Basis of Inter-

Industry Trade
Dr. Ivy Das Gupta
ivy.dasgupta@thebges.edu.in
Types of International trade
According to the nature of commodities
being exported and imported international
trade can be classified as below:
a) Inter-industry trade (distinctly different
industry groups)
b) Intra-industry trade (same/similar/or
even identical industry group)
Issues and applications for these two types
of trade are totally different.

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Inter-industry trade 3

• Bilateral Trade Between

China and India in 2004

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Arbitrage and Inter-industry trade

• Arbitrage – buying cheap and selling dear

• Arbitrage is the basic force behind any trade or transaction – spatial or
across time
• When arbitrage takes place across national boundaries, it is known as
international trade
• Arbitrage is possible only when price differences exist
• It determines which of the goods produced in an economy are to be
exported and which are to be imported

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Arbitrage and Inter-
industry trade
For example:

Computers are sold at a lower price in the

United States compared to India

Cotton textiles are sold at a lower price in

India compared to the US

This will constitute exports of cotton

textiles and imports of computers by India

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 Of course, the transportation costs matter in
real life

Arbitrage If the cost of transporting the goods is larger

and Inter- than the prevailing price difference, export of
industry the commodities is neither profitable nor
feasible
trade
Another important factor is the prices
prevailing in the countries that potentially may
compete with the country concerned

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 Thus, cross-country price differences net of transport
costs and consequent arbitrage is the only driving
force of international trade as long as the products
produced elsewhere are not differentiated
Arbitrage and
Inter-industry For inter-industry trade in non-differentiated
trade products arbitrage is the key force

For successful arbitrage, there must be cross-country

differences in autarky prices

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Arbitrage and Inter-industry trade

ØPrice differences are actual manifestation of the basis of

trade
ØActual basis is that reason why prices may differ across the
8
countries for the same goods
ØIt may depend on many factors like technology etc.
ØBut it is the relative scarcity or abundance that makes
prices higher or lower in one country than other

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Arbitrage and ØSuppose the relative demand for
computers, d = DC/DT is higher India
Inter-industry than in the US.
ØIndia has a relative demand bias
trade ØNow suppose relative supplies of
computers in both the countries are
same
ØComputers are relatively scarce in
India
ØHigher autarky relative price of
computers in India
Arbitrage and Inter-industry Trade

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 ØThe difference in autarky prices creates scope for
Arbitrage and arbitrage
ØIt determines the pattern of trade
Inter-industry
ØIndia will export cotton textile and import
trade computers from the US
ØThis pattern of trade is feasible as long as the
transport cost does not erode the profits
ØA similar pattern of trade will arise if the relative
demands for computers are same in both the
countries, but the US has a supply bias in
11 computers

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 ØThus, international trade
arises either due to demand
bias in India or supply bias in
the US in computers
Arbitrage
ØA country may have both
demand bias and supply bias
and
in the same commodity
relative to other commodity Inter-
ØMay not lead to any cross-
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country price difference and
hence trade among the
industry
countries12
ØMay not arise any scope for trade
arbitrage
 ØIn general, trade will take place when a
country has either a demand bias or a supply
bias
Arbitrage ØOr has both demand and supply biases but
in different commodities
and Inter-
ØA demand bias in computer makes it
industry relatively dearer and cotton textiles
trade relatively cheaper
ØA supply bias in cotton textiles makes it
cheaper and computer dearer and therefore
reinforces demand bias in computers

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 14

Arbitrage
and Inter- But a country may have demand bias
and supply bias in the same commodity
industry
trade There can be 3 possibilities:

• At any given relative price, a larger supply bias

than the demand bias in the same commodity
• At any given relative price, a larger demand bias
than the supply bias in the same commodity
• At any given relative price both demand bias
and the supply bias are equal
Arbitrage and Inter- • Demand and Supply Biases and the Pattern of trade
industry trade
 Classical and neo-classical trade
theories emphasize on these
fundamental sources of bias
Sources of
Demand
and Supply
Biases Three fundamental sources:
Taste or Factor
Technology
preferences endowments

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Sources of Demand and Supply Biases

ØTaste bias in computers as in case of India (with same technology

of production) leads to price difference
ØSupply bias due to superior technology along with homothetic or
identical tastes leads to price difference ------- Ricardo
ØWith homothetic or identical tastes but difference in the supply of
factor endowments lead to price difference ---------Heckscher-
Ohlin
 Comparative Advantage

3 fundamental sources of
Difference in autarky comparative advantage:
prices essentially reflects • Technology asymmetry
the comparative advantage • Difference in factor endowments
• Demand asymmetry or the taste
bias

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 Favourable technological conditions do not
lead to comparative advantage or lower
relative pre-trade (autarky) price if demand
condition and factor endowment
Comparative conditions are not favourable at all

Advantage Another important element of comparative

advantage is the government of the
country – public policies which can improve
or deteriorate the comparative advantage
of the country under consideration

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 Externalities of public investment in
infrastructure:
Public Policy vPublic investment in infrastructure or social
overhead capital like transport,
and Induced communication, power, irrigation generate
Comparative positive externalities
Advantage: vBetter roads for eg., can lower the transport
cost
Fundamental vPublic investment can offset inferiority of
Sources technology and can establish a comparative
advantage

