INTERNATIONAL ECONOMICS

Lecturer: Vo Hoang Kim An

Email: vohoangkiman.cs2@ftu.edu.vn

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CHAPTER 5
NEW APPROACHES
TO TRADE THEORY
 CHAPTER ORGANIZATION

▰ Economies of scale
▰ Overlapping demands
▰ Intra-industry trade
▰ The gravity model of trade
▰ Product cycle theory
▰ National competitive advantage

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Economies of scale and international trade

New trade theory suggests that the ability of firms to

gain economies of scale (unit cost reductions
associated with a large scale of output) can have
important implications for international trade

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Economies of scale and international trade

Countries may specialize in the production and export

of particular products because in certain industries, the
world market can only support a limited number of
firms

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 Economies of scale and international trade

▰ When defining comparative advantage, the Ricardian model and the

Hecksher-Ohlin model both assume constant returns to scale:
▻ If all factors of production are doubled then output will also doubled
▰ But a firm or industry may have increasing returns to scale or
economies of scales:
▻ If all factors of production are doubled, then output will more than
doubled
▻ Larger is more efficient: the cost per unit of output falls as a firm or
industry increases output 7
 Economies of scale and international trade

▰ The Ricardian and Hecksher-Ohlin models also rely on competition to

predict that all income from production is paid to owners of factors
of production: no “excess” or monopoly profit exists
▰ But when economies of scale exist, large firms may be more efficient
than small firms, and the industry may consist of a monopoly or a
few large firms.
▻ Production may be imperfectly competitive in the sense that excess or
monopoly profits are captured by large firms.
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 Two types of economies of scale

Economies of scale could mean either that larger firms or that a

larger industry (e.g., one made of more firms) is more efficient.
▰ External economies of scale: occur when cost per unit of
output depends on the size of the industry
▰ Internal economies of scale: occur when cost per unit of
output depends on the size of a firm

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 Two types of economies of scale

▰ External economies of scale: may result if a larger industry

allows for more efficient provision of services or equipment to
firms in the industry
▻ Many small firms that are competitive may comprise a large industry
and benefit from services or equipment efficiently provided to the
large group of firms
▰ Internal economies of scale: result when large firms have a
cost advantage over small firms, which lead to an imperfectly
competitive market.
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 Economies of scale

Through its impact on the economies of scale, trade can

increase the variety of goods available to consumers and
decrease the average cost of those goods.
Without trade, nations might not be able to those products where
economies of scale are important
With trade, markets are large enough to support the production
necessary to achieve economies of scale
So, trade is mutually beneficial because it allows for specialization of
production, the realization of scale economies, and the production of a
greater variety of products at lower prices. 11
 Economies of scale

In those industries when output required to attain economies of

scale represents a significant proportion of total world demand,
the global market may only be able to support a small number of
enterprises.
First-mover advantage – the economic and strategic advantages that
accrue to early entrants into an industry
economies of scale
First movers can gain a scale-based cost advantage that later entrants
find difficult to match. 12
 What are the implications of New trade theory for
nations?

Nations may benefit from trade even when they do not differ in
resource endowments or technology
A country may dominate in the export of a good simply
because it was lucky enough to have one or more firms among the
first to produce that good
Governments should consider strategic trade policies that
nurture and protect firms and industries
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 Summary of Economies of scale (Paul Krugman)

1. Trade need not to be the result of comparative advantage.

Instead, it can result from increasing returns or economies of
scale, that is, from a tendency of unit costs to be lower with
larger output.
Economies of scale give countries an incentive to specialize and
trade even in the absence of differences in resources or technology
between countries
Economies of scale can be internal (depending on the size of the
firm) or external (depending on the size of industry) 14
 Summary of Economies of scale (Paul Krugman)

2. Economies of scale can lead to a breakdown of perfect

competition, unless they take the form of external
economies, which occur at the level of the industry instead
of the firm.

