1. how can international trade theory explain intra-industry trade? 2. why might

Question

1. how can international trade theory explain intra-industry trade? 2. why might we except intra-industry trade based on scale economies to be less politically controversial than intra-industry trade based on comparative advangate? 3. This question asks you to analyze the effects of removal of a tariff on imported oranges. The following table summarizes the situations in the orange market with and without the tariff. The first column describes the situation with a $4.00-per-bushel tariff on oranges. The second column represents the situation after the tariff is removed. You may assume that transportation costs are zero and that the supply and demand curves are straight lines. With $4.00 Tariff With Free Trade World Price of Oranges ($/Bushel) $12.00 $12.00 Tariff Per Bushel ($/Bushel) $4.00 $0.00 Domestic Price of Oranges ($/Bushel) $16.00 $12.00 Oranges consumed domestically 24 8 (million bushels/year) Oranges produced domestically 8 6 (million bushels/year) a. Illustrate the effects of removal of the tariff. Label the free-trade and tariff equilibria in terms of consumption, domestic production, imports, and domestic and world prices. b. Estimate the amount domestic consumers gain from removal of the tariff. Show and explain your work. c. Estimate the amount of the net effect on the country’s welfare from removal of the tariff. Show and explain your work. d. In this case, would the optimal import tariff on oranges be negative, zero, or positive? Why? Under what assumptions is the “optimal” tariff really optimal?

