Chapter 5
Beyond Comparative Advantage
◼ Outline
Introduction: More Reasons to Trade
Intraindustry Trade
Characteristics of Intraindustry Trade
The Gains from Intraindustry Trade
Case Study: United States and Canada Trade
Trade and Geography
Geography, Transportation Costs, and Internal Economies of Scale
Case Study: The Shifting Geography of Mexico’s Manufacturing
External Economies of Scale
Trade and External Economies
Industrial Policy
Industrial Policies and Market Failure
Industrial Policy Tools
Case Study: Clean Energy and Industrial Policy
Problems with Industrial Policies
Case Study: Do WTO Rules Against Industrial Policies Hurt Developing Countries?
30 Gerber • International Economics, Seventh Edition
◼ Learning Objectives
After studying Chapter 5, students will be able to:
5.1 Give examples of interindustry and intraindustry trade.
5.2 Compare and contrast internal and external economies of scale.
5.3 Analyze the effects of international trade in a monopolistically competitive
market.
5.4 Describe the gains from intraindustry trade.
5.5 Explain how transportation costs and internal economies of scale help determine
firm location decisions.
5.6 Present the pros and cons of industrial policies.
◼ What Students Should Know after Reading Chapter 5
One of the main objectives of Chapter 5 is to show that a large share of international trade is intraindustry
trade and to describe why this trade occurs. Intraindustry trade is not based on comparative advantage
since it consists of the export and import of similar products; rather, it is based on economies of scale and
product differentiation. Because a large share of world trade is between industrialized countries with
similar factor endowments, understanding intraindustry trade is important in explaining real-world trade
patterns.
Understanding the source of economies of scale (internal or external) and how that affects firm behavior is
also emphasized. Internal economies of scale may lower costs for existing firms and domestic consumers,
creating a win-win situation and making this type of trade less controversial. Internal economies of scale
may result from (1) ability to spread fixed costs over a larger market; (2) capabilities for better engineering
and marketing associated with larger firms; (3) capabilities by larger firms to conduct R&D for better
machines and tools; and (4) increasing specialization of labor in larger firms, etc.
External economies of scale may come from regional agglomerations of firms. The decrease in costs
from an agglomeration may be caused by: (1) knowledge spillovers that help keep all firms abreast of the
Chapter 5 Beyond Comparative Advantage 31
orientation in the 1980s (pre-NAFTA). This shift from inward to outward policies was an important factor
in the concentration of firms on the border with the United States where they are nearer the new, larger
market.
The chapter bridges from external economies to industrial policy by explaining how small differences in
initial conditions can lead to large differences in outcomes because of scale economies. The example
focuses on U.S. agglomerations for aircraft production. European nations used subsidies and other
interventions to help Airbus become competitive against the U.S. cost advantages.
◼ Assignment Ideas
1. Ask students to analyze bilateral trade between two nations that have similar factor endowments.
Which items seem to be intraindustry trade? Which items seem to be interindustry trade? In percentage
terms, how much of the top-ten exports/imports are intraindustry trade? Has any political or media
attention been paid to this bilateral trade pattern, and if so, in what areas? (Assuming different
students focus on U.S. bilateral trade with different nations there may be some variation in answers
that could support the general idea that interindustry trade is more controversial because it necessarily
creates winners and losers.)
2. Have students choose an industrial policy and analyze it according to the criteria given in Chapter 5.
Begin with a description of the policy and then focus on whether the policy is justified. In particular,
for what market failure is the policy designed to compensate? Does the description of the policy
address this issue? Are there justifications for this particular industry and not for others? Finally, what
32 Gerber • International Economics, Seventh Edition
◼ Answers to End-of–Chapter Questions
1. What is intraindustry trade how is it measured, and how does it differ from interindustry trade? Are
the gains from trade similar?
Answer: Intraindustry is international trade of products made within the same or similar industries,
for example, car-for-car, beer-for-beer, etc. Differentiated products, which are
characteristics of monopolistic competition and often oligopoly, lead to trade between
2. Comparing U.S. trade with Germany and Brazil, is trade with Germany more likely to be based
on comparative advantage or economies of scale? Why?
Answer:
Trade with Germany is more likely to be based on economies of scale since it consists of
the export and import of similar products and occurs mostly in countries that have similar
3. What are the differences between external and internal economies of scale with respect to (i) the
size of firms, (ii) market structure, and (iii) gains from trade?
Answers:
i. An external economy of scale exists when the fall in the average costs of the industry
lowers the average costs of the typical firm. With external economies, the size or scale effects are
located in the industry, and NOT THE FIRM. Thus, even though the size of each firm in the
Chapter 5 Beyond Comparative Advantage 33
Copyright © 2018 Pearson Education, Inc.
This usually leads to larger firms because size confers a competitive advantage in the form of
lower average costs.
34 Gerber • International Economics, Seventh Edition
ii. As mentioned above, with external economies of scale the scale effects are located within the
industry, and not within the firm. The potential for external economies of scale gains leads firms
to concentrate in specific regions. The market structure in this case is agglomerations. On the
other hand, declining average costs within internal economies of scale invite outsiders to enter
iii. Intraindustry trade is a byproduct of internal economies of scale. As explained in the text, the
benefits include: (a) lower prices passed on to consumers by monopolistically competitive firms
enjoying economies of scale; (b) lower prices passed on to consumers when international trade
4. What are the three key incentives for firms in a particular industry to cluster together in geographical
region?
Answer: These are: (1) large pool of skilled labor, which reduces the search costs and encourages
high degrees of labor specialization, (2) specialized suppliers of inputs, which helps firms
5. How might trade hurt a country if it imports goods that are produced under conditions of external
economies of scale?
Answer: Trade may stifle the development of new industries that could be more efficient than the
existing ones, reducing global efficiency. This could be due to a historical accident of an
initial head start, or trade otherwise gives a scale advantage to already existing firms in
6. When the United States signed a free trade agreement with Canada (1989), no one in the
United States thought twice. When the agreement with Mexico was signed (1994), there was
significant opposition. Use the concepts of interindustry and intraindustry trade to explain the
differences in opposition to the two trade agreements.
Chapter 5 Beyond Comparative Advantage 35
Answer: Canadian productivity, technology, and factor endowments are more or less comparable
with those of the United States. Consequently, trade between the United States and
7. What are the theoretical justifications for targeting the development of specific industries?
Answer: The primary justification is to counteract a market failure. Although market failures come
in all shapes and sizes, all imply that markets do not result in the optimal allocation of
resources—either producing too much or too little. Industrial policies are mostly
36 Gerber • International Economics, Seventh Edition
8. What are some of the common problems in implementing industrial policies?
Answer: They are: (1) the difficulty of obtaining information necessary to measure the extent of
market failure, and choosing which industry to target; (2) knowing the optimum amount
9. Figure 5.3 in the text illustrates the case of an industry that generates external social benefits with its
production. Draw a supply and demand graph for an industry that creates external costs with its
production. Compare and contrast the market determined price and output level with the socially
optimal price and output levels.
Answer: In a negative externality the social returns are less than private returns, so a free
market produces more than the optimal amount (Q2 instead of Q1 in Figure 5.3). This
is because producers fail to take into account the external costs when calculating their