Inter-industry and intra-industry trade. Heckscher-Ohlin Model

Differences between inter-industry and intra-industry trade. 

International trade is one of the key factors of macroeconomic prosperity for any country. Today with the increasing force of globalisation international trade has become very complex with multi-billion transactions taking place every year. Yet, some of the aspects of international trade are still not fully researched and even existing theories related to the international trade need to be submitted to critical analysis taking into account ever-changing global economic environment.

 

Difference between Inter-industry and Intra-industry trade

Although their wording is very similar the terms ‘inter-industry’ and intra-industry’ trade have a very different meanings.

Inter-industry trade is a trade of products that belong to different industries. For instance, the trade of agricultural products produced in one country with technological equipment produced in another country can be classified to be an inter-industry trade. Countries usually engage in inter-industry trade according to their competitive advantages.

Intra-industry trade, on the other hand, is a trade of products that belong to the same industry. As it has been noted, “intra-industry trade (IIT), that is trade of similar products, has been a key factor in trade growth in recent decades. These trends have mostly been attributed to the fragmentation of production (outsourcing and offshoring) as a result of globalisation and new technologies” (Handjiski et al, 2010, p.15).

 

Explanation of Intra-Industry Trade by Economic Theory

It first sight it may seem strange that countries do engage in importing and exporting same type of products with their international partners. However, there are a range of benefits intra-industry trade offers businesses and countries engaging in it in general.

The benefits of intra-industry trade have been explained by various business researchers, and all of these benefits can be summarised into three points that which is illustrated by Johnson and Taylor (2009) in the following way:

Firstly, intra-industry trade increases the variety of products the same industry, which is beneficial to both, businesses, as well as consumers. This benefit of intra-industry trade is possible because today product range from the same industry can be highly differentiated, and intra-industry trade will provide the opportunity of having a vast range of differentiated products within the markets of trading partners.

Secondly, intra-industry trade gives opportunity for businesses to benefit from the economies of scale, as well as use their comparative advantages. In other words countries will get more economic benefits if they concentrate on producing specific types of products within specific range, according to their comparative advantages rather than producing all ranges of specific products.

Thirdly, inter-industry trade stimulates innovation in industry, and can assist the economy in cases of short-term economic fluctuations.

The main benefit of intra-industry trade can be explained in simple terms by using an example of car trade between  Japan and Germany. Let’s suppose Toyota, a Japanese car company mainly produces family cars, and German car manufacturer Audi concentrates on producing sport cars. Accordingly, when Toyota produces more family cars, the lower will be the unit cost, and similarly, more sports cars are produced by Audi, the lower unit price of the car will be.

 

Heckscher-Ohlin Model and Intra-Industry Trade

Heckscher-Ohlin Model was developed by Eli Heckscher and Bertil Ohlin and offers a general equilibrium approach to the issues of international trade. The essence of the model can be summarised to the idea that countries will concentrate on exporting products for the production of which their abundant resources are required, at the same countries try to import those products for production of which resources required that are scare in respective country (Kemp, 2008).

Ruffin (1999) mentions three fundamental characteristics of Heckscher –Ohlin model of intra-industry trade as following:

Firstly, each county exports products according to its comparative advantage. For instance, China produces and exports technology products because the low prices of relevant resources in China provide comparative advantage in producing and exporting this type of products, while Turkey mainly exports clothing products due to the cheaper prices of cotton and advanced textile industry present in Turkey.

Secondly, international trade that is based on the comparative advantage will benefit some industries, at the same time hurting other industries. For example, when UK exports technology abroad, technology companies will benefit; however, when clothing items are imported into UK, unskilled workers within clothing industry in UK will be hurt.

Thirdly, international trade between countries will result in price equalisation.

To put it simply Heckscher –Ohlin model of intra-industry states that “economies export the services of their abundant factors and import the services of their scarce factors” (Ruffin, 1999, p.4)

However this theory has attracted criticism due to a set of assumptions it makes. Specifically Heckscher-Ohlin Model assumes that there is a constant supply of productive factors in the in a country, the points of differences between of countries are only on factor endowment, and also the theory does not take into account technological progresses.

Nevertheless, apart from the serious shortcomings of Heckscher-Ohlin theory, it still fails to explain intra-industry trade between countries, because the theory contradicts to the notion of intra-industry trade in fundamental level.

Specifically, Heckscher-Ohlin theory states that countries will engage in exporting those products for the production of which their abundant resources are going to be used. However, intra-industry trade involves products from the same industry being traded between countries, compromising the validity of Heckscher-Ohlin theory in today’s economic environment.

