Page 93 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 7 : Causes of Emergence and Measurement of Intra-Industry Trade and Its Impact on Developing Economics

Notes
∑ ( i X i + M ) i
Share of Two-Way Trade = ∑ ( j X j + M ) j ... (15)

where i ≡ two-way traded goods and j ≡ all traded goods.
Abd-el-Rahman (1991) pioneered this method in disentangling intra-industry trade. The index of
two-way trade, however, had been proposed by Fontagnè, and Freudenberg (1997). Although the
Grubel-Lloyd Index and the Two-Way Trade Index measure two different phenomenon—the Grubel-
Lloyd Index measures the degree of trade overlap, while the two-way trade index considers all trade
over the γ percent threshold to be two-way trade—when they are compared, they are quite similar.
Fontagnè, and Freudenberg (1997), using regression analysis and a quadratic specification, found
the fit between the two indices to be impressive : R = 0.97. Given the longevity of the Grubel-Lloyd
2
Index, this goodness of fit has provided some comfort to researchers.
Thus far, we have only differentiated between one- and two-way trade. We now must move to
disentangle horizontal and vertical intra-industry trade. Within a given commodity classification
that experiences two-way trade, products may or may not differ in their quality. In models of intra-
industry trade, horizontal product differentiation is characterized by products with similar quality
levels, with different attributes, while vertical differentiation is characterized by products with
significantly different quality levels. Following Stiglitz (1987), empirical work that has disentangled
intra-industry trade has assumed that prices represent quality, even under imperfect information.
From this assumption, differences in the unit values (UV) or prices of these commodities can be
assumed to represent these quality differences. Unit values have been defined for each commodity
classification as the value of trade divided by the quantity traded, giving an average price of the
goods traded in this category. Clearly, the more disaggregated the classification system, the better
this method will be in capturing the price of the commodities. A classification system such as the 10-
digit Harmonized Tariff Schedule with 20,000 commodity classifications will capture this well. The
categories are so specific that different commodities will have different quantity measures : liters,
kilograms, number, etc. while the SITC classification system is more general and uses tonnes as its
quantity variable for all commodity categories.
Regardless of the level of disaggregation, horizontal product differentiation is defined as having the
ratio of the export unit value to the import unit value falling within a range :

UV X
1 − α ≤ ≤ + α ... (16)
1
UV M
whereα is the threshold for the range. Vertical product differentiation is then defined as :

UV X >1+ UV X <1−
UV M α or UV M α . ... (17)
Fontagnè, and Freudenberg (1997) have suggested a modified criteria that preserves the relative
nature of the threshold :

1 ≤ UV X ≤1+ α
1 + α UV M ... (18)
for horizontal product differentiation, and :

UV X >1+ UV X < 1
UV M α or UV M 1+ α ... (19)
for vertical product differentiation. For small values ofα there is little difference between the two
methods, but asα gets large the relative “distance” from the lower bound to unity becomes
increasingly larger than the distance from unity to the upper bound.

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