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Models of Vertical IIT in Final Products

CHAPTER THREE LITERATURE REVIEW

3.1 Theoretical Review

3.1.1 The Theories of IIT in Final Products

3.1.1.1 Models of Vertical IIT in Final Products

The distinction between vertical and horizontal models is an important one. HIIT models are usually expressed as a way of explaining IIT flows between two developed countries/regions. However, IIT between developed and developing countries (VIIT) may be expected to be of a different kind and caused by other factors than IIT between two developed countries. That is to say, VIIT models require a modification of the usual explanations. An essential and innovative element in VIIT models is the postulation of vertical product differentiation by quality as the crucial determinant of IIT between developed and developing countries. There are three major theories in VIIT. They include Neo-H-O model, Natural Oligopoly and Vertical Differentiation as well model of North- South and Vertical Product Differentiation.

i. Neo-Heckscher-Ohlin Model

This approach can be considered as an alternative to that of modelling IIT as a consequence of scale economies and monopolistic competition. The first study this approach is Falvey (1981). Falvey (1981) attempts to minimise the departure from the traditional H-O-S theorem by modifying the standard framework in a minor fashion. In the traditional 2 × 2 × 2 H-O-S model, two factors are used to produce two commodities in two countries. This model assumes that differential factor endowments that cause autarkic factor price differences between the potential trading partners are the reason for trade. There is also the assumption of constant returns to scale in the H-O-S model.

Falvey (1981) retains these two central assumptions of traditional theory. However, for the sake of extending the H-O-S model, he makes two crucial modifications. First, he

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assumes that one of the two factor inputs used in each industry (capital) is specific to that industry, second each industry is no longer assumed to produce a single homogenous product, but can produce a range of products using as inputs labour and its own industry specific capital, in other words, at least one industry is assumed to produce a differentiated commodity. The commodity concerned is vertically, differentiated with respect to quality (Greenaway, 1987).

Falvey (1981), after touching upon his basic modifications, constructs the closed economy features of the Neo-Heckscher-Ohlin model. The industry under consideration is assumed to posses a given stock of capital (K) and to be able to hire labour (L) at the given wage rate (w). Using the services of K and L , the industry can produce a range of products, which will be referred to as different ‗qualities‘. On the supply side, product quality is determined by the capital-labour ratio (α ) used in the production. Higher quality products require more capital intensive techniques and therefore have higher prices. On the other hand, from the demand side, demand for each quality is taken to be a function of the prices of all qualities and total consumer income. Consumers are assumed to prefer high quality to low quality products. Since, However, choice is income constrained, some consumers will initially be confined to some low quality variety with substitution towards higher qualities resulting from income increases (Greenaway, 1987).

Trade conditions of the neo Heckscher-Ohlin model are again explained by Falvey (1981). According to Falvey (1981) trade takes place in a two-country (home and foreign) world, in each of which the industry under consideration has a given capital stock (K and K*, respectively) and faces given wage rates (w and w*, respectively).

Capital is industry specific and internationally immobile, but is freely mobile in the production of this industry‘s various qualities in each country. The returns to capital (r and r*, respectively) adjust so as to maintain the full employment of the two capital stocks. Each industry is assumed to be perfectly competitive. Then, for any given returns to capital in the two countries, domestic production costs (c) and foreign production costs (c*) for a given quality i α can be represented as

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c w   

i

r

(1)

* * *

c   w

i

r

(2)

It is assumed that the home (foreign) country is relatively well endowed with capital (labour) resulting in w*<w and r*>r. Given these autarkic factor price differences the home country will enjoy a comparative advantage in a range of high quality products while the foreign country enjoys a comparative advantage in a range of low quality products. To see this Falvey (1981) identifies the ‗marginal quality‘ 1 α , such that

*

1 1

( ) ( ) 0

c   c  

(3)

* *

( ) 0

i i

w    r w   r

(4)

and correspondingly

*

1 *

w w r r

 

(5)

*

*

1 1

( )

i

( )

i

w w (

i

)

cc   

   

(6)

It can be seen from 2.24 that the home country has a comparative advantage whenever

c ( )

1

c

*

( )

1

0

(7)

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*

*

1

, w w 0

w w

(8)

c ( )

1

c

*

( )

1

0

if and only if

 

i i (9)

From 2.24 it is apparent that the home country has a comparative advantage in those qualities which require more capital-intensive techniques than the marginal quality, and is at a comparative cost disadvantage in the other (lower) qualities. Therefore, the higher wage home country will specialise and export those qualities above the margin  i 1, and import the below marginal qualities  i 1. Since higher quality requires higher capital-intensity in production, the capital abundant country exports relatively high quality products while the labour abundant country exports relatively low quality products and IIT occurs as a consequence of countries‘ specialisation in the production of different varieties (Torstensson, 1996).