Explanation / Answer

Introduction:
Over the years empirical international studies have shown that trade among international
countries cannot be adequately explained by conventional theories like comparative
advantage or the Heckscher Ohlin trade theories. This empirical critique is pointed out by
three aspects of world trade which seems to contradict the well-established Neo Classical
theories.
First, much of the world trade is between countries with similar factor endowments
(contradiction to Heckscher Ohlin). Second, a large part of trade is intra industry in character
in the sense it consists of “two way trade in similar products” (contradiction to comparative
advantage). Finally much of the expansion of trade in the post war period has taken place
without sizable reallocation of resources or income-distribution effects. This is very relevant
in the case of EEC (European Economic Community) and North American Automobile Pact.
Intra-industry trade arises if a country simultaneously imports and exports similar types of
goods or services. By similarity we mean by the goods or services being classified in the
same “sector”. Suppose, we focus on the sector “bikes”. Intra-industry trade then occurs, for
example, if Canada exports bikes to the US and simultaneously imports Bikes from Japan. On
the one hand this raises the question why Canada is exporting bikes in exchange for
importing bikes instead of focusing exclusively on so-called inter-industry trade, namely
exporting bikes in exchange for importing different types of goods (such as food or
airplanes). On the other hand, this raises the question why different goods are grouped
together in the same sector, as the exported Canadian Bike differ from the imported USA
bikes. These two questions are addressed below.
Historical Background
Although in various antecedents can be traced, the phenomenon of intraindustry trade as such
first received attention in the 1960s in studies by Pieter Verdoorn and Bela Balassa on the
increased trade flows among European countries. In 1975 Finger tried to explain intra
industry trade, according to him occurrence of intra industry trade was “unremarkable “as the
classifications that were prevailing placed goods of heterogeneous factor endowments in a
single industry. But it has been seen that even when industries are disaggregated to extremely
fine levels Intra Industry Trade still occurs.
Flavey and Kierzkowski (1987)gave another explanation where they modelled to get rid of
the idea that all products are produced under identical technical conditions.The model
portrayed thatdemand side goods are distinguished by the perceived quality of that good and
high quality goods are produced under conditions of high capital intensity.However there
remains a question whether the model applies to intra industry trade as it does not address
trade between goods of same factor endowment.
Herbert Grubel and Peter Lloyd (1975) provided the definitive empirical study on the
importance of intra-industry trade and how to measure it
The most widely accepted and extensive study in this field was done by Paul Krugman in his
New Trade Theory.According to him economies specialise to take advantage of increasing
returns ). Trade allows countries to specialise in a limited variety of production and thus reap
the advantages of increasing returns (i.e., economies of scale), but without reducing the
variety of goods available for consumption.
Donald Davis in his article (Intra Industry Trade:A Hecksher Ohlin Ricardo
Approach,1995) explained that both the Heckscher–Ohlin and Ricardian models were still
relevant in explaining intra-industry trade. He developed the Heckscher-Ohlin-Ricardo
model, showing that even with constant returns to scale that intra-industry trade could still
occur under the traditional setting. The Heckscher-Ohlin-Ricardo model explained that
countries of identical factor endowments would still trade due to differences in technology, as
this would encourage specialisation and therefore trade, in exactly the same matter that was
set out in the Ricardian model.
.
Types of Intra-Industry Trade:
Intra industry trade can be distinguished between two types:
Horizontal intra-industry trade denotes to the simultaneous exports and imports of
commodities categorized in the same sector and at the same stage of processing. This is
based on product differentiation, for example South Korea’s simultaneous import and
export of mobile telephones in the final processing stage. As these mobile phones are
produced using similar technologies and provide similar functions they are classified in
the same sector. Nonetheless, the exported Samsung telephones differ in appearance and
product characteristics slightly from the imported Nokia telephones, catering to the
desires of different types of consumers.
Vertical intra-industry trade refers to the simultaneous exports and imports of goods
classified in the same sector but at different stages of processing. This is based on the
increasing ability to organize “fragmentation” of the production process into different
stages, each performed at different locations by taking advantage of the local conditions.
China, for example, imports technology-intensive computer components and uses its
