Intra-Industry Trade: Trade Creation and Trade Diversion - Example

International Trade Demand Contents Intra Industry Trade 3 2.Intra-industry trade: Trade creation and trade diversion 6 3.Optimum Currency Area: The case of Eurozone 14 3.1 Inflation 16 3.2 Unemployment 17 3.3 Labour Migration 17 4.Exchange rate volatility and the Eurozone 19 Reference List 26 1. Intra Industry Trade The concept of intra industry trade has theoretical foundations in the New Trade Theory which has started to gain momentum from the late seventies. Before the advent of this theory the traditional theories of trade assumed that different countries produce different commodities and liberalization of trade helps in production of one specialized commodity. However, proponents of intra industry trade believe that producers in a country can produce multiple varieties of a same product and start exchanging them (Hoen and Oosterhaven, 2006). The fundamental economic rationale behind this is differentiation of products based on the economies of scale. Works of researchers like Greenaway and Milner (1987 cited in Davis, 1995) has shown that economies of scale, product differentiation and divergence in the taste and preferences of consumers are the three basic principles which guide the concept of intra-industry trade. Figure 1: Cost-reduction due to intra-industry trade (Source: Author’s creation) The graph in the above figure shows the effect of trade in a market that is characterized by monopolistic competition. It shows that each of the firms sells products at the same price despite of the fact they are differentiated from one another. The graph shows that in case of intra-industry trade the firms produces a greater variety of goods which in turn helps in the reduction of their per unit average cost of production. The downward shift of the curve from CC1 to CC2 represents the reduction in the overall cost of production. Multiplication of the number of firms and increase in the variety of the goods supply reduces the price of the goods. Proponents of intra-industry trade states that firms becomes a part of a much larger global market where they specialize in the production of any one particular type of a good. Lower costs of production indicate that a mutually beneficial trading relationship can exist between nations as the cost of production falls even if the technology of production and factor endowments are equal. Researchers have argued that the source of external economies of scale in intra-industry trade arises from a number of factors like agglomeration of industries and quick supply of specialized equipments, accumulation of a large pool of human resource and positive knowledge spillover (Freinkman and Polyakov, 2004). The works of researchers like Root (1993 cited in Malmberg and Maskell, 1997) had pointed out that external economies of scale arise when the average cost of production of the industry falls as the level of output expands. Accumulation of knowledge is the main reason which reduces the cost of production over time. Factors related to historic events have been found to be important determinants of economies of scale. These factors are rather accidental as they happen by chance. Firms have often been found to produce under constant returns to scale when external economies of scale exist. Another group of researchers have focused on the role of internal economies of scale in intra-industry trade. Internal economies of scale rather than the external economies have been found to be the major determinant of intra-industry trade. If firms are producing differentiated goods then they can export their products profitably to other countries despite facing competition in the home country. Internal economies of scale arise particularly when per unit cost of production falls with the increase in the firm’s production level. It has been found that presence of internal scale economies creates an imperfect market structure like oligopoly, monopolistic competition or monopoly. Trade opens up the possibility of expansion of production capacity of the firm and the cost of production falls. Firms have been found to be producing under increasing returns to scale when internal economies of scale exist. Figure 2: Internal economies of scale (Source: Author’s creation) The graph in the above figure shows that the long-run cost curve of the firm is U-shaped. It clearly shows that the short-run cost of production keeps on falling up to a certain point as the level of output rise. Improvement in factors like production process, purchasing power of the large firms and financial benefits are provided to only large firms through internal economies of scale. The plethora of empirical evidences shows that the level of intra industry trade is on a rise. There is no denying the fact that the rise of intra-industry trade in the recent times could be largely attributed to the improvement in the coordination of the international value chain. Intra-industry trade has also been supported because it increases the instance of foreign investment in the country. Researchers like Krugman and Helpman (1985) had pointed out that production of variety of a particular product is rather useful because it is quite helpful in capturing the economies of scale and thereby faster economic growth. 