Economies of Scale and Comparative Advantage Jana Štefaňáková & Maroš Ciran

To determine the pattern of international trade we have to think about how economies of scale interact with comparative advantage. imagine a world consisting of Home and Foreign country each country has two factors of production: capital and labor Home – capital abundant country Foreign – labor abundant country there are also two industries: Manufactures (more capital – intensive industry) Food (labor intensive)

Interindustry Trade (manufactures for food) Home (capital abundant) will produce more manufactures (capital intensive) they will export manufactures and import food Foreign country will act contrary (export food and import manufactures) in a world without economies of scale, there would be a simple exchange of manufactures for food

Intraindustry Trade (manufactures for manufactures) suppose that manufactures don´t produce homogenous products (monopolistically competitive industry = firm now produce differentiated products) Home country will still be net exporter of manufactures and importer of food but some Home consumers will prefer Foreign varieties

Four points about this pattern of trade: Interindustry trade reflects comparative advantage (Home, capital abundant country, is a net exporter of capital-intensive manufactures) Intraindustry doesn´t reflect comparative advantage. It is economies of scale that keep each country from producing the full range of products The pattern of intraindustry trade is unpredictable. We don´t know which country produce which goods within the manufacture sector. All we know is that countries produce different products.

Four points about this pattern of trade (cont.) 4. The relative importance of intraindustry and interindustry trade depends how similar countries are (measured by capital-labor ratio). Home and Foreign with similar capital-labor ratio = little interindustry trade and dominant intraindustry trade Home and Foreign with very different capital-labor ratio = no intraindustry, all trade based on interindustry trade

The Significance of Intraindustry Trade About one-fourth of world trade is Intraindustry trade (according to the standard industrial classifications) It plays a particular role in the trade of manufactured goods among advanced industrial countries The major trading industrial countries have become similar in their levels of technology and resources (skilled labor and capital) therefore, there is often no clear comparative advantage within an industry

The Importance of Intraindustry Trade (I) I = 0, if a country is either exporter or importer (not both) in an industry = interindustry trade I = 1, if a country´s exports equal its imports within an industry = intraindustry trade

Industries with high levels of Intraindustry trade tend to be sophisticated manufactured goods (such as chemicals, pharmaceuticals, power-generating equipment) exported by advanced nations Industries with very little Intraindustry trade are usually labor- intensive products (such as footwear and clothing) exported by less developed countries

Why Intraindustry Trade Matters? Intraindustry trade produces extra gains from international trade it allows countries to benefit from larger markets Consumers benefit from increased variety of goods Country can reduce the number of varieties produced and increase its productivity with lower costs it can produce each product at larger scale

When the Intraindustry Trade is most likely to happen? It is most common between countries at a similar level of economic development – similar in their capital-labor ratios, skill levels and so on Gains from Intraindustry trade will be large when economies of scale are strong and products are highly differentiated Example: Establishment of a free trade area in manufactured goods in Western Europe in 1957 (EEC) – the result was a rapid growth of trade (twice as fast as the whole world trade in the 1960s)

Case Study - Intraindustry Trade in Action American Auto Pact of 1964 Before 1964 – a tariff protection on auto industry goods between Canada and U.S. Very self-sufficient industry – neither importing nor exporting a lot Canadian industry controlled by the same firms as the U.S. industry – a miniature version of the U.S. industry small scale production was a big disadvantage for Canadian subsidiaries Labor productivity in the Canadian auto industry about 30% lower than of the U.S.

Case Study - Intraindustry Trade in Action (cont Case Study - Intraindustry Trade in Action (cont.) American Auto Pact of 1964 In 1964 – establishment of a free trade area in automobiles between Canada and U.S. it allowed auto companies to reorganize their production thanks to importing the products no longer made in Canada and exporting the goods Canada continued to make overall level of Canadian production and employment remained the same Both exports and imports increased sharply By the early 1970s – productivity of Canadian industry comparable to the U.S. productivity

Thank you for your attention!