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 Summary of Economies of scale (Paul Krugman)

3. External economies give an important role to history and

accident in determining the pattern of international trade
When external economies are important, a country starting
with a large advantage may retain that advantage even if another
country could potentially produce the same goods more cheaply.
When external economies are important, countries can
conceivably lose from trade
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 Trade and the environment

▰ Environment regulation can lead to a policy tradeoff

▻ Increased costs can reduce comparative advantage of regulated industry
▻ Public receives health and environmental benefits
▰ Concerns that polluting industries would move to poor countries
with less regulation
▻ But studies indicate that environmental rules have a small role in
investment location decisions
▰ Polluter-pays principle: incentive to find ways to reduce pollution
at least cost 17
Intra-industry trade

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 Intra-industry trade

Type of trade Phrase Meaning Source

Inter-industry Either/or Either imports or exports in a Comparative
given sector of the economy advantage
Horizontal Both/and/ Both imports and exports in a Product
intra-industry same given sector of the economy at differentiation
the same stage of processing
Vertical Both/and/ Both imports and exports in a Fragmentation
intra-industry different given sector of the economy at (comparative
diferrent stages of processing advantage in some
instances
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 Intra-industry trade

Intra-industry trade refers to the exchange of similar products

belonging to the same industry. The term is usually applied to
international trade where the same types of goods or services are both
imported and exported.

Intra-industry trade constitutes a large proportion of international

trade. One way to capture the degree of intra-industry trade is to
measure to what extent export and import in the industry overlap.
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 Intra-industry trade

▰  

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 Intra-industry trade

Global patterns of Intra-industry trade

▰ Approximately one-third of world trade takes place as intra-industry trade
▰ Especially prominent in manufactured goods among the developed or
high-income countries of the world
▻ Probably accounts for up to 70% of trade
▰ Globally, intra-industry trade is becoming more important overtime,
particularly in Asia
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 Intra-industry trade

Global patterns of Intra-industry trade

▰ The increasing extent of intra-industry trade in world trading system has
some important implications for the adjustment of economies to
increasing trade
▰ Increase in inter-industry trade based on absolute or comparative
advantage involve import sectors contracting and export sectors
expanding
▻ Requires that productive resource, most notably workers, shift from contracting to
expanding sectors in order to avoid unemployment
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▻ Not always an easy process – often gives rise to calls for protection
 Intra-industry trade

Paul Krugman argues that economies specialize to take

advantage of increasing returns, not following differences
in regional endowments

In particular, trade allows countries to specialize in a

limited variety of production and thus reap the
advantages of increasing returns but without reducing the
variety of goods available for consumption
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 Inter-industry and Intra-industry trade (Paul Krugman)

1. Gains from inter-industry trade reflect comparative

advantage
2. Gains from intra-industry trade reflect economies of
scale (lower costs) and wider consumption choice
3. The monopolistic competition model does not predict
in which country firms locate, but a comparative
advantage in producing the differentiated good will
likely cause a country to export more of that good
than it imports. 25
 Inter-industry and Intra-industry trade (Paul Krugman)

4. The relative importance of intra-industry trade depend

on how similar countries are.
▻ Countries with similar relative amounts of factors of
production are predicted to have intra-industry trade
▻ Countries with different relative amounts of factors of
production are predicted to have inter-industry trade
5. Unlike inter-industry trade in the HO model, income
distribution effects are not predicted to occur with
intra-industry trade. 26
The Gravity model

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The theoretical foundations of gravity models:
Newton’s Law

▰ Econometric model (ex-post analysis)

▰ Initially, NO theoretical foundations.
▰ Distance and Size determine bilateral trade

Distance Country A

Country B
The theoretical foundations of gravity models:
Newton’s Law

▰  
Estimated gravity equation: Newton’s
Law-based Normal Trade

▰ Normal trade

ln (Tradeij) = C + a ln(GDPi) + b ln(GDPj) + c ln(distanceij) + uij

“Augmenting” the gravity equations

▰ Income per capita (higher income countries

trade more)
▰ Adjacency
▰ Common language, colonial links
▰ Institutions, infrastructures, labour flows,...
▰ Trade policy measures
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Overlapping demands (Linder theory)

Review H-O model

▰ Each country export the commodity which uses its abundant
factor intensively
▰ This model suggests that the patterns of trade is largely a
supply side phenomenon
▰ Prediction: Trade between developed countries and developing
countries due to the difference in factor endowment
▰ Observation: a large volume of trade exists between the
developed countries, which have similar factor endowments 34
 Overlapping demands (Linder theory)