2. Intra-industry trade: Trade creation and trade diversion It has been observed that the use of a common currency has actually helped the intra-trade dynamics of Eurozone. According to the research conducted by Baldwin (2006) it was found out that creation of Euro had had provided a boost to the trade of Eurozone about 9%. However, their research had also pointed out imports from non-Eurozone countries received as much boost as the imports from the Eurozone countries indicating that Euro has been a major factor causing trade creation. Trade creation is referred to as a situation when the consumers shift their consumption from a high cost to a low cost producer (Calderon, Chong and Stein, 2007). Similarly trade diversion points to a condition when the consumption of a good shifts from a low-cost producer residing outside the union to that of a high-cost producer inside the union. The governments of these countries have focused on unilateral and preferential liberalization. This has resulted in the removal of domestic trade barriers from the countries and firms have eliminated the use of domestic sourcing as goods can be efficiently imported from other countries. The research of Viner (1950 cited in Bhagwati, Krishna and Panagariya, 1999) had however shown removal of trade barrier from the partner countries may also create a situation of trade diversion as the countries would prefer partner countries for importing goods even if foreign countries have better suppliers. An insightful research regarding trade creation and trade diversion was done in the works of Kandogan (2005) who had found that politics play a major role in the Eurozone. He had found out that smaller trading partners are influenced by trade creation or diversion. The trade agreements in the Eurozone have a smaller impact on the partners who had entered into the agreement at an earlier date. The research argued that similarity in capital-labour ratio is a major determinant of trade diversion. This implies that if the capital labour ratio is high then non-partners will actually be hurt by trade diversion (Kenen and Meade, 2008). Most of the empirical studies indicate that the extent of trade diversion has been quite less in the outside the Eurozone. This implies that non-Eurozone members are not much hurt with the creation of the Eurozone. Secondary data on the trade of the Eurozone reveals that integration of countries was very high even before the Euro was introduced in the area.. The Euro was officially adopted in the year 2002 but the values in the table show that intra-trade among the member countries was high even before they had adopted the same currency (Brakman, Garretsen and Van Marrewijk, 2009). These values show that the level of exports were far lesser than the level of imports in the member countries. These values are from the time the Euro was adopted in the countries. Figure 3: Intra and extra EU27 trade of goods (Source: Paulin, 2014) The figures in the graph indicate that the member countries have largely witnessed trade creation ever since the formation of the Eurozone. All of them have been trading intermediary goods with one another which have greatly raised the level of trade creation between them. The research has used the following formula in order to calculate the IIT of the 15 countries in Eurozone in 2006 and 2010. The following formula has been used in order to calculate the same: IIT=1- (X-M)/(X+M) X means the exports in one industry. M means the imports in one industry. Figure 4: Food IIT 2006 (Source: Eurostat, 2015) Figure 5: Chemicals IIT 2006 (Source: Eurostat, 2015) Figure 6: IIT of Machineries and Vehicles (Source: Eurostat, 2015) Figure 7: IIT of Other manufactured goods (Source: Eurostat, 2015) Figure 8: IIT of food 2010 (Source: Eurostat, 2015) Figure 9: IIT of Chemicals 2010 (Source: Eurostat, 2015) Figure 10: IIT of machineries and vehicles (Source: Eurostat, 2015) Figure 11: IIT of Other manufactured goods 2010 (Source: Eurostat, 2015) The figures above that the chosen countries have a very level of integration between them which in turn has helped them to grow further. The gain to the countries from joining the Monetary Union has been found to be greater than the stability loss incurred by them when they joined it. The figures in this research are quite different from the ones that have been calculated in the work of Paulin (2014). This is because those figures were collected at the time when the countries had joined the Euro area. All of the ratios that have been calculated have shown that member countries are exporting more to the member countries compared to the imports. This is the reason all the ratios have value less than one. However, despite the change in the values there is no denying the fact that the level of integration between the countries have increased after the formation of Euro. This also indicates that trade creation has actually helped Eurozone to become a better optimal currency area and this had occurred before the countries in the region had adopted the Euro. Therefore, it can be argued that the creation of Eurozone has actually enhanced the trade creation between countries. 3. Optimum Currency Area: The case of Eurozone The idea of optimum currency area developed from the works of three researchers namely Mundell (1961), McKinnon (1963) and Kenen (1969 cited Frankel and Rose, 1998). An optimum currency area is one where each region does not have a separate monetary policy. An optimum currency area is characterized by countries which are highly integrated to one another in terms of trade and other economic attributes. In such a region it is beneficial to devise a type of currency that is common to all the regions. There has been an intense debate regarding the fact that whether Eurozone is the optimal currency area or not. The research of Petreski (2007) had concluded that Eurozone is not a perfect optimum currency area because the countries have not been able to achieve desirable results in terms of labour migration and unemployment. Desirable results has however been achieved in case of inflation targeting. A similar sentiment is also reflected in the works of De Grauwe and Mongelli (2005) who has found out that mobility of labour and flexibility of wages are quite low in case of the European countries that improper competition in the single market and non-tariff barriers obstructs the functioning of the