Intra Industry Trade

The Nature and Significance of Intra-industry Trade
Roy J. Ruffin

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ntra-industry trade represents international trade within

industries rather than between industries. Such trade is more beneficial than inter-industry trade because it stimulates innovation and exploits economies of scale.

International trade is traditionally thought to consist of each country exporting the goodsmost suited to its factor endowment, technology, and climate while importing the goods least suited for its national characteristics. Such trade is called inter-industry trade because countries export and import the products of different industries. But the top exports and imports of most industrial countries are actually similar items, such as passenger cars, electrical generators, or valves andtransistors. Indeed, passenger cars are the number one export and import of Great Britain, Germany, and France. In the real world, international trade is largely trade within broad industrial classifications. Intra-industry trade occurs when a country exports and imports goods in the same industry. Intra-industry trade has been a hot topic among trade economists for several decades, but it hasreceived scant attention among economists in general.1 This article gives an overview of intra-industry trade for the generalist. In the debate over NAFTA, for example, commentators focused much attention on America’s interindustry trade with Mexico but none on the far more important intra-industry trade. This article begins with a brief summary of Ricardian and factor endowment approaches to tradetheory to highlight the contribution of intraindustry trade theory. Next, the article discusses the foundations of intra-industry trade theory and the significance of intra-industry trade for an economy. Finally, the U.S.–Mexico trade relationship is addressed as a pertinent example. STANDARD TRADE THEORY To understand why trade economists have turned their attention to intra-industry trade, it isnecessary to understand the implications of inter-industry trade. Standard trade theory involves trade in homogeneous products; hence, with perfect competition there is only interindustry trade. David Ricardo (1817) introduced standard trade theory when he formulated what we now call the theory of comparative advantage. Ricardo highlighted the key ingredient of the theory: goods are more mobileacross international boundaries than are resources (land, labor, and capital). This assumption still characterizes the theory of intra-industry trade. The theory of comparative advantage deals with all those causes of international trade that are generated by the differences among countries. Ricardo’s contribution was not simply that he noted countries are different but that he showed how thosedifferences resulted in all countries

Roy J. Ruffin is a research associate of the Federal Reserve Bank of Dallas and M. D. Anderson Professor of Economics, University of Houston.

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FEDERAL RESERVE BANK OF DALLAS

being internationally competitive even though they might have higher wages (for advanced countries) or lower productivity (for developing countries) than their neighbors. Ricardo’sown subtle explanation is couched in terms of the barter of exports for imports. In the practical world, trade is conducted in terms of prices: people buy homogeneous goods where they are the cheapest. Consider a world of two countries, called home and foreign. The two homogeneous goods are apples and bananas. Suppose in the home country apples cost $1 each and bananas cost $2 each, and in theforeign country bananas cost $1 and apples cost $2. For simplicity, the two countries are mirror images. Keeping with the simple theme, but without any sacrifice of insight, imagine everyone in the world spends exactly one-half his or her income on each good. Suppose each country has income of $100. Thus, before trade, the home (foreign) country consumes fifty apples (bananas) and twenty-five...