abundantly available labour force to assemble these components in the labour-intensive
final production stage, before the components (as part of a finished computer) are
exported again to Europe or the USA.
Measuring Intra-Industry Trade
The Grubel Lloyd Index is used most regularly used to determine the extent of intra-industry
trade which was proposed by Grubel and Lloyd (1975). The index is simple to calculate and
is very intuitive in nature. The index is calculated with the import and export values for a
particular sector at a particular time period.
If the country only imports or only exports goods or services within the same sector, such
that there is no intra-industry trade, the second term on the right-hand side of equation is
equal to one, such that the whole expression reduces to zero. Similarly, if the export value is
exactly equal to the import value the second term on the right-hand side of equation is equal
to zero, such that the whole expression reduces to one. The Grubel–Lloyd index therefore
varies between zero (indicating pure inter-industry trade) and one (indicating pure intraindustry trade).
Krugman’s Explanation
In this model Increasing Returns to Scale is taken in a differentiated product where with
increase in output Marginal Cost is reduced at the same time. By taking the profit function
= (p c)x
where is the profit, p is the price, c is the cost and x is the number of output, increase in
profit is either because of the increase in price or by the decrease in cost. Now, with increase
in price demand will fall (output in a close economy will fall). So the best policy is to reduce
marginal cost. Differentiated product is taken because with homogenous goods Increasing
Returns Scale (IRS) will lead to only one firm in the industry. With Differentiated products
all the firms will continue to operate though each producing only a single variety and hence
being a monopolist in that variety. In this model by Paul Krugman, internal economies to a
firm exists as with external economies all firms in that industry will face similar conditions
and market structure will exhibit perfect competition. Krugman solves this complex problem
of internal economies and imperfect competition by assuming Chamberlinian monopolistic
competition.
The core assumptions are
1. Utility is derived by consumers from product variety. There exists a strong positive
relation between the number of varieties and the utility.
2. Production of each variety exhibits economies of scale.
3. Free entry and exit.
Implications of these are:
1. The economy resembles Monopolistic Competition
2. Finite number of verities are produced which is ensured by economies of scale.
3. Gains from Trade arise from increased number of varieties and greater exploitation of
economies of scale.
The Basic Model:
Case 1:In Krugman’s 1979 paper(Increasing Returns,Monopolistic Competition and
International trade)The model assumes one sector economy producing a differentiated good.
The model also assumes a large number of potential varieties (N). Each variety has the same
weightage in the consumer’s utility function.Each variety is produced using the same
production function.Utility of a represented consumer is given by
U = = (ci); (ci)> 0, ("ci)< 0. [1]
Where ciis the consumption of the ith variety by the representative consumer. The model also
assumes that labour is the only factor of production. The cost function is given by
li = + xi I = 1,…,n n<N
whereis the fixed cost, and is the Marginal Cost, li is the total amount of labour used and
xiis the out produced.With the increase in output (xi) the average cost (li
i
) decreases. This is
the essence of the Increasing Returns to Scale.
Hence, with same and all varieties are perfect substitutes in production.
The model shoulders L individuals in the economy, each supplying one unit of labour. Hence
the market clearing condition becomes:
xi = ciL I = 1,…,n [2]
The full employment condition is ensured by:
= I = L [3]
The model tries to determine mainly three variables. Firstly, it tries to determine the Price of
each variety relative to wage , secondly it tries to finds the Output of each variety (xi)
and lastly the Optimal number of varieties (n). It is also assumed that all varieties are
symmetric in terms of both consumption and production and hence, a representative variety is
considered and the sub-script i are dropped from (pi, xi, ci).
There prevails a perfect substitutability on the part of production and the nature of the
consumer utility which means that the consumer’s utility rises with consumption of larger
number of varieties which means that each firm will produce only one variety and behave a
monopolist in that particular variety that they produce. Hence the equilibrium price and
quantity can be obtained when Marginal Revenue is equal to Marginal Cost.
MR = MC
The Marginal cost is given by w. The utility maximization subject to budget constraint of
representative consume is given by:
Max U = = (ci) = n.v(c)
St I = U = = ici = n.p.c [4]
From the above utility maximization problem it is concluded that
v’(c) = p [5]
where is the shadow price which is nothing but the Marginal Utility of income.
Now, under symmetry it can be seen that the market condition becomes
x = cL. [6]
From [5] and [6] the inverse demand function is deduced which is given by:
P =

