Till around 1930s, it was conventional in mainstream economic theory to assume the existence of perfect competition. However, disturbed by the fact that perfect competition was an abstract assumption, attempts were made to replace it with something more realistic.
In mid-1930s, Edward Chamberlin introduced the concepts of “product differentiation” and “monopolistic competition”. In this set up, products do not belong to an industry but to “broad groups”.
They are “close” (but not “perfect”) substitutes of each other; and they are differentiated from each other by means of brand names, trademarks, packing, size, colour, technical specifications, and a host of other things. Their demand schedules, supply schedules, prices and markets are interdependent.
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Currently, it is being claimed that product differentiation is an important cause of international trade; more so because it:
1. Caters to the varied needs, tastes and preferences of buyers,
2. Provides an incentive for research and development and introduction of improved varieties of products,
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3. Increases scope for specialisation and economies of scale,
4. Allows even small countries to export goods for which there is insufficient domestic demand, and
5. Allows emergence of monopolies which are able to dominate the international trade of their respective products.
Product differentiation, supported by several other developments, has contributed to an exponential growth in intra-industry trade in contrast with conventional inter-industry trade.
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Trade data show that developed countries are increasingly specialising in the production of different brands and models of products belonging to similar broad categories like automobiles and computers, etc., and even parts of certain products.
In addition, a large number of new products have been introduced by producers in diverse fields like pharmaceuticals, cosmetics, telecommunications, entertainment, and so on. There has also been an upsurge in financial, consultancy and other services.
The share of earnings from trade and services has grown exponentially in the GDP of several economies. Even in India, services have come to contribute more than half of its GDP.
And so is the case in several other developing countries as well. These and associated developments have led to a tremendous growth in what is termed intra- industry trade as against the conventional inter-industry trade.
The growth of intra-industry trade has also been helped by changes in consumer tastes and preferences. In most countries, increasing incomes in the hands of consumers, increasing strength of demonstration effect, and spread of consumerism have expanded the market for differentiated and new products.
This has also resulted in the surge of demand for particular sub- varieties of products by specific income groups. All these developments have widened the scope for two-way profitable trade in close substitutes. This trend has been further strengthened by growth in:
(a) Volume and diversification of foreign direct investment (FDI),
(b) Expansion in international flow of short term capital funds,
(c) International transmission of technology,
(d) “Outsourcing” of “business processing” [think of the “call centres”], spares, consultancy services, technical know-how and so on.