 

Conclusion

Intra-industry trade has evolved to be one of the important macro-economic practices that is beneficial in terms of maintaining macro-economic stability, promoting innovation and increasing the number of differentiated versions of the same type products in markets of the trading partner countries.

The above and other benefits of intra-industry trade have been explained in economic theory by various authors. However, Heckscher-Ohlin theory fails to explain intra-industry trade because the theory states that only product produced with abundant resources are going to be exported, scarce resource products will be imported to a country, whereas countries engaged in intra-industry trade use the same resources.

 

The pattern of inter-and intra industry trade within the EU

While trade between countries is can be imports and exports, depending on if the goods are coming into country, or leaving the country; movement of goods within European Union is referred to as arrivals and dispatches.

The exact definitions of arrivals and dispatches are given in the following way:

“Arrivals are goods in free circulation within the EU which enter the statistical territory of a given Member State.

Dispatches are goods in free circulation within the EU which leave the statistical territory of a given Member State to enter another Member State” (Eurostat, 2011, online)

The trade within EU from dispatches was calculated to be EUR 2 194 341 million in 2009 (Eurostat, 2011). This amount is more than double the amount of trade engaged in with non-EU countries. The share of dispatches within EU compared to exports to countries outside of EU for each country is presented on the following table:

 

The importance of the internal market was highlighted by the fact that for each of the Member States, intra-EU trade of goods was higher exports. The highest shares of intra-EU trade were recorded for the Czech Republic, Slovakia and Luxembourg,  in cases of United Kingdom, Italy, and Malta this number was considerably lower.

We can see that intra-EU trade  decreased in 2009 even more significantly compared to the exports. There are many reasons for this change, and of the main reasons can be pinpointed to be the global economic crisis that started in US in 2007, and within a short period of time extended to all EU member countries as well. Taking into account arrivals and dispatches together, the biggest decrease in intra-EU trade were observed in cases of  Latvia, Lithuania, Estonia and Finland, where intra-trade has decreased about 30%. This was the reasons why latter countries suffered the most from the global economic crises of 2007-2010.

In order to analyze performance of any given member of EU, looking at intra-industry trade would not suffice; rather the trade surplus (extra and intra-EU combined) should be looked at.

Germany was leading in terms of the trade surplus for goods for the year of 2009,  at EUR 134 780 million. The next highest trade surplus in 2009 (EUR 39 244 million) was observed in case of Netherlands, followed by Ireland (EUR 37 753 million).

However, for the same period some EU members have experienced trade deficit as well. For instance, the highest trade deficit of EUR 93 189 million was recorded by the United Kingdom, although this was an improvement compared to even worse performance in 2008.

 

Implications for Trade Diversion and Trade Creation within EU

Trade creation, as Czinkota et al (2008) inform, is a benefit of economic integration. Specifically, it is a benefit a particular country obtains as a result of number of countries trading freely among themselves, and creating barriers to non-members.

Trade diversion, according to Czinkota et al (2008) is a cost of economic integration to a particular country of being a part of group of countries that trade freely among themselves, but maintain barriers to non-members.

In order to analyse implications of above figures for trade diversion and trade creation within EU, it would be more efficient approach first to analyse EU from the point of view of Free Trade Area (FTA) or a Union.

Outside a union, and operating independently, countries will attempt to use its comparative advantage  In a free trade area, on the other hand, countries will trade with other countries they choose, attempting to exploit their comparative cost advantage by the means of specialisation They will export goods they produce most efficiently, and import goods from low-cost countries that  have exploited their own comparative cost advantage to produce cheap exports. In a situation where countries form FTA’s such as EU, trade will be vague and the pattern of trade will change. Inefficient producers may be may be protected and encouraged, at the expense of more efficient imports.

The creation of a customs union, with common external tariffs, will further change the existing pattern of trade flows. The assumption is that before the union, members imposed differential tariffs on different countries to protect their own industries.

Once a union is created, members agree to eliminate tariffs between themselves. The effect of this is that, facing lower priced, zero-tariff, imports from members, consumers increase their demand for these goods, and new trade will be created.

For example, if Denmark and the UK form a customs union, tariffs on Danish butter must now be reduced, and once they are completely removed, the free market price of 120p will be highly attractive to UK consumers. UK consumers will now consume more butter in total because average butter prices will have fallen with the removal of tariffs on Danish butter, and total demand for butter rises. For example, total output and consumption might increase to 32m kgs (up by 2m), with UK farmers down from 20m to 15m, New Zealand exports collapsing to just 2m, and Denmark increasing its output and sales of butter to the UK to 10m (from 5m to 10m).