OCA. There are a number of characteristics of an open currency area. This study limits itself only to three aspects namely labour migration, inflation and the unemployment rate. It has been observed that high mobility of labour results in most efficient allocation of resources and this helps in the functioning of the OCS. Similarly, a convergence in the rates of inflation suggests that the terms of trade of the countries will also converge thereby enhancing the welfare of the region. In this case the need for adjustment of exchange rates between the regions is also eliminated. The proponents of optimum currency area had also suggested that flexibility in the price and wages between regions helps in reducing the instances of unemployment (Lopez and Papell, 2007). The theory of optimal currency area asserts that it is most appropriate for countries to have a fixed exchange rate regime. The model described by Mundell (1961 cited Dellas and Tavlas, 2009) had pointed out that a cost-benefit analysis exists in case of an optimal currency area. His model had pointed out that joining an optimal currency area can impose certain costs on the country as it loses stability. However, the major benefit of joining the monetary union is that the countries are very highly integrated with one another which improve their overall efficiency growth (Dellas and Tavlas, 2009). It has been observed that a country can prudently eliminate the risks associated with exchange rate volatility once it joins the Monetary Union. Better integration also helps in the removal of stability in the economy. Based on this analysis a country should decide whether it should join the Union or not. The GG-LL schedule has been employed to understand the advantages and disadvantages that are faced by a country when they join the monetary union. The benefits reaped from the level of integration and gains in efficiency from joining a monetary Union are measured by the GG curve. The LL curve on the other hand measures the association between level of integration and loss of stability when a nation decides to join the currency area. Figure 12: Gains and losses of joining the optimal currency area (Source: Paulin, 2014) The area on the left represents that losses from joining the currency area outweighs the gains that can be reaped from joining the area and the area on the right represents that gains from joining the currency area outweighs the losses from joining the area. Based on this logic it can be argued that the intersection of the IIT value of the 15 countries represents the equilibrium value. This implies that if the value of the IIT index of a particular nation is higher than the average level then the nation belongs to the optimal currency area. On the other hand if the value is lesser than average the country does not belong to the optimal currency area. The average value of the IIT index of the four industries for 2006 has been found to be 0.7900 and the same for 2010 is 0.8003. This implies that Germany, France, Netherlands, Belgium, Spain, Hungary, Poland and Czech republic are the nine countries which belongs to the optimal currency area as these countries have an IIT value larger than 0.79. This implies that Finland, Greece, Austria, Portugal, Ireland, Luxemburg and Netherlands are countries which do not belong to the optimal currency area. The value in 2010 was 0.800. However, the same countries have been found to belong to the category of optimal currency area. 3.1 Inflation The graph shows the visual representation of the inflation rates in the countries which are a part of the optimal currency area. The countries which have been included in the study include Germany, France, Spain and Portugal. Figure 13: Comparing inflation rates of Eurozone countries (Source: The World Bank, 2015a) It can be seen from the above graph that there is a consistency in the movement of interest rates in a similar direction. There are a handful of studies in the literature which have focused on the inflation rates of the countries in the Eurozone area. The findings from these studies indicate that ever since the Euro area had embraced the same currency there are increasing instances of convergence of the interest rates. This conforms to the theory that has been propagated by Mundell in the first place. 3.2 Unemployment The Eurozone and the free trade areas have been heavily influenced by the global financial crisis of 2008. The following graph represents the extent of unemployment in Germany, France, Portugal and Spain. Figure 14: Comparing unemployment rates of Eurozone countries (Source: The World Bank, 2015b) The above graph shows that there has been quite a huge difference between the nations in terms of unemployment rates. It can be seen that the fiscal policies in Spain has been unable to fight the high inflation rates while Germany has shown an impressive performance over the years. Secondary research conducted in this regard has revealed that different economies have different rates of adjustment to economic shocks which is the primary reason behind the differences in the unemployment rates. Empirical research in the United Sates and Eurozone has revealed that the former have been much resilient in terms of absorbing the economic shocks which in turn has allowed an impressive convergence of the macroeconomic factors. 