[7]
If the number of goods is very large then each firm’s pricing policy will have a insignificant
effect on the marginal utility of income, hence can be treated as a constant.
The elasticity of demand in this case will turn out to be
= -



= -

." ;

c< 0 [8]
Marginal Revenue (MR) is can be written as
–

hence, equating Marginal Revenue with
Marginal Cost will give: =
c
c = >= c c [9]
From [8] and [9] it can be concluded that when consumption c increases then then the
demand elasticity decreases hence the Price of each variety relative to wage increases.
As
c< 0 and there is an inverse relation between the Price of each variety relative to wage
and demand elasticity , a positive relation can be seen between Price of each variety
relative to wage and consumption c.This can be seen in fig 1. through the PP curve.
Fig 1.
In the above figure the price is everywhere above Marginal Cost to ensure that losses don’t
exceed fixed cost.Price rises with consumption as elasticity of demand € falls with
consumption.This increase in price rise gives the firm more monopoly power.Now average
cost pricing condition(resultant of free entry assumption gives the profit function as
i = pixi ( + xi)w
In the equilibrium,zero profit condition yields:
0=px-(+x)w thus

=+
c
This condition gives a negative relation between

and c.This is th ZZ curve in the figure.
Now given the symmetry in both consumption and production and having L=n(+x) we get
the value of n as n=
+c.Thus with all these we get the values of ,x and n. This solution
was given by Krugman in his 1979 paper.
Case 2-In Krugman’s 1980 paper(Scale economies, Product differentiation and pattern of
trade) modification was present incorporating product differentiation.This has been as
follows.As before the consumer preference was additively separable but now it remained
symmetric in commodities.Thus the utility function is
U= i= vci);0<<1
Hence in the first case the varieties were perfect substitutes but now it becomes imperfect
substitutes. All the other assumptions are same as in the first case.The cost function is also
same given by
Li=+xi where and are same and hence all the varieties are perfect substitutes in
production. Perfect substitutability on part of production means that each firm will produce
one variety and behave as a monopolist in that particular variety.Similar in the first case
equilibrium price obtained by MR = MC
P= €c
€cw
P=-1w
With the Average Cost Pricing as free entry and exit exists, profit function is given by
=px-(+x)w
At equilibrium zero profit condition yields x=
(€-1)or x= ( )
Equilibrium number of firms under one industry model is n=
+(same as before)
Case 3:In Krugman’s 1981 paper(Intra Industry Specialization and gains from trade) the
frame work of the model incorporating Increasing Returns to Scale, monopolistic competition
and hence intra industry trade all are same but here he has incorporated multiple industry
framework with product differentiation(as mentioned in the second case).The utility function
are symmetric in commodities which is
U=ln( = i) 1 + ln( = j) 1; 0< <1
So as we can see initially varieties were perfect substitutes but later they became imperfect
substitutes though close ones.Here also all the assumptions are same and labour is the only
factor of production.The cost function is given by li=+xi where with increase in xi the
average cost
li
i
will decrease and hence yields Increasing Returns to Scale.Here also and
are same and hence all varieties are perfect substitutes in production.As here are two
industries the varieties within the industry remain perfect substitutes but not across
industries.So the cost functions of each of the industries are
L1i=+x1i for all i=1,...,n1
L
2j=+x2j for all j=1,...,n2
Full employment condition is common for all the models:
= i = L or = 1i = L1; = 2j= L2
Perfect substitutability on part of production at least within industry means that each firm will
produce only one variety and be a monopolist in that variety. Hence, equilibrium price
obtained by MR = MC which is given by
P= €c
€cw
p1=-1w1w1 p2=-1w2
Consider Average Cost (AC) pricing condition which is a result of free entry assumption.
Profit function is then given by:
i = pixi - ( + xi)w or 1i = p1ix1i - ( + x1i)w1; 2j = p2jx2j - ( + x2j)w2
At equilibrium zero profit condition yields x=
(€-1)or x= ( )
With two separate industries n1 and n2 are:
n1 =
+ =
z
+
n2 =
+ =
z
+ where z is the factor proportion and total labour force is assumed to be
2.This z is the additional parameter which measures factor proportions. Initially in case1 and
case2 the wages are same as labour is homogeneous but in this model labour is sector specific
and hence with the fraction of income going to both the industries are equal the relative
wages depend on factor proportions which is


