Deconstructing Intra-Industry Trade. With Special Reference to EU-Trade

Transcription

1 Deconstrcting Intra-Indstry Trade With Special Reference to EU-Trade Joakim Gllstrand Department of Economics Uniersity of Lnd P.O. Box 7082 S LUND Abstract An important refinement of the methodology in analysing intra-indstry trade (IIT) has been to diide two-way bilateral trade flows into a horizontal and a ertical part. Most econometric analyses hae sed these parts as a proportion of total trade to test different nderlying theories of IIT. The reslts are, howeer, not particlar robst and in many cases they contradict the predictions of the theories, especially within the Eropean sphere. One of the problems cold be the reslt of sing the different proportions separately, since the denominator consists of inter-indstry trade pls horizontal and ertical IIT, while the econometric analyses test the different theories of IIT one at a time. In this paper we will try to integrate two complementary theories of IIT, and test hypotheses regarding the share of horizontal IIT in total IIT. The econometric analysis shows rather robst reslts that spport both the nderlying theories and therefore nderline the importance of diiding total IIT into a ertical and a horizontal part. The reslts stress that similarities in factor proportions, especially hman capital, and demand pattern, measred by per capita income leels and spatial closeness, are important determinants of the share of horizontal IIT in total IIT. Frthermore, the market sizes matter and we fond that the interaction between the aerage and the difference in market sizes are important.

2 Introdction The most common approach to analyse intra-indstry trade (IIT) is to se the Grbel-Llyod index from Grbel and Llyod (1975) or a refinement of this index. One important refinement is to diide two-way bilateral trade flows into a horizontal and a ertical part, following Abd- El-Rahman (1991). These different parts are then sed to calclate the proportions of ertical and horizontal IIT in total trade with the intention of testing the nderlying theories of IIT. 1 The reslts, howeer, from the econometric analyses are not particlar robst and in many cases they contradict the predictions of the theories. One problem cold originate from the se of the different proportions separately, since the denominator consists of inter-indstry trade pls horizontal and ertical IIT, while the econometric analyses test the different theories of IIT one at a time. An additional problem cold be that if we se the total trade as a weight, the index becomes ery sensitie to total specialisation patterns de to, for example, technological differences. The aim of this paper is to se a model that integrates two complementary theories of IIT within one analysis with the intention of increasing the robstness of the predictions. We beliee that the adantage of this approach is twofold; the first adantage is that the predictions become more transparent since we allow ariables to affect both ertical and horizontal IIT flows at the same time. The second adantage is that we concentrate on the prodcts that are traded in two-ways so that total specialisation patterns does not affect the analysis. We will also describe the distribtion of ertical and horizontal IIT in bilateral intra- EU IIT flows in the manfactring sector, and these distribtions are sed in the econometric analysis of the contry-specific factors that determine the distribtion of IIT. The rest of the paper is organised as follows. The first part deries hypotheses from a formal model with two qality grops within one indstry, both grops are characterised by monopolistic competition and many arieties. The second part discsses the measre sed to analyse the distribtion between ertical and horizontal IIT, and it also proides a descriptie analysis of the distribtion. The third discsses the econometric model, its reslts, and diide EU into two different geographical areas in order to see if the reslts are robst. Finally we conclde and smmarise the findings of the paper. 1 The nderlying theories are, in most cases, the New Trade Theory, explaining horizontal IIT, and Faley-type schemes, explaining ertical IIT. Empirical analysis of both horizontal and ertical IIT is fond in, inter alia, Greenaway, Hine and Milner (1994 and 1995), Greenaway, Hine and Elliott (1999), and Atrpane, Djanko and Hoekman (1999).

3 The Model Settings In this chapter we shall formalise the relationship between ertical and horizontal IIT by integrating the New Trade Theory with Faley-type schemes. 2 We simplify, following Lancaster (1979, chapter 6), by assming that there are two different income strata, one is the high-income stratm and the other the low-income stratm, and consmers hae identical preferences within each stratm. All consmers prefer a higher qality bt they are constrained by their income, and as long as the high-qality prodct is more expensie than the low-qality prodct, low-income consmers will demand low-qality prodcts while highincome consmers will demand high-qality prodcts. That is, if the price of low-qality prodcts is the same or greater than the price of high-qality prodcts, the demand for lowqality goods will anish. This strctre implies that we hae one indstry with two different kinds of qality leels, high- and low-qality goods. These two qalities are non-combinable, niersal, and there exist seeral different arieties within each qality leel. The nmber of high-income indiidals within each contry depends on exogenos factors that reflects different historical and instittional factors, and hence this nmber cold differ between two contries of the same poplation and income size. Each income stratm consists of a proportion of the total poplation, and each stratm holds a proportion of the contry's total income. The high(low)-income stratm holds z (1-z) of the total income E (= rk+sh+wl, where r, s and w is the factor retrn to physical capital (K), hman capital (H), and labor (L) respectiely), and its share of the total poplation in is ρ (1-ρ). 3 The indiidal income leel is niformly distribted within each stratm. In the absence of income redistribtion, a high-income (h) consmer earns w pls a share of the total capital retrn ((rk+sh)/ρl), while a low-income (l) consmer only earns w. The income leel of a representatie consmer, after a redistribtion, in each stratm is defined as i h = (1-ι)[w + (rk+sh)/ρl ] for the high-income consmer and i l = w + ι[i h ρ/(1-ρ)] for the low-income consmer. That is, a part of the each high-income consmer is redistribted among the lowincome consmers, and the redistribtion is constrained so that i l (w,i a ) (where i a = E/L). This setting implies that the share of the low-income stratm can be defined as (1-z) = (1- ρ)l i l (E) -1, which is decreasing in ρ and increasing in ι. In other words, the income share of 2 The model, stylised in this chapter, follows ideas from, inter alia, Faley (1981), Faley and Kierskowski (1987), Helpman and Krgman (1985), Lancaster (1979 & 1996), and Bergstrand (1990 & 1991). 3 Let the amont of labor (L) in each contry eqals the poplation size.