An extension of this work can be found in Falvey and Kierzkowski (1987). IIT is derived in a manner similar to that described above. One extension is that the capital-abundant country will have a comparative advantage in higher quality goods and this advantage will become larger as one moves up the quality spectrum. Further, the model implies that vertically differentiated products will be distinguishable in terms of quality and price.

The Falvey and Kierzkowski models are of importance since many international markets are characterised by IIT in vertically differentiated goods.

ii. Natural Oligopoly and Vertical Differentiation

In series of studies (Shaked and Suttan 1982; 1983; 1984), the case of ‗natural oligopoly‘

and trade in vertically differentiated products was examined. They focused on situations where the number of firms that can enter a market with new, higher-quality varieties is

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bounded by the demand and supply characteristics of the market. According to Shaked and Suttan (1984), large numbers of qualities would be available if the income range is wide, fixed (R&D) costs associated with quality improvements are low; and average variable costs rise sharply as a result of quality improvements. By contrast, if unit variable cost does not rise sharply with quality20 then an upper bound exists to the number of firms that can survive with positive market shares, and prices in excess of unit variable cost. This later situation is referred to as the ‗natural oligopoly‘ case (Shaked and Suttan,1984).

Basic autarky and trade features of the Shaked and Suttan model are explained by Williamson and Milner (1991) by reference to Shaked and Suttan (1982; 1983; 1984). In the Shaked and Suttan model, under autarky conditions, only two home firms producing distinct qualities can survive, given the country‘s income distribution. The reason for this is that competition on quality drives all firms to produce the highest quality possible, but (Bertrand) price competition between similar qualities drives price to marginal cost and causes the exit of firms. According to Williamson and Milner (1991), the Shaked and Suttan model analyses the impacts of the opening up of trade under two different approaches: identical economies and different economies approaches.

If the two economies are identical in all respects, their combined market will still support only two firms. Given the competition in quality and in price as discussed above, the number of firms that can be supported is independent of market size. When trade opens up, two of the firms will exit and two will remain to serve the joint market. A priori, it is impossible to predict the direction and type of trade involved in this case. However, in the event that one firm from each country exists, the result will be IIT in vertically differentiated products. But, if the two economies are different, differences in income distribution facilitates a larger number of firms in the post-trade equilibrium, with the higher (average)-income country specialising in a range of higher quality products and

20 This case is likely to be relevant in situations where the main burden of quality improvements falls on fixed costs, rather than increases in labour and raw material inputs

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the lower (average)-income country specialising in lower-quality products. Since trade drives down prices in general and consumers prefer higher quality, it is lowest-quality firms that tend to be driven from the market. Thus, all other things being equal, VIIT is more likely, the greater the degree of taste overlap between economies. The opening up of two-way trade will be welfare improving in both of the above cases, since competition will drive down prices, while market expansion will induce overall quality improvement.

As a result, according to the Shaked and Suttan model, the more dissimilar the economies are, the larger the number of producers will be and the more the distribution of income becomes closer, the lower the number of firms in the combined economy.

iii. Model of North-South and Vertical Product Differentiation

Flam and Helpman (1987) developed a model of North-South trade based on vertical product differentiation (that is, differentiation according to quality). They assumed that two commodities exist: homogeneous product and a vertically differentiated product.

The homogenous products can be consumed in every desirable quantity, whereas the consumer can choose the quantity of differentiated product from those available in the market. The North produces and exports high quality, high cost varieties, while the South exports low quality, low cost varieties. Given an overlap in income distribution, there exists IIT. The Flam and Helpman (1987) opine that the higher the relative income of the North and the larger the share of income of southern individuals that consume imported varieties, the larger is the share of IIT. They predicted further that the share of IIT depends on relative country size, on income distribution in both trading countries.