Staffan Linder (1961)

▰ Linder agreed that trade in primary products (natural resources) and
agricultural products is determined by factor endowments, but not
manufactured goods.
▰ Linder’s hypothesis, referred to as overlapping demand hypothesis or the
preference similarity hypothesis (demand-side oriented)
▰ Countries generally produce goods for the domestic market and then
export the surplus. Therefore, the countries that have an interest in
acquiring this surplus would have demand patterns similar to those of the
exporting country 35
 Overlapping demands (Linder theory)

Linder’s assertions:
1. Manufactured good is created by an innovative entrepreneur in
response to a perceived demand. The potential demand, rather
than factor endowments that trigger production
2. An entrepreneur is most familiar with the Home market. Hard to
perceive what kind of new products will be successfully
introduced into Foreign market (cultural difference, language
difference, geographically distance)
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Overlapping demands (Linder theory)

Linder’s assertions:
3. For a manufactured product that potentially exported from a
country, which has a Home demand for it. It will export to a country
with a very similar demand patter to the home country. Thus, the
production of a range of manufactured goods is determined by
domestic demand as much as by production considerations such as
factor endowments.
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Overlapping demands (Linder theory)

Linder’s assertions:
4. The countries with the most similar demand patterns for
manufactured goods will tend to be those with similar per capita
income
Low K income → tend to buy + simple products
High K income → tend to buy + sophisticated devices
US and Canada
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 Overlapping demands (Linder theory)

Conclusion
▰ (Trade pattern) Predictions about with specific products each country
might export are difficult to make, because such exports depend on the
history of entrepreneurial activity in each market.
▰ However, international patterns of income and demand determine the
extent of trade in manufactured goods. In particular, it is possible to export
goods for which there is a strong demand.
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 Product life cycle industry

▰ The product life-cycle theory – as products mature both

the location of sales and the optimal production location
will change affecting the flow and direction of trade
▻ Proposed by Ray Vernon in the mid-1960s
▻ At this time, most of the world’s new products were
developed by U.S. firms and sold first in the U.S.

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 Product life cycle industry
New product stage
- High production costs
- Invented by wealthy countries
- Consumed within the invented
countries
Absolute advantage in
production and consumption
belongs to the inventing
country (USA)
Maturing product stage
- Low production costs
- Using standardized technology
- Widely produced and
consumed (in Europe and
Japan) (The production
technology was imitated)
Comparative advantage of the
product belongs to the countries
that imitate the production
technology
Standardized product stage
- The production process is
divided into many different
stages
- Low production costs
(abundant labor inputs with low
costs)
Comparative advantage belongs
to developing countries
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 Product life cycle industry

Inventing country

t1 t2 t3
t0 t4

Developed country
Least developed country

New product stage Maturing product stage Standardized product stage 42

Product life cycle industry

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Product life-cycle theory

▰ Early in the life cycle of a typical new product, while

demand is starting to growth in the U.S., demand in
other advanced countries is limited to high-income
groups, and so it is not worthwhile for firms in those
countries o start producing new product, but it does
necessitate some exports from the U.S. to those
countries
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Product life-cycle theory

▰ Overtime, demand for the new products starts to grow in other

advanced countries, making it worthwhile for foreign producers
to begin producing for their home markets
▰ U.S. firms might also set up production facilities in those
advanced countries where demand is growing limiting the
exports from the U.S.
▰ As the market in the U.S. and other advanced nations matures,
the product becomes more standardized, and price becomes
the main competitive weapon 45
Product life-cycle theory

▰ Producers based in advanced countries where labor costs are

lower than the U.S. might now be able to export to the U.S.
▰ If cost pressure becomes intense, developing countries begin
to acquire a production advantage over advanced countries
▰ The U.S. switches from being an exporter of the product to an
importer of the product as production becomes more
concentrated in lower-cost foreign locations
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Evaluating the Product life-cycle theory

▰ While the product life-cycle theory accurately explains what

has happened for products like photocopies and a number of
other high technology products developed in the U.S. in the
1960s and 1970s, the increasing globalization and integration
of the world economy has made this theory less valid in
today’s world.

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