4 the low-income stratm is dependent on income redistribtion and the distribtion of consmers between the two income strata.. Frthermore, we cold define the ineqality measre (IM) as the ratio between the income share and the share of the poplation in the low-income stratm, i.e. IM = (1-z)/(1-ρ). That is, a contry moes towards a more eqal income distribtion when ι increases as long as ρ (0,1). All contries hae a fixed amont of factors of prodction, which are all mobile within contries bt not between contries. There is one indstry that prodces a differentiated good (X) nder increasing economies of scale, and one indstry that prodces a homogenos good (Y) nder constant retrns to scale. The arieties in the x-indstry are either of a high-qality (x h ) or a low-qality (x l ). Both qalities are, howeer, spplied on a market that is characterised by Chamberlin's monopolistic competition, and we therefore find seeral arieties in each qality grop. Both qalities are prodced with the same marginal technology, bt the prodction of x h needs a larger amont of fixed capital (hman and/or physical capital) than the prodction of x l (to coer R&D expenditres). We assme, following Bergstrand (1989 and 1990) and Geraci and Prewo (1982), that all firms face a transport cost when they spply the different markets, inclding the domestic market, that is reflected by a CET (Constant Elasticity Transformation) fnction. That is, there is a trade off between different export destinations as long as the elasticity of transformation (λ) is less than infinity. This implies that firms se some of their inpt resorces to distribte the prodct to different contries, and this will affect firms' mark-p oer marginal costs. Demand The tility of a representatie consmer in a gien income stratm is represented by a Cobb- Doglas fnction U = y (1-φ) C φ ; where = h,l, and C is a CES fnction: C Σ ρ ρ D ) 1 ω, h, l ρ = 1-, ω Ω ( ) σ = L N M 1 O = QP where h and l indicate the qality consmed, and Ω() is the set of different arieties within the indstry for each qality grop. The sbstittion elasticity between different arieties depends on the constant parameter σ (1, ); which also, in this setting, is the elasticity of

5 demand, which is negatiely correlated to the mark-p size and scale. We assme that σ l > σ h, i.e. the consmers of high-qality prodcts are less inclined to sbstitte between different arieties. A representatie consmer's demand in contry e for each ariety is soled by: Σ Σ Σ Σ e e e e e ρ min D P T, s.t. C ( D ), = L N M e ω( ) ω( ) Dw( ) M ω Ω( ) Mω Ω( ) ω ( ) O QP 1 ρ where P e ω is the f.o.b. price of the prodcer of ariety ω in contry, and T e is the exogenos transport cost between e and. This leads s to the aggregated bilateral import demand fnction of a certain ariety between contry e and since the bdget constraint E j = P C j has to be flfilled for all j consmers (where P = H [1/(1-σ())], i.e. the c.i.f. price index for the composite demand, and E j = φi j ). Contry e's aggregated import demand for each ariety is therefore: 4 e e e e σ e 1 D = E ( P T ) ( H ), ω( ) Ω( ), and = h, l; ω( ) ω( ) (2) where E h e and E l e are φi e h ρ e L e and φi e l (1 - ρ e )L e respectiely. Firms All firms that prodce the same type of qality se an identical technology, and a firm that prodces ariety ω will choose a price that maximises its profit, all other prices taken as gien. Free entry and exit sqeeze the profit leel to its normal leel of zero. Hence, there are two pricing conditions, one is that each firm sets prices with a mark-p oer the marginal cost, and the second is that the firm's profit eqals zero. This implies that there is only one firm per ariety prodced, and the nmber of firms is therefore endogenos. Each firm's prodction technology is defined as an inpt reqirement of each factor: V = α + β X, and V = β Y, where g = K, H, L and = h, l; g, ω( ) g g ω( ) gy, gy, 4 This is similar to Armington (1969).