=
z
z
This equation means that the lower the value of z the higher the value of wages in industry 2
and vice versa.The term implies the degree of substitutability.The lower value of implies
higher degree of differentiation.Moreover here =agial C
Aeage C
which is the elasticity of cost
with respect to output.Now another aspect worth mentioning is the Edgeworth Box diagram
in Krugman’s 1981 paper and its relation with its factor proportions and intra industry
trade.With z tending to 1 which means the factor proportions are equal to 1 then l1=l2 and so
subsequently |l1-l2|tends to zero.The proposition that countries with similar factor
endowment will engage in intra industry trade while countries with different endowments
will engage in Hecksher Ohlin trade is shown here.The measure of intra industry trade is
taken by Grubel Lloyd index of trade overlap given by and accordingly trade occurs between
two countries with similar factor endowment where z=1 and interindustry trade occurs with
z=0.
I = 1 –( | |/ [ + ]
Thus we can conclude saying that Krugman’s 3 papers focused on increasing returns to
scale,monopolistic competition as the source of intra industry trade where mostly occurs due
to consumers love for variety for goods.
Illustrations from some other works:
Rudolf Loertscher and Frank Wolter’s paper1980 (”Determinants of IntraIndustry Trade: Among Countries and across Industries” )
in his paper ”Determinants of Intra-Industry Trade: Among Countries and across Industries”
have concluded from the studies by Linnemann [1966] and Balassa [1966] , Linder
[1961],that two strands of intra-industry trade can be identified.
1: First, there are variations of intra-industry trade intensity for any given industry depending
on country-specific characteristics of the trading partners.
2: Second, given trading partners, there are variations of intra-industry trade intensity across
industries depending on commodity-specific demand and supply characteristics.
It therefore seems appropriate to adopt an approach covering intra-industry trade both among
countries and across industries in combination. He drew these country hypothesis from the
above literature mentioned:
1. Intra-industry trade among countries is intense if the average of their levels of
development is high.
2. Intra-industry trade among countries is intense if the difference in their levels of
development is relatively small.
3. Intra-industry trade among countries is intense if the average of their market sizes is
large
4. Intra-industry trade among countries is intense if the difference in their market sizes is
small.
5. Intra-industry trade among countries is intense if barriers to trade are low.
These were his industry hypothesis
1. Intra-industry trade in an industry is intense if the potential for product differentiation
is high and market entry in narrow product lines is impeded by significant barriers
2. Intra-industry trade in an industry is intense if transaction costs are low.
3. Intra-industry trade is intense if the definition of an industry is comprehensive.
His basic findings are:
With respect to intra-industry trade intensity among countries, the analysis suggests that
autonomous catching-up processes, a simultaneous growth of domestic markets or a lowering
of transaction costs among trading partners, whether it is by a relative decrease of prices for
transport and communication services or by a removal of policy imposed trade barriers, tend
to be accompanied by an increase in intra-industry trade.
In observations across industries, the relevance of transaction costs in influencing intraindustry trade patterns is revealed as well. As in an earlier study [Pagoulatos and Sorensen,
1975] the role of product differentiation, however, has remained ambiguous. While industryspecific value added per establishment - a variable which can beexplained as a measure of
standardization - was systematically negatively correlated with the level of intra-industry
trade across industries thus an effort to directly measure product differentiation within
industries failed to yield significant results. As an explanation for this unsatisfactory finding
may lie in the difficulties of adequately measuring product differentiation.
Intra Industry trade-The Case of India
Choorikkad Veeramani’spaper 2002 (Intra-Industry Trade of India:
Trendsand Country-Specific Factors)
The liberalization policy was introduced in India in the early 1980s, it was expected that
liberalization would lead to restructuring of the economy. The structure of trade under the
import substitution regime was thought to be shaped mainly by the nature and bias of
protection policy. Study from Globerman and Dean (1990: 27) suggested that liberalization
would bias trade expansion in the direction of intra-industry trade (IIT). Veeramani’s paper
on intra-industry (IIT) examines the important aspects of India’s Intra-Industry Trade in
manufactured commodities. Firstly he examines the levels of multilateral Intra-Industry
Trade from 1987-88, 1994-95, and 1999-2000 and the importance of exports vis-à-vis
imports in influencing such changes. Secondly, it also analyses the influences of various
country specific factors on the intensity of India’s intra-industry trade with her major trading
partners.
Recent empirical studies have shown that vertical intra industry trade is predominant as
compared to horizontal intra industry trade even among the developed countries (Greenaway
et al. 1994). However most of the econometric studies investigating the influence of country
specific factors on the intensity of intra industry trade derived hypothesis from the models of
horizontal intra industry trade.
The recorded levels of India’s multilateral Intra-Industry Trade in different sections of
commodities for the years 1988, 1995, and 2000 showed that the recorded levels of IntraIndustry Trade in all sections of commodities and in overall trade are significantly higher for
the year 2000 as compared with the year 1988. The lowest increase recorded was in the
Instrument and apparatus followed by Transport equipment, whereas the largest increase was
seen in Plastics and rubber.
Intra-Industry trade is generally observed in the context of advanced industrialized countries
but the paper found a significant level of Intra-Industry Trade in India’s international
trade.The analysis of India’s multilateral trade showed that, in agreement with the evidence
from other countries, the liberalization policy environment biases trade expansion towards
Intra-Industry Trade. Vaeeramani in his paper also concluded that the increased level of IntraIndustry Trade is largely export-led, which means that the Intra-Industry Trade is caused by a
faster growth of exports than of imports.
Some other Empirical Characteristics of
Intra-Industry Trade
In a study with the growing importance of intra-industry trade, the OECD (2002) lists the
following empirical characteristics:
Intra-industry trade has risen significantly since the 1980s in most (OECD) countries
is particularly high for sophisticated manufactured products (chemicals, machinery,
transport equipment, electrical equipment, and electronics; both based on product
differentiation and fragmentation)
is particularly high for very open countries (“super trading” economies, where both
imports and exports account for more than half of GDP) is connected to FDI inflows,
particularly in Eastern European “transition” economies
is related to preferential trade agreements, for example the sharp increase in
intraindustry trade in Mexico after the North American Free Trade Agreement
is to a large extent based on intra-firm trade, either based on product variety or on
fragmentation (intra-firm trade accounts, for example, for one third of exports in
Japan and the USA).
In conclusion, we note that intra-industry trade, the simultaneous import and export of
similar types of goods or services, is measured using the Grubel-Lloyd index, is to
some extent based on lumping together different types of goods in one sector
(aggregation problem), can be based on (horizontal) product differentiation or
(vertical) fragmentation, is associated in particular with the production of
sophisticated manufactured goods, and is an increasingly important part of (intrafirm) total trade flows in today’s globalizing world, particularly for developed
countries.
Conclusion
Intra-industry trade representing international trade within industries rather than between
industries is more beneficial than inter-industry trade because as 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. As trade liberalization takes place in all the countries (whether developed
or developing) the share of Intra Industry Trade in total trade can be expected to grow. Intra
Industry Trade will be greater as countries become more similar both in relative factor
endowments and economic size. More Intra Industry Trade will occur in vertically
differentiated, nonstandard, made-to-order products produced by large, globally integrated
industries. In India Intra-Industry Trade is largely export-led, which means that the IntraIndustry Trade is caused by a faster growth of exports than of imports. Theoretical and
empirical models of North-South trade should focus attention on sources of Intra Industry
Trade related to country characteristics, vertical product differentiation based on quality
differences, the degree of product standardization, and labour cost differences between the
North and South to bridge the gap between developed and developing countries.

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