While the idea of comparative advantage is the foundation of our understanding of gains from trade and its potential income distribution effects, there is a problem.
The problem is that it is exceedingly difficult to measure a country’s comparative advantage. This problem is further compounded by the fact that there are many potential products an economy might export that use the same comparative
advantage and there is no way to determine which specific products will dominate.
Furthermore, and perhaps most seriously, a large share of international trade is not based on comparative advantage. The comparative advantage and factor endowment models do not paint a detailed picture of economic life but create a simplified model of the economy focusing on key economic relations in the area of trade. They ignore exceptional cases, which become more important over time. Intra-industry trade is a case to ponder over.
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Intra-industry trade means trade within the same industry, e.g., steel-for-steel. Intra-industry trade theory explains the reasons why countries often export the same goods they import, and to explain how they benefit from this type of trade. Intra-industry trade among the industrialised countries is very common.
This is due to acquired advantage over natural advantage. This reflects a country-similarity theory, which is linked into the process of intra-industry trade. According to an estimate, the US intra- industry trade is more than 50% of total merchandise trade (excluding services and food). World trade comprises of 40% intra-industry trade.
A basic question to be clarified here is the meaning of industry. If the definition is broader like a personal computer defined as office machinery, then pencil sharpener will also come in the same industry. Broader the definition, more trade appears to be intra-industry.
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More detailed the definition then less trade is intra-industry. Evidence suggests that intra-industry trade is greater in high-tech industries where the rapid generation of new products leads to greater degree of product differentiation, and is greater in countries with few barriers. Such trade also grows in importance as a nation’s income rises.
Intra-industry theory is based upon the premise of economies of scale or decreasing costs. Economies of scale can be either internal or external economies. The advantage of internal economies goes only to the larger firms, whereas of external economies the size or scale effects are located in the industry and not the firm. Internal economies lead to monopolistic competition.
With the entry of new firms competition heightens leading to decline in price. When more firms divide the market, each firm on an average sells fewer units of output, and therefore, costs rise. The presence of internal economies is the reason why firms want to enter export markets.
Intra-industry trade provides two advantages: (a) Increase in market size leads to lower costs, and (b) competition forces firms to pass their lower cost benefit to consumers. The prices of both exports and imports decline as a result of increased output under conditions of internal economies. International trade enables these firms to produce at a higher level of efficiency and that raises everyone’s income through the reduction in prices. Also it increases consumer choices.
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An analysis of trade between Canada and the US in the year 1999 substantiates this theory. In terms of value, an overwhelming share of top seven exports and imports of the US and Canada are car related.