6 where V g is the necessary amont of factor g to prodce ariety X w(), β g, is the constant nit inpt reqirements while α g, is the fixed reqirement. We assme that we only need a fixed amont of physical and hman capital, and the high-qality prodct need more of physical and/or hman capital. The total otpt of ariety ω in contry (X w()) is defined by the CET fnction of a representatie firm: L e λ X = ( X ), λ, ω( ) ( ), h, l. N M O Σ Q P > 0 Ω and = ω( ) ω( ) e M λ λ+ 1 λ + 1 The term X ω e is the export from to e of ariety ω. This setting leads s to the following profit fnctions: Σ e e π = P X α r α s ( β w + β r + β s ) X, ω( ) ω( ) ω( ) K, H, L K H ω ( ) e M (3) where P e ω is the f.o.b. price, β K r + β H s + β L w (=MC ) is the marginal cost, and α K r + α H s (FC ) is the fixed cost of a firm in contry. The first pricing condition is fond by maximising eqation (3) in respect of X e ω, and by defining the elasticity of demand as σ (= (- X e ω / P e e ω )( P ω / X e ω )): P e ω = F HG I KJ σ ( ) MC σ () 1 F HG X X e ω ω I 1 λ, ω Ω ( ), and = h, l, (4) KJ which mst hold if this firm wishes to export to contry e. This condition implies that the amont of export from to e affects the firm's f.o.b. price as long as the transformation is imperfect (i.e. λ() < ). 5 The second pricing condition helps s to sole for the total otpt of each firm by setting eqation (3) to zero and sbstitting eqation (4) for the price leel in each contry: 5 Remember that P h > P l, otherwise the demand for low-qality goods anishes. This implies that we hae implicit restrictions on the ales of FC, σ(), and X e. The price of high-qality prodcts will, howeer, be higher for a large range of ales een if MC h = MC l, FC h > FC l, and X e l > X e h ;as long as σ(l) > σ(h).

7 FC ( ) Xω ( ) = ( σ ( ) 1 ). (5) MC Finally, if all factor markets are characterised by perfect competition, the amont of each factor of prodction within a contry eqals the se of factors in prodction. That is, we can sole for the nmber of firms that prodce x h, x l, and y within each contry since the total prodction of each good eqals the nmber of identical firms times the otpt leel of each firm. Eqations A1 in Appendix show the nmber of firms that prodce x h (N h ) and x l (N l ) in contry. We can see in these eqations that if we increase the amont of physical capital and N h increases, we expect N l to decrease. The otcome depends, howeer, on the prodction technology, gien factor prices, for x h, x l as well as y. Eqations A1 show the increased complexity of the model compared to a model with two factors. And we can see that any change of a factor of prodction may hae a positie effect on the prodction of both high and low-qality or positie on one and negatie on the other. How the prodction pattern is affected by changes in a factor endowment is an empirical qestion, bt or hypotheses are bilt on that there is a technological difference so that the nmber of firms that prodce high(low)-qality arieties increases as the amont of capital (both hman and physical) increases (decreases). Bilateral trade If we sbstitte eqation (5) in eqation (4) and sole for the redced form of X e and P e with the help of eqations (4) and (2), we get e's import ale from firm ω() sitated in, i.e. X e ω P e ω. Contry e's total import ale of each qality leel from contry, is determined by mltiplying the import ale of each ariety with the nmber of firms in, since all firms hae the same behaior within a particlar qality stratm: e e e e e e P X N = imp = T δ E δ H δ MC w( ) F σ( 1+ λ) 1+ λ ( 1+ λ) ( 1 σ )( 1+ λ) δ σ 1 λ( 1 σ ) ( 1+ λ)( σ 1) δ σ δ δ ( σ 1) N, (6) where δ = (λ+σ ), and the same procedre will gie s the export from e to. The leel of IIT, horizontal IIT, and the ratio between these two leels in indstry X will be defined as:

8 IIT e e = 2 min( Σ imp, Σ exp ), e e e e e hiit = 2{min( imp,exp ) + min( imp,exp )}, riit e e = h, l = h, l e hiit = [ 01, ]. e IIT l l h h A riit e that eqals one indicates that there is no ertical IIT between contry e and. In other words, contry e exchange arieties from one/both qality grops for different arieties with the same qality leel. Howeer, a riit e that eqals zero indicates no horizontal IIT, and hence contry e exchange different arieties for arieties with a different qality leel. We begin or analysis with two identical contries, and they stay identical in all respects dring the analysis, as long as we do not explicitly indicate any differences between the two trade partners. This implies that the initial riit eqals nity since contry e's import from and export to contry are the same in both qality strata, i.e. imp e = exp e. A greater dissimilarity in relatie factor endowments (relatie to labor) decreases riit. (H1) Or first hypothesis ses the assmption that different qalities are prodced with different factor intensities, and we assme that a high-qality ariety is more intense in physical and/or hman capital. 6 These technological differences imply that we hae a Rybzcynski effect when the relatie endowments change, and we assme that the prodction of high-qality arieties increases when physical as well as hman capital increases. If we, for example, increase K e and L, and decrease K and L e, withot affecting the total income or prices, riit decreases since the more (less) capital-abndant contry will increase its prodction of high-qality (low-qality) goods. The implication of a change in relatie factor endowments is deried from eqations (6) and (A1), since the trade flow is only affected by changes in the nmber of firms in each qality grop: e e imp N imp N dimp dl N L N K dk iff l e ( ) ( ) ( ) ( ) ( ) = + <, ( ) ( ) T 0 = > 0 iff = h R S 6 Torstensson (1996) spports the importance of hman capital in determining the qality.

