International Economics
Eighth Edition
Chapter 5
Beyond Comparative Advantage
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Learning Objectives (1 of 2)
5.1 Give examples of interindustry and intraindustry trade.
5.2 Compare and contrast internal and external economies of
scale.
5.3 Analyze the effects of international trade in a
monopolistically competitive industry.
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Learning Objectives (2 of 2)
5.4 Describe the gains from intraindustry trade.
5.5 Explain how transportation costs and internal economies of
scale help determine firm location decisions.
5.6 Present the pros and cons of industrial policies.
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Introduction: More Reasons to Trade
• The theory of comparative advantage is one of the
foundations of trade theory.
– Nevertheless, it has a mixed record at explaining trade
patterns.
– It is difficult to measure precisely.
• A large proportion of world trade is not well described by
comparative advantage alone.
– Most countries export the same or similar goods as the
ones they import.
– Example: Auto trade between Canada, the United States,
and Mexico.
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Intraindustry Trade (1 of 8)
• Definitions:
– Intraindustry trade: Exports and imports of the same
products.
▪ The U.S. exports aircraft to the European Union and
imports aircraft from them as well.
– Interindustry trade: Exports and imports of different
products.
▪ China exports cell phones to the Latin America, imports
copper and oil.
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Intraindustry Trade (2 of 8)
• Intraindustry trade is common between high income,
advanced economies.
• The measured importance of intraindustry trade varies,
depending on how broadly we define an industry.
– For example, if we define an industry as “office
machinery,” then computers and pencil sharpeners are in
the same industry.
– The broader the definition of “industry,” the more trade
appears to be intraindustry.
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Intraindustry Trade (3 of 8)
• Intraindustry trade is greater:
– Where there is more scope for product differentiation.
Example: A country may import sports cars, export trucks.
– In high technology industries.
– In countries with larger amounts of foreign investment.
– In countries more open to trade.
• Intraindustry trade is encouraged when there are internal
economies of scale in production.
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Intraindustry Trade (4 of 8)
• Economists have extended trade theory beyond the Ricardian
and HO models to account for the growth and importance of
intraindustry trade.
• New Trade Theory
– Not so new anymore: developed in the 1970s and 1980s.
– Models of trade based on economies of scale, both
internal and external.
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Intraindustry Trade (5 of 8)
• Internal economies of scale: As a firm increases in size, its
average cost of production falls.
– Examples: Autos, jet aircraft.
– The most efficient firms are large.
– Markets are not perfectly competitive.
• External economies of scale: As an industry grows in size, the
average cost of production falls for individual firms.
– Examples: Software, music, craft beer.
– Firms do not have an incentive to get large.
– Markets often remain perfectly competitive.
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Intraindustry Trade (6 of 8)
• Intraindustry trade often involves firms with internal economies of
scale (EOS).
– We call it internal EOS because the scale economies depend on
the size of the individual firm. As it grows, average cost falls.
• Several types of market structures are possible:
– Oligopoly: A small number of firms, each formulates a strategy
based on what it thinks the other will do.
– Monopolistic competition: Firms have brands that give them a
monopoly, but they compete against other firms with different
brands making close substitutes. Monopolistic competition
relies on product differentiation.
– Monopoly: One firm.
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Intraindustry Trade (7 of 8)
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Intraindustry Trade (8 of 8)
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The Gains from Intraindustry Trade
• Lower costs and prices.
– A larger market means:
▪ More economies of scale and lower average costs
▪ More competition and lower prices.
• An increase in consumer choices. There is more variety in the
market.
• An opportunity for domestic firms to expand. The market is
larger and well-run firms will increase output.
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Case Study: Intraindustry Trade
Between the U.S. and Canada, 2019
Top 5 U.S. Exports Dollars Top 5 U.S. Imports Dollars
(Billions) (Billions)
Vehicle parts, not engines 21.1 Crude oil 62.7
Busses, trucks, other vehicles 18.5 Passenger cars 37.1
Passenger cars 13.3 Vehicle parts, not engines 11.6
Crude oil 10.1 Other petroleum products 7.6
Industrial machines 9.7 Other industrial supplies 6.1
• Vehicles and vehicle parts are the largest traded items.
• Intraindustry trade is extremely important.
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Transportation Costs and Internal
Economies of Scale
• Firms in general want to locate near their markets to reduce
transportation costs.
– But if they have internal EOS they cannot build a plant in
every market because they would have too many small
firms.
– Solution: Locate near the largest market.
• This helps explain why most foreign investment is directed to
high income countries.
– High income markets have larger markets.
• Avoiding high transportation costs also help explain why firms
may locate where they incur higher labor or other costs.
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Case Study: Mexico’s Changing
Economic Geography
• From the 1930s until the 1980s, Mexico focused its manufacturing
on producing for its national market.
– Mexico City grew dramatically: Internal EOS and transportation
costs partially explain its growth.
– Similar policies in other parts of Latin America, with similar
results: Giant mega-cities.
• In the 1960s, Mexico created an export processing zone (EPZ)
policy.
– Plants are called maquiladoras.
– They can locate anywhere in the country; they can import inputs
and pay no tariffs as long as they export the output.
– The market is the U.S.: Plants choose to locate in the border
region and border manufacturing takes off in the 1980s.
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Trade and External Economies of Scale
(1 of 3)
• External EOS:
– The scale economies are external to the firm, but internal
to the industry.
– No incentive for a firm to get large.
– But average costs fall as the number of firms increases.
