Characteristics of Intraindustry Trade

In the models of comparative advantage-based trade presented in Chapters 3 and

4, production costs are either constant (Chapter 3) or increasing (chapter 4).
Accordingly, each additional unit of bread produced led to the loss of a fixed or
increasing amount of steel. The production of many .goods, however, is
characterized by economies of scale, or decreasing costs, over a relatively large
range of output. Economies of scale can be either internal economies of scale or
external economies of scale. Internal economies are defined as falling average costs
over a relatively large range of output. In practice, this leads to larger firms because
size confers a competitive advantage in the form of lower average costs. One of the
distinguishing features of intraindustry trade is the presence of internal economies
of scale. In the case of external economies, larger firms have no inherent advantage
over smaller firms, but average costs decline for all firms as the sizeof the industry
increases. Unlike internal economies of scale, with exter nal economies, the size or
scale effects are located in the industry and not in the firm. We will examine
external economies when we look at industrial clustering later in the chapter.
Table 5.1 illustrates a firms cost structure when it experiences increasing
returns to scale. More output leads to higher costs, but the cost per unit, or average
cost, declines, In most cases, with increasing production levels, average cost
eventually begins to rise. In a few cases, such as commercial jet aircraft discussed
later in the chapter, the output level at which average cost starts to rise is equal to
a large share of the entire world market and, consequently, large firms have
enormous advantages. Increasing returns are usually based on the inherent
development, engineering, or marketing aspects of production and are associated
with products that have a large fixed cost component. Car companies, software, and
popular household brand name products, to name a few, tend to have large fixed
costs. These occur for various reasons, such as the cost of constructing a large
production plant, large R&D budgets, or large marketing expenditures. Software, for
example, requires large up-&ont expenditures on R&D to develop a product, and the
more units a firm can sell, the more it can spread out those fixed R&D costs.
Internal economies of scale have important implications for the type of
market that prevails. In Chapters 3 and 4, it is assumed that firms operate in
competitive markets where no one firm can influence prices or overall industry
output. When larger firms are more competitive, however, it reduces the number of
firms in a market and leads to one of several types of market structures. In an
oligopoly, a handful of firms produce the entire market output. In this case, the
pattern of production and trade is very difficult to predict because each firm uses
predictions about the actions of its competitors as it formulates its own profitmaximizing strategy. This type of response means that each firm alters its output
level as it sees what its competitors are doing, and production levels and trade
become less predictable. An example is presented later in the chapter when we
discuss industrial policies and strategic trade theory.
Often, internal economies lead to the relatively common market structure
called monopolistic competition. Recall that in a pure monopoly, one firm produces

the entire industry output. In monopolistic competition, there is competition among

many firms, but their competition is attenuated by the practice of product
differentiation. With product differentiation, each firm produces a slightly different
product. This gives rise to the monopoly element of monopolistic competition, in
that each firm is the sole producer of its products. For example, only Ford can sell
Ford Explorers. Unlike a pure monopoly, however, every other firm produces a close
substitute and this introduces a real element of competition.
In monopolistic competition, the level of competition among firms increases
whenever new firms enter the market. This has two effects. On he one hand,
heightened competition will lead to lower prices because products are subsitutes for
each other and in the struggle to capture sales, downward pressure is placed on
prices. On the other hand, when more firms divide the market, on average each firm
sells fewer units of output, and so costs rise. This follows directly from the internal
economies of each firm. As long as prices are above costs, more finns will enter the
market, and whenever prices are below costs, firms exit. .
The presence of internal economies of scale is the reason why firms want to
enter export markets. Any firm that exports has a competitive advantage since it
will have higher sales and be able to take advantage of the cost-reducing effects of
its internal economies,of scale. For any given number of firms, average costs are
lower in a larger market. This follows from the economies of scale that each firm
experiences and the fact that if the number of firms is held constant, each firm sells
more as the size of the market expands.