9 and similarly for exports. That is, imp e h (imp e l ) decreases (increases) while exp e h (exp e l ) increases (decreases), and hence riit becomes less than one. The implicit assmptions in this hypothesis are that the share of the poplation and the share of the total income in each income stratm are nchanged, bt these assmptions will be relaxed below. Frthermore, in the empirical analysis we will take a closer look at the importance of both relatie total, physical and hman capital. A greater dissimilarity in the demand pattern decreases riit. (H2) If ρ e increases and ρ decreases then the demand pattern changes, bt we keep the total demand of the two qalities nchanged so that all prices are the same. This implies that the demand pattern within the two bilateral partners changes, which is seen if we differentiate eqation (7) with respect to ρ e : e ( imp ) e ( ρ ) R S T = e e ( imp ) ( E ) < 0 iff = l. e e ( E ) ( ρ ) > 0 iff = h The change in exports from e to will hae the opposite signs. In other words, contry e increases its import (export) of high(low)-qality arieties while it decrease exports (imports) of high(low)-qality arieties, which implies that riit fall below nity. That is, we can see that an increased difference between ρ e and ρ affects bilateral trade flows. And this difference cold be initiated by a difference in the aerage per capita income, i.e. a Lindertype hypothesis. Bt it cold also be initiated by historical and instittional factors. 7 The change in the distribtion of people will, howeer, affect the ineqality measre since IM e decreases with ρ, bt the athorities can keep IM constant by changing ι. A greater dissimilarity in the income distribtion decreases riit. (H3) 7 A richer contry can "afford" a larger share of the poplation in the high-income stratm, bt this hypothesis also nderlines the effects of differences in historical and instittional factors. Identical contries (i.e. identical relatie endowments, income leels, and ineqality measres) can trade in different qalities if the nmber of people in each income stratm is different.

10 If the redistribtion schemes are changed so that ι e decreases and ι increases marginally, the income ineqality increases in contry e and decreases in. This implies that riit falls below nity de to similar changes in the demand pattern as in H2 aboe, while the prodction patterns are nchanged. That is, the demand and trade pattern is affected by the redistribtion schemes in both partner contries. An increased difference in the economic size has an ambigos effect on riit. (H4) If the bilateral trade partners differ in their economic size, ceteris paribs, the absolte demand and prodction will be concentrated in the larger contry, since it has a larger income leel and prodces a greater nmber of arieties. The demand effect will, howeer, be smaller than the prodction effect, de to an imperfect sbstittion between arieties. That is, the larger contry's exports increase while its imports decrease in both qality grops, and hence the riit does not fall below nity if the two contries are initially identical. If, howeer, the two trade partners differ in any sense, the riit can increase as well as decrease. This ambigity is seen if we increase (decrease) the endowments in e () while we keep all prices and relatie endowments fixed, i.e. any changes in L reflects changes in economic size. The total change in imp e is indicated by: L NM e e 1+ λ 1 1 dimp ( imp L L dl ) =, e δ O QP where dl = dl e = -dl, and we can see that the effect on imports and exports become more complex. The economic size of the two partners (i.e. a sitation with L e L ) determines the direction of the change, the relatie change between different qalities depends on the elasticity of demand, and the size of the change depends on the size of the trade flow. The total IIT, howeer, decreases when the prodction becomes more and more concentrated in the larger contry, as predicted by the New Trade Theory. Bt if we hae an initial difference between the two contries, we can not predict if the share of horizontal IIT in total IIT becomes greater or not since we allow for different elasticities of demand. In other words, a large contry can increase or decrease its exports in low-qality arieties at the same time as it decrease its exports in high-qality arieties and all imports. If, howeer, the difference in economic size becomes ery large, the riit moes towards one, een if it falls initially, since

11 the majority of the prodction of all qality leels is fond in the larger contry. Frthermore, if the aerage size of the two contries is large, an initial absolte difference in size becomes less important to initial differences between the partner contries. An increased aerage economic size has an ambigos effect on riit. (H5) The reason for the ncertainty in this hypothesis is similar to the one discssed aboe. We can analyse trade flow changes by increasing the endowments in both contries while we keep the relatie endowments nchanged. The total change in imp e is indicated by: L NM e e 1+ λ 1 1 dimp ( imp L L dl ) = +, e δ O QP where dl = dl e = dl. This implies that the relatie change in the high-qality grop is larger than in the low-qality grop, de to a higher elasticity of demand, as long as the leels of both trade flows are similar. If both contries are initially identical then an increase of the aerage economic size has no effect on riit. On the other hand, if they differ in any sense so that riit is below one, the riit cold increase as well as decrease. The otcome depends on the initial trade pattern, the elasticity of demand, and the economic size of both contries. We can compare this ambigity with the New Trade Theory and the Faley-type schemes, both of which predict an increasing olme of IIT when the aerage economic size increases.