Furthermore, this will enable a dynamic reaction within Denmark and the UK. Over time, as countries (Denmark and the UK) become more integrated, increased trade will generate further efficiency gains, such as through the application of economies of scale. Prices may fall even further, relative to those of non-member countries, and the process of trade creation continues. For example, with increased sales, Denmark can specialise further in butter production, and produce on large scale, bringing prices down even further (perhaps nearer to the New Zealand level). Also, the UK can now free up its resources, and move them out of butter production and into goods and services for which the UK has a comparative advantages over Denmark. Hence, over time, trade creation will continue as a positive long-term effect of a customs union.

The major loser in this is the previous trading partner left outside the bloc – less trade now exists between new members and their old trading partners.

For example, after Denmark and the UK form a customs union, New Zealand, which was the most efficient butter producer, suffers a loss of  sales to the UK, from 5m to 2m, with trade diverted from New Zealand to Denmark. However, there is some debate about the use of the term trade diversion. In its simplest form it means any trade diverted away from efficient global producers as a result of the creation of a customs union. Other economists regard trade diversion as relating to the long-term loss of trade resulting from inefficient producers (such as Denmark, in our hypothetical example) becoming more efficient following membership of the union. For example, if the price of Danish butter falls from 120p to 95p as a result of trade expansion within the union, it is now 5p cheaper than New Zealand in the open market, and more trade may now be diverted away from the formerly highly efficient New Zealand. Whichever definition is accepted, it is clear that in this case the union has distorted trade.

 

Within a free trade area many markets and multiple countries are affected by any economic or otherwise changes within that area. Therefore, to analyze the total effects of a FTA, we need to aggregate the impacts across markets and countries.

Accordingly, each member state of EU has experienced economic disadvantages in the form of trade diversion. A good example of trade diversion in case of UK would be the import of lamb into the UK. Before UK joined the EU lamb was imported into the country from New Zealand at a suitable price. However, as a result of UK joining EU France became the main importer of lamb into UK with much higher price than it was imported from New Zealand. In this was we can see the economic disadvantage UK had to experience as a result of joining EU.

 

The recent enlargement of the European Union (EU) be attributed and the need for the expansion intra-industry trade within the EU. Explain.

The secondary data research has revealed that recent enlargement EU was undertaken for a variety of reasons, and one of the main reasons was the need for the expansion of intra-industry trade within EU.

According to analysis by The Centre for Economic Policy Research (2011) one of the main reasons of recent EU enlargement was to improve the level of intra-industry trade within EU, by trading low-skill and high skill products within one sector. Moreover, the analysis states that the amount of total intra-industry trade among Singapore, South Korea, and Taiwan was bigger than the EU before the expansion, and the recent EU enlargement put the Union ahead of above named countries in terms of the amount of inter-industry trade.

The above statement can be explained in a more simple terms. For instance, if Latvia exports low priced clothes to UK, the clothes will be the result of work of low-skilled workers working for minimum wages according to EU standard. Accordingly, when at the same time UK exports clothes to Latvia, these clothes will be highly priced, apparently with good quality because they would be produced by high-skilled workers in UK.

In the above situation the benefit for UK labour market will be in a way that the demand for skilled workers in UK will increase, because more clothes need to be produced to export to Latvia and other new members of EU, and at the same time the demand for low-skilled workers in UK will decrease, due to the fact that cheaper clothes made by low-skilled workers are already being imported by Latvia and other new members of EU.

 

Conclusion

This paper has looked at the issues of inter-industry trade within countries from the EU perspective. It has been identified that partner countries gain significant benefits through engaging intra-industry trade in many levels. Moreover, it has been also established that EU countries engage intensively in intra-industry trade, however in some occasions trade diversion may put some countries in disadvantaged positions. Also, the paper has established that one of the main reasons for EU enlargement was to promote intra-industry trade between member-countries.

References

• Handjiski, B, Lucas, R, Martin, P & Guerin, SS, 2010, Enhancing Regional Trade Integration in Southest Europe, World Bank Publications
• EU Enlargement: Implications for East-West Trade, Centre for Economic Policy Research, Available at: http://www.cepr.org/pubs/bulletin/meets/719.htm
• External and intra-EU Trade-Statistical Yearbook, Data 1958-2009, Eurostat Statistical Books
• Johnson, D & Turner, C, 2009, International Business: Themes and Issues in the Modern Global Economy, Taylor & Francis
• International Trade in Goods, 2001, Eurostat, Available at: http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/International_trade_in_goods#Further_Eurostat_information
• Kemp, MC, 2008, International Trade Theory: A Critical Review, Routledge
• Ruffin, RJ, 1999, The Nature and Significance of Intra-industry Trade, Federal Reserve Bank of Dallas