensively
documented in the semiconductor industry located
in Silicon Valley.
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The Theory of External
Economies
 Labor Market Pooling


A cluster of firms can create a pooled
market for workers with highly specialized
skills.
It is an advantage for:
 Producers

They are less likely to suffer from labor
shortages.
 Workers

They are less likely to become unemployed.
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The Theory of External
Economies
 Knowledge Spillovers


Knowledge is one of the important input
factors in highly innovative industries.
The specialized knowledge that is crucial
to success in innovative industries comes
from:
 Research
and development efforts
 Reverse engineering
 Informal exchange of information and ideas
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External scale economies and trade
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Free trade with external
economies of scale
 The importing countries gain from trade, even
if local production ceases, because
consumers benefit from the lower prices of the
imported product.
 A key difference from the standard model is
that with external scale economies consumers
in the exporting country also gain surplus as
trade leads to lower costs and prices, because
production is concentrated in few locations
that can better achieve the external
economies.
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Free trade with external
economies of scale
 Producers of the product in an exporting
country tend to gain producer surplus as
a result of the expansion of industry
output, although the decline in price will
mitigate the gain.
 Producers in importing countries lose
producer surplus.
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Results from external scale
economies and trade
 In industries that can reap external economies
(e.g., knowledge spillovers from firm to firm), a
rise in demand triggers a great expansion of
supply and lowers costs and price.
 Therefore, increasing trade brings gains to all
consumers (home-country and foreign alike) as
well as to the exporting producers.
 Corollary: Among nations having the same
initial factor endowments, cost curves, and
demand curves, whichever nation moved first to
capture its export market would gain a cost
advantage in this product.
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Figure 5.6
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Question 1
 For major product categories,
international trade between the industrial
countries and the rest of the world in
1999 looked something like this (in
billions of dollars):
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Products
Exports (X) by the
industrial countries to
the rest of the world
Imports (M) into the
industrial countries from
the rest of the world
Food, beverages, and
tobacco
65
76
Petroleum and other
fuels
21
127
Chemicals
114
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Machinery and
transport equipment
481
341
Clothing
15
101
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a.
b.
c.
Calculate the intra-industry trade share for
each individual product category. Calculate
the net trade for each product category as a
percentage of total trade (X+M) in the category.
Which product categories have the highest
intra-industry trade share. Why might this be?
What might explain the pattern of net trade
(net exports or net imports) across the
categories that show substantial net trade as a
percentage of total trade?
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Question 2
 Evaluate the relative importance of
economies of scale and comparative
advantage in causing the following:
a. Most of the world’s aluminum is
smelted in Norway or Canada.
b. Half of the world’s large jet aircraft are
assembled in Seattle.
c. Much of the world’s best wine comes
from France.
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Question 3
 The global market for household dishwashers is
monopolistically competitive. It is initially in a
free-trade equilibrium, with 40 models offered,
and a price of $600 for a typical dishwasher. In
your answer use graphs like those shown in
Figure 6.5 and 6.6. There is now a permanent
increase in global demand for dishwashers
generally, so the global market size increases
by about 15 percent.
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a.
b.
c.
Show graphically and explain whether the
typical firm earns an economic profit or a loss,
in the short run just after the general increase
in demand occurs.
Show graphically the effect on the number of
dishwasher models offered, after the global
market has adjusted to a new long-run
equilibrium. Explain the process of adjustment
to this new long-run equilibrium.
Show graphically and explain the situation for
the typical firm in the industry.
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