12 The distribtion of IIT Data and Methodology Trade statistics sed in this paper originate from OECD's data base ITCS HS Reision 1, and we se trade flows at the 6-digit leel that are aggregated to 22 different NACE indstries within the manfactring sector (see Table A1 in the appendix). We hae chosen to stdy EU15 dring the period , and we calclate flows as an aerage of three years ( and , which are called period one and two respectiely), since we wish to minimise distortions from oer or nder-aled exchange rates and other temporary shocks. 8 We hae also remoed, in order to improe the data material, trade flows that are smaller than 20,000 $US, and trade flows withot any qantity measres. Frthermore, the bilateral trade within EU15 is calclated with Germany, France and Great Britain as reference contries, which lead to 36 different bilateral trade flows. 9 We se the same threshold to define two-way trade as in Fontagné and Fredenberg (1997), bt we will not define total trade of a prodct as a two-way or one-way trade type. That is, we define an oerlap, in export and import ales, as a two-way trade if the minimm ale is at least 10% of the maximm ale: Oerlap trade in prodct j is defined as IIT flows EX j IM j iff OI j = min(, ) 01.. max( EX, IM ) j j (D1) In other words, trade in prodct j is only defined as IIT if it is considered to be a significant featre of the trade flow. The reason for this is that we want to catch two-way flows steered by strctral differences between the bilateral partners, which cold be qestioned in small trade oerlaps de to statistical errors and temporary market penetrations. The former reason originates from misclassifications, transportation costs, and fewer incenties for monitoring exports; all of which affect the relationship between ale and qantity. 10 Some of these distortions are, howeer, redced since we hae already remoed ery small flows and flows withot any qantity measres. Bt we beliee in an improement of the data material if we remoe flows with OI < 0.1. This is spported by a comparison between France's and 8 See e.g. Greenaway, Hine and Milner (1994; fn 3). 9 Trade flows of Belgim and Lxemborg are assigned to Belgim in this paper. The reason for sing EU15 before 1995 is de to the free trade agreements between EU and EFTA contries. 10 For a discssion, see Yeats (1995).

13 Germany's trade flows at the 6-digit leel when both contries act as reference and partner contry. The reslts from this comparison show that only 56 % of the prodcts with OI < 0.1 matched, while 86 % of the prodcts with OI 0.1 matched. The latter reason is de to the fact that small trade flows cold be more affected by asymmetric information since these flows cold reflect temporary market penetrations. That is, high prices only signal high-qality with a certain probability, which cold be as low as zero, while low prices signal low-qality. This implies that there will be a bias towards horizontal IIT that originates from "wrong" price signals. 11 A similar comparison to the one aboe between France and Germany shows that the share of oerlapping prodcts with one (two) non-zero obseration between 1991 and 1993 is abot for (three) times larger for prodcts with OI (0.1,0) than for prodcts with OI Trade flows, defined as IIT, are diided into trade in horizontal and ertical differentiated prodcts. This separation is done with nit ales per tonne, which is a rather common approach in the recent literatre: 13 Oerlap trade in prodct j is defined as horizontal IIT iff OI j x j 01. and H j = [( 1 α),( 1+ α)], m j (D2) where x j and m j are the nit ales of export and import respectiely. The ale of α is arbitrary and we se similar ales to most stdies, i.e. α eqals 0.25 or The leels of total IIT and horizontal IIT in indstry i are therefore: IIT = 2*min( EX, IM ), hiit = 2*min( EX, IM ), ip Σ jp jp ip j Ωi( OIj' ) j Ωi( OIj', Hj' ) Σ jp jp where Ω i (OI j' ) is the set of prodcts in indstry i that hae a significant featre of IIT and Ω i (OI j', H j' ) is the set of prodcts in indstry i that hae a significant featre of horizontal IIT. These two flows are then sed to derie the ratio of horizontal IIT in indstry i: 11 See e.g. Lancaster (1996). 12 The percentages for the one (two) non-zero obseration in each grop are between % (16-22 %) and 6-8 % (4 %) respectiely. 13 See e.g. Abd-el-Rahman (1991), Greenaway, Hine and Milner (1994, 1995), and Fontangé and Fredenberg (1997).

