Chapter 6: Alternative Theories of Trade Topics in chapter 6: Standard trade theory has increased difficulties in explaining real world trade flows - there is a need for alternative theories Intra-industry trade Product differentiation and monopolistic competition Oligopoly and trade

Trade and comparative advantage Trade based on theories of comparative advantage focus on the supply side of the economy - countries trade because they are “different” The H-O model explains “resource based” trade well - e.g. trade for DCs to LDCs, trade in natural resources, etc. Countries which are “similar” should only trade a little with each other

Economies of scale Without trade, equilibrium is in point A with 40 units of X and 40 units of Y With trade, nation 1 can specialise in the production of good X in point B, and nation 2 in the production of good Y i point B` By exchanging 60X for 60Y consumption can take place in E, with a gain of 20X and 20Y

Economies of scale It is a matter of complete indifference which of the two nations specialise in the production of X or Y - the trade pattern may be random If scale economies exist over a sufficiently long range of outputs, one or a few firms will capture the entire market monopoly oligopoly

Trade based on Product Differentiation A large portion of the output of modern economies today involves differentiated rather than homogenous products As a result, a great deal of international trade can and does involve the exchange of differentiated products of the same industry or broad product group A great deal of international trade is intra-industry trade in differentiated products, as opposed to inter-industry trade in completely different products

Intra - Industry Trade The level of intra-industry trade can be measured by the intra-indystry trade index (T), where X and M measure respectively the value of exports and imports

Intra - Industry Trade Intra-industry trade can take various forms: Horizontal trade in similar products with differentiated varieties (e.g. cars of a similar class and price range) Vertically integrated differentiated products distinguished by quality and price (Italy exports high quality clothing and imports lower quality clothing) Vertical specialisation of production that results in trade in similar goods at different stages of production

Intra - Industry Trade Explanations for these may be different Horizontal intra-industry trade enables countries with similar factor endowments to benefit from economies of scale Trade in vertically differentiated products may reflect different factor endowments, particular skills of the work force or high fixed research and development costs Vertical specialisation of production across countries may be driven by comparative advantage

OECD – EO 71, 2002

OECD – EO 71, 2002

OECD – EO 71, 2002 Why is IIT in Norway so low?

Intra - Industry Trade The extent of intra-industry trade is typically much higher across categories of manufactured goods than across trade in non-manufactured goods, and highest for the more sophisiticated manufactured products such as chemicals, machinery and transport equipment, electrical equipment and electronics This is probably because sophisticated manufacturing products are more likely to benefit from economies of scale in production and are easier to differentiate to the final consumer

Formal models of IIT Different demand conditions are important, but are not the only important factor A producer cannot make every conceivable variant of a product - would loose economies of scale in production Internal - expansion of the firm itself External - expansion of the industry

Monopolistic competition If scale economies are modest or moderate, there is room for a large number of firms Many firms selling a differentiated product with easy entry or exit from the industry - monopolistic competition

Monopolistic competition

Number of firms and IIT

Intra- and inter-industry trade Suppose we have two nations, 1 and 2, and two goods, X and Y Nation 1: labour abundant Nation 2: capital abundant Good X: labour intensive Good Y: capital intensive Which trade pattern will we observe ?

Intra- and inter-industry trade If X and Y are homogenous, nation 1 will export X and import Y, while nation 2 will export Y and import X, as postulated by the H-O theory This is inter - industry trade and reflects comparative advantage only

Intra- and inter-industry trade If there are different varieties of X and Y are (X and Y are differentiated), nation 1 will still be a net exporter of X (inter- industry trade, based on comparative advantage), but will also import some varieties of X and export some varieties of Y (intra - industry trade, based on product differentiation and economies of scale)

Gains from trade There will be an increase in the varieties of goods which become available through imports Increased international competition can lower prices Distribution of factor income has not been much affected, exports may make up for loss of domestic market share due to imports

Product cycle and trade

Transportation costs