3.3 Labour Migration Labour migration has been the most important problem for the regions in the Eurozone. The data on immigration of labour in the countries has shown that the degree of disparity between the countries is very high. Germany has been found to be a country which has shown the highest degree of labour migration as it has been able to maintain a very high degree of employment rates even during the period of recession. The migration scenario of Spain is more difficult as the country has been facing huge emigration due to the persistent rates of high unemployment in the country. Figure 15: Net migration in the European Union (Source: Deutsche Bank Research, 2014) Statistics indicate that 480,000 inhabitants had emigrated Spain from 2010 to 2013 (Deutsche Bank Research, 2014). The migration scenario of Portugal is quite similar to that of Spain. In case of labour migration one of the most pertinent problems are the differences in the culture and lifestyle of the people. It has been found that the migration of labour between the regions of Eurozone has been significantly smaller than that of the inter-regional migration in that of the U.S. One of the most plausible explanations is that the linguistic difference between the regions of the Europe discourages the citizens from visiting the other countries. 4. Exchange rate volatility and the Eurozone The synthesis of the existing literature points out that the main reason behind the volatility of exchange rate is unpredictability of major macroeconomic variables of the country. Exchange rate has been found to be highly volatile in the short-run due to a variety of reasons namely political decisions, regulation of monetary policy and exchange rate and any change in the expectations of the economic agents (Verheyen, 2012). This has hugely contributed to the volatility of exchange rate in the short run. Floating exchange rate has in turn enhanced the level of foreign transactions which also contributes to the volatility. The works of researchers like McKenzie (1999) has pointed out that there is a bilateral relationship between the macroeconomic variables and exchange rate itself as changes in variables like demand and supply, volatility in rates of inflation, variability in service and investment patterns are strong determinants of volatility of exchange rates. Improper functioning of the financial markets have been found to be a major factor which causes the spot exchange rate to vary from its long-term equilibrium value contributing to the overall volatility. One of the most important jobs of the policy makers is to eliminate the volatility of the exchange rate as it is harmful for the overall economy (Baccheta and Wincoop, 2000). The works of researchers like Auboin and Ruta (2011) has shown that that volatility of exchange rate has an overall negative impact on international trade. Their research had confirmed that a number of factors like extent of integration of the country with the world economy, use of hedging instruments by financial institutions and structure of the firms in the economy determine the strength of negative impact of exchange rate volatility on trade. The literature review on the topic as a whole however reveals a mixed picture. The work of Brollet, et al. (2006 cited in Zakaria, 2013) explores the impact of exchange rate volatility on international trade and comments that the overall effect can be negative, positive or neutral as a whole. The empirical research of Huchet-Bourdon and Korinek (2011) had focused on the fluctuations of the exchange rate of Eurozone and the possible impacts of its trade. Their research had established that volatility of exchange rate does not have much of a negative impact on the trade of the Eurozone. They had also found that the level of exchange rate have a higher impact on the agricultural trade of the region compared to the manufacturing sector. Another study by Fertő and Fogarasi (2012) had explored the exchange rate volatility and concluded that it has a negative impact on the trade of the Central European countries but this volatility can be reduced to a great extent if these countries were joined to the Eurozone. The graphs below show the fluctuations of exchange rate in Eurozone with four of the major currencies for the first six months. The values of 2010 and 2014 are plotted in the figure. Figure 16: Exchange rate of Euro with USD in 2010 (Source: European Central Bank, 2015) Figure 17: Exchange rate of Euro with USD in 2014 (Source: European Central Bank, 2015) Figure 18: Exchange rate of Euro with Yen in 2010 (Source: European Central Bank, 2015) Figure 19: Exchange rate of Euro with Yen in 2014 (Source: European Central Bank, 2015) Figure 20: Exchange rate of Euro with Yuan in 2010 (Source: European Central Bank, 2015) Figure 21: Exchange ratye of Euro with Yuan in 2014 (Source: European Central Bank, 2015) Figure 22: Exchange rate of Franc in 2010 (Source: European Central Bank, 2015) Figure 23: Exchange rate of Euro with Franc in 2014 (Source: European Central Bank, 2015) Figure 24: Exchange rate of Euro with Pound in 2010 (Source: European Central Bank, 2015) Figure 25: Exchange rate of Euro with Pound in 2014 (Source: European Central Bank, 2015) The figures above shows that the Euro have exhibited high volatility during the period under study. The global financial crisis of 2008 had greatly increased the extent of fluctuations of the dollar and euro thereby impacting the exchange rate. An empirical research on the trade pattern of the Eurozone countries to the U.S. reveals that volatility had adversely affected the Euroarea (Verheyen, 2012). A meta analysis on the trade data of the U.K. exports to the Eurozone was studied after the area had adopted the Euro. The result from the study had shown that the creation of Euro had particularly been harmful for the U.K. as exports from the country had reduced phenomenally after few countries had joined the European Union. U.K.’s exports to the Eurozone countries had been negatively affected and a significant portion of this reduction can be attributed to the volatility in the exchange rate (Springford and Tilford, 2014). Reference List Auboin, M. and Ruta, M., 2011. The relationship between exchange rates and international trade: A review of economic literature. Econstor [pdf]. 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