14 riit i hiiti =, (D3) IIT i which is sed to analyse the distribtion of horizontal and ertical IIT. One drawback of the empirical measre is that we can not measre IIT in different qality leels within a certain prodct grop, and thereafter compare this with the total IIT of the prodct grop. The empirical measre calclates the aerage similarity or dissimilarity in the qality leel of the trade flow of a certain prodct. That is, it assmes that all IIT in a certain prodct grop is either horizontal or ertical IIT, bt it still reflects the nderlying model of this paper and it corresponds with the theoretical measre when a contry only prodce one qality. Indstry leel We start with a riit at the indstry leel, and we se a rather generos measre of horizontal IIT (i.e. α=0.25). In other words, we allow for rather large price differences between imports and exports before we call its trade flow a two-way trade in ertical differentiated prodcts. Figre 1 presents the arithmetic mean of riit (α=0.25) and the ariation coefficient within each indstry. 14 We can see in Figre 1 that there are large ariations between the different indstries. Manfactre of tobacco prodcts is the indstry with the smallest share of riit while manfactre of basic metals has the largest share. Other indstries with relatiely large shares of horizontal IIT are manfactre of food, plp and paper prodcts, rbber and plastic prodcts, and motor ehicles. The share of horizontal IIT, howeer, is in general rather small, althogh we hae applied a generos definition of horizontal differentiation. Only one indstry, manfactre of basic metals (NACE code 27), has a share greater than 50%. Figre 1: Aerage riit (α=0.25), period one. Figre 1 also indicates that there are large ariations within each indstry, which is indicated by the ariation coefficients. All bt one indstry in the manfactres of electrical and optical eqipment and motor ehicles (NACE code 30-36) hae a ariation coefficient that exceeds 0.5. The highest ariation coefficients, howeer, are fond in indstries sch as manfactre of tobacco, paper, and coke and refined petrolem. This sggests that there are not only large differences between indstries, bt also within each indstry. And the pictre 14 The ariation coefficient is defined as the ratio between the standard deiation and the mean, and this coefficient indicates wether there are relatie large ariations within a particlar indstry.

15 that emerges from Figre 1 is also spported by another measre of the importance of horizontal IIT, the ratio between the nmber of prodcts related to horizontal IIT and the nmber of prodcts related to total IIT. This ratio, shown in Figre A1 in the Appendix, confirms the aboe pattern, bt it downsizes the importance of horizontal IIT as compared to the riit measre sed in Figre 1. We can also see that the ariation between and within indstries mitigates, bt it does not disappear since we can see that the ariation pattern is similar to the one discssed aboe. A qestion that arises is wether the patterns fond in Figre 1 are coherent oer time. If we compare the indstries' mean riit of period one with the mean riit of period two, we obtain a rather nclear pattern (see Figre A2 in the appendix). Manfactre of coke and refined petrolem show ery large changes between the two periods, bt there are also seeral indstries with small changes. We can also see that riit, in general, has decreased for indstries between 27 and 36, while it has increased for indstries between 15 to 26. There are, howeer, some problems when we compare these two periods, since there has been a break in the method of collecting trade statistics within EU. The realisation of the internal market implied that firms within the EU became responsible for reporting trade flows within the EU. Contry leel The next isse concerns the contry dimension of riit. Figre 2 presents the aggregated bilateral riit (α=0.25) of period one, and we can see that the largest share of horizontal IIT is fond between Germany and France (arond 60%), while the smallest share is fond between France and Ireland (arond 16%). The figre presents two different patterns; one rather nclear pattern, indicating differences between different partner contries independently of the reference contry, and another ery distinct pattern, indicating large differences between the different reference contries independently of the partner contry. The latter pattern is particlarly isible in the case of Astria, which has a share of horizontal IIT that is greater than 50% with Germany, arond 40% with France and arond 25% with Great Britain. Figre 2 also shows the effect of a geographical aggregation of trade flows, i.e. we can see a conergence towards a rather high ale of riit as soon as we aggregate oer EU15 or oer all trade partners (AAA). The aggregation oer EU15, howeer, implies that horizontal IIT is more important in intra EU than extra EU trade flows. Figre 2: Aggregated riit; α=0.25, period one.