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Public Policy and Induced Comparative
Advantage: Fundamental Sources

vSimilarly, despite having better technology, a country may suffer from poor
infrastructure
vA typical example is the hardware industry of India
vIndia takes many hardware assemble tasks for its domestic market with
the components coming from East and Southeast Asia
vSeveral East Asian countries gained comparative advantage in such tasks
vDue to absence of high-quality infrastructure India could not achieve the
comparative advantage

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 vSuppose countries have no differences
in their fundamental technology, factor
Public Policy endowments and taste
vDifferences in infrastructure facilities
and Induced can create a supply bias
Comparative vThere might also be an indirect
Advantage: demand effect of infrastructure
development
Fundamental
vInfrastructure development raises
Sources national income
vIf income elasticities are not same, it
may lead to a taste bias
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 Externalities of Public investment in
education and human capital formation:
Public Policy and
• India has a growing comparative advantage in
Induced information technology and software and in
Comparative information technology enabled services (IteS) over
the last two decades
Advantage: • Public investment in setting up IITs together with
Fundamental English being the primary mode of instruction in
the higher education
Sources • It enabled India to enjoy comparative advantage in
export of these services over China, Israel and
many other Asia and European countries

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24

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Public Policy and Unlike hardware industry, poor

Induced infrastructure does not affect the

development of these software industry
as relatively low SOC is required
Comparative
Advantage: Availability of cheap labour also helped

Fundamental
Sources Sources of comparative advantage of
India is shown in the next table
Public Policy and Induced Comparative Advantage: Fundamental Sources

• Sources of Comparative Advantage in Software

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Regulation of such market particularly that generates negative
externalities
vSuppose home country produces iron and steel; and cotton
vIron and steel being the industrial activity degrades environment
by producing industrial ashes which is deposited in the soil and
erodes the fertility of soil
vCotton yield per unit of land declines

Public Policy and Induced

Comparative Advantage
Public Policy and Induced Comparative
Advantage

vIndustrial activity makes the marginal cost of agricultural production higher

which includes marginal social costs
vSoil erosion can be controlled by a cleaner technology by recycling the
industrial wastes
vBut it involves a higher costs for industrial activity compared to dirty
technology (though lower costs for agricultural production)

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 Public Policy and Induced
Comparative Advantage
vSuppose India and the United States are similar countries
and thus have no fundamental sources of comparative
advantage
vThus, demand and supply relations in the two countries are
identical
vThe US strictly enforce environmental standards i.e., follows
cleaner technology
vIndia does not enforce any such regulations
vThe pre-trade relative price of iron and steel will be higher
in the Unites States

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Public Policy and Induced
Comparative Advantage

• Environmental Standards and

Comparative Advantage
• The vertical distance between S and S’
measures (relative) pollution abatement
cost incurred in the US to correct negative
externality
• Here a comparative advantage emerges
for India
• Perverse comparative advantage

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 30 Public Policy and Induced Comparative
Advantage
vPerverse comparative advantage

vDifferent from genuine comparative advantage derived from fundamental

sources – either in terms of relative labour productivity or in terms of the
relative availability of a factor that is used intensively in the production of
exportable (strength of an economy)
vPerverse comparative advantage is generated from the weakness of the
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economy
 Perverse comparative advantage is
based on an under-estimation of social
cost

Public Policy This is essentially known as ecological

and Induced dumping
Comparative
Advantage
A comparative advantage in a dirty good
arising due to lax environmental
standards or taxes that allow it to be
priced below the SMC
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Innovations and Shifting

Comparative Advantage
32
vComparative advantage is not a static concept

vIn a dynamic world comparative advantages of nations change rapidly causing rise or fall of
countries as leading exporter of a particular commodity

vDeterminants of comparative advantages may prove unsustainable

vA narrow basis of comparative advantage often makes it easy for global competitors to
circumvent (evade).
33

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Innovations and Michael Porter (1990) was the first to argue
Shifting and exemplify that innovations to offset
selective disadvantages are more likely than

Comparative innovations to exploit strengths

Advantage What may appear to be a weakness in the

short run may become an advantage in the
long run in a dynamic competitive world

The automated production process of Japan

replaced labour and established the
country’s comparative advantage in
electronics
 Michael V Posner (1961) offered a dynamic version of
technology asymmetry as a determinant and basis of trade in
his technology gap theory
Innovating countries can reap monopoly profits and gain
from trade as long as they can maintain their technological
Innovations lead

and Shifting This technology gap theory emphasizes inter-country

differences in technical change as the basis of international
Comparative trade flows

Advantage It is variations across the countries with innovative

capabilities which explain the pattern of trade

Countries with innovative capabilities will specialize in

technology-intensive products

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 35
Revealed Comparative Advantage
vBela Balassa (1965, 1989) formulated the concept of RCA
vIt is not based on a bilateral comparison of pre-trade prices or labour
costs
vIt is based on actual exports and imports of countries
!"#$% &' ()*+# +) ,&,#- +./&$, &' 0&..&*+,123 41 ,"% 5)+,%* !,#,%6
RCAk =
!"#$% &' ()*+# +) ,&,#- +./&$, &' #-- 0&..&*+,%6 41 ,"% 5)+,%6 !,#,%6
If RCAk is greater than 1, India will have a RCA in commodity-k otherwise
the export of commodity k will not reveal any comparative advantage
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RCA is an ex-post estimate

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