• Three drivers of external EOS:
– Pooling of labor markets for specialized skills.
– Pooling of input markets for specialized inputs.
– Knowledge spillovers between firms.
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Trade and External Economies of Scale
(2 of 3)
• External EOS leads to geographical concentration.
– There are self-reinforcing feedbacks from attracting
specialized labor and input supplier
– Nashville (music); Silicon Valley (software, computer
hardware); Hollywood (movies), etc.
• Historical accident may play a role: circumstances cause a
group of firms to locate in one area, they attract more firms,
etc.
• Learning curves also may play a role: Whoever learns first
keeps that advantage by staying one step ahead.
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Trade and External Economies of Scale
(3 of 3)
• Every trade model looked at so far shows gains from trade.
Trade with external EOS may in some cases create losses.
• Suppose the U.S. gains skill and experience in making widgets.
Suppose also that other countries could do it better, but only
after some years accumulating skills and learning.
– Trade lets the U.S. sell its lower price widgets to foreigners.
– Foreigners are not able to develop their industry because
the low price of U.S. widgets makes foreign widgets
unprofitable until they accumulate some years of
experience.
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Industrial Policies (1 of 9)
• Industrial policies are used by governments that want to
support the development of a particular industry.
– It may be a new industry or an existing one.
• Most countries use industrial policies, either overtly or
covertly, sometimes extensively and sometimes rarely.
– Examples in the U.S.: Support for the development of clean
energy, new generations of motor vehicles, health care
technologies and procedures, etc.
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Industrial Policies (2 of 9)
• The rationale for industrial policies (IP) is based on the fact
that markets sometimes do not provide an optimal quantity
of a good or service.
– For example, when there is a divergence between private
returns (the benefit to the individual) and social returns
(the benefit to society as a whole).
– Or, between private costs (the cost to an individual firm)
and social costs (the net cost to society).
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Industrial Policies (3 of 9)
• If some of the costs or benefits are not included in the market
transaction, there is an externality.
– Externalities are known as market failures.
– Examples: Vaccinations (private and social benefits differ);
pollution (private and social costs differ).
• Basic rules:
– When social returns are greater than private, markets
produce too little at too high a cost.
– When social returns are less than private, markets produce
too much at too low a cost.
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Industrial Policies (4 of 9)
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Industrial Policies (5 of 9)
• Why private and social returns might be different:
– Knowledge spillovers: A new product generates benefits
for the producer (profits) and for others (the new
knowledge that can be used in other areas). Example:
personal computers.
– Coordination problems: For two products to be
successful, they both have to be created at the same
time. Example: Electric cars and plug-in stations.
– Capital market imperfections: A lack of information by
banks and financial firms keeps financing out of the
hands of people with profitable ideas.
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Industrial Policies (6 of 9)
• Industrial policy tools.
– Keep foreign products out of the domestic market.
– Provide information about foreign markets.
– Tax breaks and subsidies—to producers or to consumers
of the product to encourage sales.
– Sell foreign currency at a low rate.
– Loans, loan guarantees, and subsidies.
– Government purchases to encourage production.
– Allow firms to collude to pool resources.
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Industrial Policies (7 of 9)
• Obstacles to industrial policies: WTO rules.
– WTO agreements limit their usage, although most
countries find ways around the limits.
– WTO agreements allow governments to provide a
financial benefit (subsidy) for precompetitive research
and development, but not for commercial products. This
distinction is difficult to make in practice.
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Industrial Policies (8 of 9)
• Obstacles to industrial policies: Practical.
– Measuring market failures is difficult, but necessary to
determine the gap between private and social returns.
– Which industry to target?
– Industrial policies encourage rent seeking. Individuals
and firms spend money to get a benefit rather than
spending to become more productive.
– Opportunities for corruption.
– Downstream firms may be hurt; e.g., an industrial policy
to build a steel industry may result in higher cost steel for
domestic firms.
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Industrial Policies (9 of 9)
• Economists: The “con” side.
– IP cause rent seeking.
– We don’t know which industries to fund, the market may not
be perfect but it is better than a government committee.
– The economic record is very mixed on their success.
• Economists: The “pro” side:
– Information gaps and coordination problems means the
market is sometimes ineffective or takes too long.
– All counties but particularly developing countries can benefit
from a selective boost to key industries.
– Most countries have used these policies throughout their
history, including the U.S. and other proponents of free
markets.
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Case Study: WTO Rules and Industrial
Policies (1 of 2)
• The Uruguay Round of trade negotiations created the WTO
and extended several agreements that affect industrial
policies.
• Trade related investment measures (TRIMS)
– Designed to ensure national treatment for foreign
investments.
– Restricts requirements to use local inputs or to reach
export targets.
• Subsidies and countervailing measures (SCM)
– Parallel to TRIMS.
– No subsidies allowed if they hurt firms in foreign markets.
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Case Study: WTO Rules and Industrial
Policies (2 of 2)
• The Uruguay Round also set requirements for enforcement of
intellectual property rights.
• Trade-Related Aspects of Intellectual Property Rights (TRIPS)
– All countries must enforce intellectual property rights laws.
▪ Patents, copyrights, trademarks, geographical designations,
blueprints, designs.
– Restrictions on reverse engineering.
– Limits on requirements that foreign firms transfer technology.
• All these rules are controversial: Do they limit the ability of
developing countries to support economic development?
• Are they designed to protect the profits of multinational
corporations at the expense of host country citizens?
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