Intra-Industry International Trade Term Paper

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Trade Theory

Intra-Industry International Trade

Standard trade theory and its deviations

The classical theory of international trade can be traced back to the founding father of capitalism Adam Smith: Smith's 1776 Wealth of Nations theorized that free trade would be beneficial to all nations. Smith stated that much like merchants, nations should specialize in the particular goods and services which they could produce most efficiently and trade with other nations who could produce alternate goods and services equally efficiently. Thus free trade resulted in advantages for both trading parties. Smith's theory was later fleshed out by David Ricardo in his Principles of Economics. Riccardo stated that free trade could optimize efficiency for every country on a global level by reducing the inefficiencies generated by the excess resources involved in producing the goods and services the nation was not suited to produce (Sen 2010: 2).

This common wisdom remained relatively consistent for many years: the concept that trade was mutually beneficial for nations at the macro level and consumers at the micro level. What became known as the Heckscher-Ohlin Samuelson (HOS) model of free trade doctrine "modified that Ricardian comparative cost doctrine to an endowment-based explanation for nations having similar access to technology" (Sen 2010: 4). In short all access to resources being relatively equal (such as technology) results in advantageous free trade in which the goods and services one nation can produce cheaply get exchanged with those of another nation in a mutually advantageous relationship; however, in the real world, things do not always proceed so smoothly. Politics and other influences disturb the neat equilibrium that supposedly should manifest itself according to the pure concepts of free trade theory.

Economies of scale

The assumptions of once commonly-accepted theories of free trade have been challenged by a number of theories. One common criticism is that HOS assumptions focus primarily upon how economies of scale and comparative advantages create value. The concept of comparative advantages, simply put, is that it 'makes sense' for a nation like Jamaica to specialize in producing coffee, which it can do at a lower price while it makes sense for Canada to import coffee and to export products it produces in abundance such as maple syrup (Heakal 2013). However, economies of scale are another important factor in creating comparative advantages. This means that high-level producers in the developed world are in a better position to control market prices, not just market share, because of the imperfect competition that results from their first-mover advantage and greater access to resources (Sen 20010: 6).

Larger entities, regardless of the natural resources present within the nation, generate comparative advantages simply by being large. Simply being part of a developed world nation can create a comparative advantage which is "disruptive to the predictive power, as well as the major theorems, of the traditional HOS model" (Sen 2010: 8). Just as larger firms domestically have an advantage over smaller firms, this is also true internationally of small and large nations. Returns to scale on a national level can be generated via lower input costs and taking advantage of volume discounts in bulk; spreading the cost of inputs over production units; using technology and access to specialized labor and knowledge to increase efficiency and also the development of support industries (Heakal 2013).

Comparative advantages alone cannot explain why certain nations thrive in an environment of free trade while others do not. Furthermore, there is argument that similarity amongst nations and cultures likewise generates a freer flow of trade. As the "range of goods that are typically demanded at the respective per capita income, determine… [so does] the feasibility of trade across nations. To produce and trade, representative demand in the respective countries needs to have an overlapping zone in terms of the range of goods that are produced and consumed in common," thus questioning the specialization emphasis and the theory of comparative advantages (Sen 2010: 6). In other words, the reason that industrialized nations trade with one another, despite having similar types of economies which would seem to cancel out some comparative advantages for certain goods in services, is generated by feasibility and the convergence of shared economic, political, and cultural factors which generate similar goods and services and encourage a free flow of trade.

Monopolistic competition and the gravity model of trade

In contrast to HOS assumptions, the gravity model of trade is based upon a kind of economic formula of 'gravity' similar to that of Newtonian theories of gravity. Rather than comparative advantage, factors such as national distance from one another; common languages; colonial links; common currency; institutions; and migration that facilitates trade (Gravity model, 2008: 6). The idea of the gravity model can even be seen in the architecture of the European Union, which attempted to create free trade between all members by doing away with such barriers as tariffs that impeded the flow of goods and services across national borders. According to the gravity model, "bilateral trade between any two countries is positively related to their size and negatively related to the trade cost between them" trade (Gravity model, 2008: 6). Thus, France and Germany may both produce cheese, but this does not mean they will not trade with one another: rather, proximity and shared culture and heritage generate a mutual interest in one another's similar products and encourage trade.

One of the problems of theorizing this 'gravitational' is the creation of monopolistic competition amongst national trading blocks: because of shared resources and other commonalities, nations develop de facto or in some instances actual exclusive trading relationships with one another. This tends to reinforce the ability of the 'haves' of the global trading environment to dominate the 'have-nots' in a continuance of old patterns, even if certain developing world economies may have natural advantages to produce certain goods and services in excess of developed world nations. So-called free trade does not necessarily result in optimal efficiency.

This gravitational pull may be reinforced by current trade agreements. According to Sen (2010): "despite the goals initially set up in the Uruguay rounds of trade talks to bring in efficiency gains by eliminating trade barriers across nations, the rich industrialized nations have managed to rely on various nontariff barriers. These include the various subsidies on agriculture, industrial, and innovative activities in the home countries" (Sen 2010:17). Trade agreements such as NAFTA made in the supposed spirit of free trade often actually result in shutting developing world nations out of current advantageous relationships between major powers.

Global oligopoly (Strategic Trade Policy)

Given the recognition of apparent 'irrationalities' in terms of trading patterns regarding natural resources, the concept of strategic trade or global oligopoly began to gain currency. "It was generally recognized that the 'vagaries of history' rather than resources determine what a country produces and exports. Thus the role of 'history and accident' was both considered crucial in determining the location of an industry in the world map" (Sen 2010:9). The persistent tendency of former colonial powers to trade with colonies likewise underlines this influence of politics upon trade policies.

Of course, it could be argued that while strategic trade policy is not rational from an economic perspective in terms of generating comparative advantages, from a political perspective it often seems rational. Nations may withhold trading from other nations to gain leveraging power to secure more profitable trading relationships, for example. Or they may begin a 'trade war' in the hopes of gaining eventual leverage to break down walls of tariffs or other barriers to free trade with another nation. Policies may be enacted such as "Canada's first trade adjustment assistance program, the Canadian-American Automotive Agreement" which "provided loans to automobile parts manufacturers almost exclusively to help expand exports rather than to compensate for injury" and later provided "private loans, direct government loans, and consulting grants to develop adjustment proposals" to shore up the industry (Carlton & Perloff 2010). Although technically designed to 'help' workers, this Canadian policy was perceived by many as a kind of subsidy.

Many nations subsidize industries threatened by free trade as well as have outright taxes and tariffs on imports: this may discourage free trade in the short run on a global level but may be politically and strategically advantageous either on a domestic level for the ruling government or depending upon the international negotiations the nation is attempting to secure. Consumers may suffer but because of the popularity of protectionism or the power of the industries demanding such shelter, these measures may be perceived as political necessities.

Agglomeration Economies (External Economies of Scale)

Yet another reason that economic irrationalities may arise in regards to free trade and a non-optimal use of resources is that of agglomeration economics or the benefits of concentrating economic activities in particular areas (particularly developed world nations). These include existing infrastructure, supply channels, and a pool of workers that have the necessary skill set to function optimally in the industry. "Due to agglomeration economies, people and firms often concentrate in particular areas. For example,…

Sources Used in Document:


Agglomeration economies. (2013). Economics Help. Retrieved from:

Carlton & Perloff. (2010). Strategic trade. Modern Industrial Organization (4th ed). Pearson.

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