Intra-Industry Trade

Types of Intra-Industry Trade

The two types of intra-industry trade are:

• horizontally differentiated trade
• vertically differentiated trade

Let's look into the types of intra-industry trade. The first type is horizontal trade where two similar goods are of the same standard and price range.¹ Horizontal intra-industry trade allows the consumer to have a wider variety of goods to choose from. For example, the US produces many types of fruit from oranges and limes to peaches and grapes, but it imports mangoes, bananas, and avocados. Although some might prefer one fruit over the other, they are generally considered to be in the same standard category and are priced similarly depending on the season. When nations engage in horizontal intra-industry trade the quality of the goods as well as their price range is going to be very similar.

The second type of intra-industry trade is vertically differentiated trade where the goods are of the same type but are of different quality and/or price levels.¹ An example of vertically differentiated intra-industry trade would be Italy producing and exporting expensive high fashion clothing while importing fast fashion that was manufactured in China. The goods that are being imported and exported belong to the same clothing industry but they are of varying quality and price.

Intra-Industry Trade Benefits

Intra-industry trade benefits both the nations that engage in it and the industry that is experiencing it.

Nations engage in intra-industry trade for two main benefits:

1. Fosters product development, innovation, and skill development
2. Economies of scale

Intra-industry trade encourages competition between manufacturers of the same good. This competition pushes them to develop new product features and improve existing ones to constantly try and gain an edge over their competitors.

Intra-industry trade encourages specialization to where countries can produce the part of the good they are best at and not the whole product. It is increasingly rare to find a good that is exclusively manufactured in one country thanks to intra-industry trade and countries allowing for specialization. When countries specialize they lower their costs and improve their efficiency by splitting up each step of the manufacturing process. This allows workers and factories to focus on specific aspects of production rather than the whole, start-to-finish manufacturing. This allows factories to produce more output, and bring in more revenue.

Intra-Industry Trade Benefits: Economies of Scale

A benefit to intra-industry trade is it allows for economies of scale. Economies of scale is a concept that theorizes that as output rises, the average cost to produce each unit of output will decrease up to a certain point. A firm or country wants to produce as much output as possible until the point where the average production cost will start rising with each additional unit. But what does this have to do with intra-industry trade?

Intra-industry trade allows for economies of scale. The larger a company grows, the more output it produces. This increased output decreases the per unit cost of each unit manufactured. In theory, the larger a company can grow, the more efficient they become, and the more it can produce. With this concept, it would be most efficient for one giant company to produce all the goods in a particular industry. In real life, that would become rather monotonous for the consumer, and innovation would be lacking since there is no competition.

This is where intra-industry trade saves the day. It allows large, efficient companies to exist while providing the industry with competition from other nations and maintaining a diverse selection of goods for the consumer to choose from.

Fig. 1 - Economies of Scale

Looking at Figure 1, smaller firms will find themselves in the economies of scale portion and as they grow will move along the long run average cost (LRAC) curve, to the right and enter constant returns to scale, where each extra unit of output creates little to no extra cost. However, a firm does not want to become so large that they enter into diseconomies of scale, where each additional unit of output begins costing them more.

Intra-Industry Trade Index Formula

The formula for the intra-industry trade index is:

\[\hbox{Intra-Industry Trade Index}=1-\frac{|X_i-M_i|}{X_i+M_i} \]

Where:

X represents the nation's exports.

M represents the nation's imports.

i is the good in question.

The intra-industry trade index formula was developed by Herb Grubel and Peter Lloyd in 1975, as a way to calculate the level of intra-industry trade of a given product.² To calculate the intra-industry index, also known as the Grubel-Lloyd Index, we need to know the quantity of the good imported and the quantity exported.

Let's have a look at Table 1, below. We will use the values provided there to calculate the intra-industry trade index for each good.

If we take the values for pounds of fish exported and imported and insert them into the formula from above, we arrive at an intra-industry trade index of 0.815.

\(\hbox{Intra-Industry Trade Index}=1-\frac{|356-245|}{356+245}\)

\(\hbox{Intra-Industry Trade Index}=1-\frac{|111|}{601}\)

\(\hbox{Intra-Industry Trade Index}=1-0.185\)

\(\hbox{Intra-Industry Trade Index}=0.815\)

But what does this mean? The value of the index will always be between zero and one. If the index is zero, it indicates that there is no intra-industry trade occurring and the country solely imports the good or exports the good. If the index is one, then only intra-industry trade is occurring, and the country is exporting the same amount of the good as it is importing.

Table 2 provides the intra-industry trade indexes as calculated using the same formula for all the goods as we did for fish.

Intra-Industry Trade Examples

Some intra-industry trade examples are:

• flights on domestic and international airlines
• electronics trade between the US and China
• trade between Italian and US designer brands

Looking at some intra-industry trade examples, we can see that they come in many varieties. Starting with some examples of horizontal intra-industry trade, let's examine the airline industry since trade is not limited to goods. Flights on airlines are considered services that travelers buy to get from one place to another quickly. Countries usually have at least one airline that they associate with, but they operate those flights all over the world. Most regional flights are operated by domestic airlines, but for international flights, a domestic airline will sell a ticket but have the actual flight be operated by a foreign airline. Also, airlines both bring travelers into the country and out of the country. For the airlines, it simply depends on what is most economical.

Another example of horizontal intra-industry trade is the import and export of electronics between the US and China. In 2017, the US imported $205,606 million worth of electronics from China while also exporting $14,963 million worth back to China.³

Lastly, an example of vertically differentiated trade would be the trade between Italian designer brands like Armani, whose suits retail for upwards of $3,000, and the US brand Tommy Hilfiger. Both clothing brands are popular in both the US and Italy, but one is clearly more affordable and the other is known for its high quality.