16 Are these patterns coherent oer time? Figre A3 in the appendix presents percentage changes of the aggregated riit between the two different periods. No clear trend emerges since the riit of all three reference contries increases with some partner contries and decreases with others. The figre also shows that the changes of a partner contry's bilateral riit are not coherent between different reference contries. Finland, for example, has increased its share of horizontal IIT in total IIT with both the UK and France, while it has decreased with Germany. We can see, howeer, that the importance of horizontal IIT for all reference contries has decreased when we aggregate trade flows oer all partner contries, and that the importance of horizontal IIT in EU15 trade flows has decreased for Germany and Great Britain bt increased for France. The Econometric Analysis Independent Variables The hypothesis abot the effect of differences in relatie factor endowments is tested with two different proxies, relatie physical and hman capital. We s the absolte difference in nonresidential Capital Stock per Worker (in 1985 international prices) as a proxy for relatie physical capital, which originates from the Penn World Table (PWT) Mark 5.6. The proxy for relatie hman capital is the proportion of total poplation that has attained a higher edcation, which originates from Erostat. 15 The second hypothesis is tested with the absolte difference in the real GDP per capita in constant 1992 dollars (the base year is 1985), and this proxy also originates from PWT. The argment for sing this proxy is that a more similar per capita income leads to a more similar demand pattern; or in other words, the distribtion of people in different income leels becomes more similar. This hypothesis catch the idea of Linder-hypothesis that " per capita income differences are a potential obstacle to trade, trade can only take place in certain qalitatiely homogeneos prodcts." (Brenstam-Linder (1961, p. 98)). In this paper we allow for qality differentiation bt we expect that the demand strctre regarding the qality leel is steered by the per capita income, and therefore we expect horizontal IIT to be higher when the per capita income is more similar. We will also se land border dmmies since the closeness between two bilateral partners can indicate similarity in the demand pattern de to rather similar historical and instittional factors. 15 Higher edcation is defined by leel 5-7 of ISCED (International Standard Classification of Edcation).

17 The proxy sed for the third hypothesis is the absolte difference between the bilateral partners' Gini coefficients. The Gini coefficients sed in this paper are collected from UN's World Deelopment Indicators Finally, we will also control for the market size of the bilateral partners, both the aerage size and the absolte difference in size. We se the GDP in PPP 1991 prices to define the economic size, since it controls for different price leels, and the data originates from OECD's Otlook We will also se an interaction term (INTER) between the aerage GDP (AVGDP) and the absolte difference in GDP (DGDP). This interaction term is sed since we expect a rather complex relationship between the share of horizontal IIT in total IIT and the market size. Table 1: Smmary of the proxies that reflect the hypotheses. Hypothesis: Expected Proxy: sign: Explanation: H1 - DKPL Absolte differences between bilateral partners' capital stock per worker, in thosands of $US. H2 - + DGDPC BORD Absolte differences between bilateral partners' GDP per capita, in thosands of $US. Land border dmmies. H3 - DGIN Absolte differences between bilateral partners' Gini coefficients. H4 -/+ DGDP Absolte differences between bilateral partners' GDP, in hndreds of thosands $US. H5 -/+ AVGDP Aerage GDP of the bilateral partners, in hndreds of thosands $US. +/- INTER Interaction term between DGDP and AVGDP. The Regression Model The theoretical part of this paper does not lead s to any fnctional form that can be sed in the econometric analysis, and we will therefore se different regression methods for testing the sign relationships established in the formal model. 16 The data material consists of a nmber of cases where we hae total ertical or total horizontal IIT in the obsered bilateral trade flow, i.e. riit eqals zero or one. The material reeals that there are 14.4 % (9 %) zeros and 0.1 % (0.6 %) ones when α eqals 0.15 (0.25). These cases are important to consider in the analysis since they sggest that the trade flow is specialised, de to spply or demand factors, in different qalities. The first regression model is a Least Sqares (LS) estimation of riit lj. A drawback of the LS estimation is that the dependent ariable is a proportion between zero and one, i.e. the estimation gies s inefficient estimates, de to heteroskedasticity, and predictions are not 16 Note that we base the econometric analysis on the first period, i.e. the aerage trade flows between

18 constrained between zero and one. We will therefore se, to contrast the LS model, the Tobit model; which has an appealing constrction since we se the obsered IIT when there is a strctral two-way trade, and zero if otherwise. The analysis is performed with panel data that consists of two dimensions, 36 bilateral partners (P) and 22 indstries (J), and we therefore test for indstry effects before we define the assmption of the error term. The reslts of these tests are fond in Table A2 in the Appendix, and they sggest that the indstry effects are significant. We also searched for any particlar indstry or constellation of indstries that cold explain the indstry effects, bt cold not pinpoint a special indstry or grop of indstries. One constellation was obtained by pooling indstries according to technology, and high-, medim-, and low-technology indstries were considered (see Hatzichronoglo (1997)). Other constellations were obtained by pooling the most significant indstries, and testing for each specific indstry one at a time. The discssion aboe points towards a fixed indstry effect model for the linear specification, and we se Arellano's method (see Baltagi (1995)) to calclate a robst general ariance-coariance matrix. That is, we assme that E[ mj, ps ] = w mjs if m = p, and zero in all other cases. We also considered a WLS, which gae similar reslts when we assmed indiidal obserations. The reslts were sensitie, howeer, to the different ariables sed as an approximation of the grop size. The FE model is therefore defined as: = α + X β + λ + µ, riit pj p j pj where X p is the matrix of independent ariables, and λ j the fixed indstry effect. The Tobit model is estimated by: riit pj = X p β + λ j + µ pj, where λ j is estimated as ordinary parameters. We se this method since P = 36 > J, and hence the estimation gies s P consistent λ j. Regression Reslts The reslts from the regression of the FE and the Tobit model, when α eqals 0.25, are fond in Table 3. The regressions of this mlti-contry and mlti-indstry approach show a rather high oerall fit, and the adjsted R 2 for the FE model stretches from 0.23 to Moreoer,

