International Finance Discussion Papers

Explaining the Volume of Intraindustry Trade: Are Increasing Returns Necessary? Donald Davis 1991-411  (September 1991)

Abstract:  The recent theoretical literature has suggested that increasing returns to scale are necessary to account for the volume of intraindustry trade among developed economies. The present paper shows that such trade can arise quite naturally in a setting with constant returns to scale.

An example is developed with "perfectly-intraindustry goods," in which countries with identical endowments and arbitrarily small technical differences nonetheless trade substantial amounts of goods of identical factor intensity. This is extended to a case with factor price equalization, fully determinate trade and the possibility of substantial intraindustry trade. Finally, we develop the simplest possible model that can give a unified account of interindustry and intraindustry trade, while allowing a straightforward comparison with standard Heckscher-Ohlin results. A striking feature of the last example is that intraindustry trade attains a maximum at a point where countries have identical factor endowment ratios.

Increasing returns, in short, are not necessary to explain intraindustry trade.

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