The Gains from Intra industry Trade

Intra industry trade also creates gains from trade. While the increase in the size of
the market leads to lower costs through the effect of scale economies, competition
among firms forces them to passon their lower costs to consumers in the form of
lower prices. Lower prices for exports and imports stands in marked contrast to the
case of comparative advantage-based trade. Recall that in the trade models of
Chapters 3 and 4, each countrys consumers benefit from a reduction in the price of
the good it imports, but at the same time, the price of the export rises. With intra
industry trade, however, prices for imports and exports decline, leading to
unambiguous benefits for consumers in both countries. Trade enables firms to
produce for a larger market and at a higher level of efficiency That raises
everyones real income through the reduction in prices.
The expansion of the market that occurs with trade ultimately leads to an
increase in the number of firms. This follows from the fact that exports create a
situation where costs are below prices, attracting new firms into the market untilexcess profits arc competed away. It is indeterminate if the increase in the number
of firms comes about through an increase in domestic or foreign firms, or how the
increase might be divided between -the two. While it s safe to say that the
combined foreign and domestic industry will expand, the location of the expansion
is indeterminate, it is even conceivable that foreigners might expand

disproportionately and leave the domestic industry smaller than it was initially.
While this cannot be ruled out, in -general, intra industry trade is usually perceived
as less threatening to jobs and firms than comparative advantage-based trade. This
difference is primarily due to the decline of the import sector in comparative
advantage-based trade, and the need for some or all-of its workers to look for work
in the expanding export sector. By contrast, in intra industry trade, there is a
significant likelihood that trade expands the number of domestic firms and the
quantity of domestic output. At -the very least, domestic firms have an opportunity
to expand, and it would be expected that well-run firms would take heed of the
larger market available to them. This makes intra industry trade inherently less
threatening and less likely to lead to complaints about fairness or that foreigners
are taking advantage of lower labor or environmental standard in order to expand
their production. Recall also that intra industry trade is primarily between countries
of similar income and factor endowments, which also reduces the tendency toward
protectionist pressure.
In addition to lower prices (higher real income) and the potential expansion of
production, another benefit from intra industry trade is that it increases-consumer
choices. Without trade, consumers are limited to the goods produced in the
domestic market. This is not necessarily a limitation for some people, but a scan of
the highways should be enough to convince anyone that many consumers prefer
foreign made goods over their domestic substitutes. The value of added choices is
not easy to measure in dollar terms, but it is clearly a significant benefit for most
people. Overall, the automobile industry began to integrate production in the United
States and Canada completely. Trade between the two countries rose dramatically,
and eventually grew into the largest bilateral trade relationship of any two countries
in the world. Table 5.2 illustrates the importance of intra industry trade. Four of the
top five U.S. exports to Canada and two of the top five imports are motor vehicles or
related products. In terms of value, an over whelming share of the top five exports
and imports are car related. Clearly, intra industry trade is fundamental to the U.S.
Canadian trade pattern.
It is also interesting 10 note that the top five U.S. imports include a number
of Canadian exports that take advantage of its natural resource endowment. This
part of the trade relationship illustrates comparative advantage-based trade built
around differing factor endowments. As a result, U.S-Canadian trade is partly intra
industry, partly inter industry comparative advantage-based.

United States and Canada Trade

In 1965, the United States and Canada implemented a free trade policy that
covered autos and auto parts. The results were dramatic, particularly on the
Canadian side the border. Prior to the Auto Pact, Canada required most car sold
domestically to be made inside country, the relatively small market in Canada
meant that only a few different car models were produced, each in small batches
that cost more to make since automakers could not take full advantage of
economies of scale in production. After the Auto Pact, automakers refocused

production on a smaller number of models that were produced for the combined
Canadian and U.S. market. Canadian productivity in the automobile industry rose
dramatically as the scale of production increased. In addition, as imports from the
United States increased, Canadian consumers had many more models to choose
from.