Prevalence of intra industry trade: Analysis of firm level total factor productivity in Pakistan’s manufacturing sector

Abstract

Introduction

Trade in today’s world has moved away from inter industry trade and towards intra-industry trade. Consumers in France can buy both French made Peugeot cars and imported German Mercedes. Similarly, consumers in Germany can also import Peugeot and many other cars from around the world while Mercedes is exported all over the globe. This represents a perfect example of intra industry trade that is marked by product differentiation and the ability of firms which produce essentially similar products to compete in the international market. The underlying mechanism that enables such trade to take place is productivity at the firm level. This is different than the concept of comparative advantage where countries as a whole specialized in industries for which they had abundance of relevant factors of production such as labor, land, technology and skilled human and financial capital.

On the other hand, the concept of trade originating from differences in firm level productivity means that within a country, all those firms export which have a sufficiently high rate of total factor productivity that enables them to compete at the international market. This is exogenous of the economy’s overall comparative advantage and a firm may be exporting products in which the country in general may not have the best factors of production. This can happen if the firm proactively improves its method of production through import of technology, develops human capital, takes advantage of economies of scale and moves along its learning curve through learning by doing. With an ideal mix of such factors, it is possible for any firm producing any product anywhere in the world to become an exporter. A second explanation of intra industry trade analyzes the effect of product differentiation. Consumers may be willing to pay extra for a product if a firm creates a market niche for its brand.

Most of the existing literature found that increase in total factor productivity (TFP) leads to increase the exports (e.g., Baldwin and Gu 2015; Haider, 2012; Wagner, 2005; Girma et al., 2004; Bernard and Jensen, 1999) Moreover, Krugman (1979) sets up a model of non- comparative advantage trade. But he does not directly examine the causal relationship between TFP and exports. He found that trade and trade gains occur even between countries that have similar technology, taste and factor capabilities. Melitz (2003) examine how intra-industry trade is incorporated into world trade. He shows how trade leads to less productive firms exiting the export market and only the more productive firms remain. Taken together, the results indicate that a relationship exists between TFP and exports. Hence, this paper will analyze how improvement in productivity affects exports.