19 the specification tests sggest that the regression model is rather good since we can reject heteroskedasticity and general alternatie specifications, which is implied by the reslts from White's and Ramsey's tests in Table 3. Ramsey's test sggests frther that there are significant indstry effects, since the reslts reject the nll hypotheses if we exclde the fixed effects (these reslts are not presented). The regression reslts from the Tobit model are also fond in Table 3, and we can see that the log-likelihood fnction follows the same pattern as the adjsted R 2 in the FE model. We hae sed a heteroskedastic Tobit model in all regressions since LM tests (see Greene (1997)) rejected homoskedasticity. A more seere problem was that we cold not reject nonnormality. The signs of the different coefficients are well in line with the expectations from the theoretical part. 17 We can see that the impact from differences in relatie factor endowments on riit follows the expectations in all regressions, both in the FE and Tobit model. This is indicated by the highly significant and negatie coefficients of DKPL and DHK. This implies that two contries tend to, as long as the nit ales actally indicate different qality leels, specialise prodction towards different qality leels if they become more dissimilar in their relatie endowments. We can see, howeer, that the coefficient of DKPL becomes insignificant in eqation (iii) and less significant in eqation (i) of the Tobit model. One explanation to this pattern cold be a mlticollinearity problem since DKPL's correlation with DGDPC and BORD is 0.42 and 0.46 respectiely. And we sspect that this affects the Tobit model more than the FE model. Howeer, we can see that the impact of DHK does not become less significant and its ale is rather stable oer all regressions. That is, differences in relatie hman capital seem to be more important, than differences in physical capital per worker, to explain specialisation pattern in qality. The second hypothesis is spported in all regressions. That is, a similar demand pattern, de to the similar distribtion of the poplation oer different income leels, increases horizontal IIT. This hypothesis is reflected by the similarity in per capita income leel between the bilateral partners and the spatial closeness. The former is measred by the proxy DGDPC, and the latter by the proxy BORD. The coefficients of these proxies are highly significant, and they hae the "right" sign if we accept that spatial closeness indicates similar demand patterns. The distance may, of corse, also affect the spply side, since we may expect that transportation cost increases with distance. Bt we expect this to hae a rather low 17 The reslts in Table 3 are also spported by the simple correlation matrix in Table A4, which is sefl if we find that the links between the theory and the regression are a bit "fzzy" (see e.g. Leamer (1994)).

20 impact on the riit since all trade flows are intra-eu trade. Moreoer, we control for agglomeration effects, de to economies of scale and transport costs, since we inclde differences in the economic size. The sign of the coefficient of DGIN aries between negatie and positie. Or hypothesis, howeer, was that it shold hae a negatie relationship since an increased (decreased) ineqality tends to increase (decrease) the wealth of high-income consmers, and hence changing the consmption pattern. 18 Howeer, the econometric interpretation is harsher since the coefficient is insignificant in all regressions. That is, the ariation of the income distribtion within the EU does not explain the ariation of riit. Both the aerage and the difference in economic size seem to hae a negatie impact on the share of horizontal IIT in total IIT. The interpretation of these reslts is, howeer, not straightforward. The reason for this is that the coefficients of AVGDP and DGDP mst be considered with the interaction term, and the coefficient of DGDP becomes insignificant if we exclde this term. Frthermore, the F-tests in Table 3 indicate that the linear restriction (see note e in Table 3) is rejected, i.e. the sms of the coefficients of INTER and AVGDP/DGDP are significant different from zero. The interaction term indicates that the partial differentiation with respect to AVGDP is negatie as long as the difference in economic size of the trade partners is small, bt it becomes positie when the difference in size increases. The same ambigity is alid for the partial differentiation with respect to DGDP. This is negatie as long as the aerage size is small, bt it becomes positie when the aerage size increases. This pattern reflects the discssion in the theoretical part, which nderlined that a larger aerage market size mitigates the possibility that an increased difference in market size, between contries initially different in size, has a negatie impact on the share of horizontal IIT in total IIT. The reason behind this is that two large markets prodce many arieties within the combined market and an increased absolte difference in their total income dierge the prodction of some arieties in all qality leels to the bigger contry. Bt there will still be a prodction of all qalities within both contries, and we may expect that the share of horizontal IIT increases since IIT in all qality leels will become determined by the export from the smaller contry. 18 The implicit assmption behind the negatie sign is that a richer contry tends to prodce higher qalities, de to a close link between factor endowments and income, and hae a more eqal income distribtion.

21 Table 3: Regression reslts. Dependent ariable: riit lj Independent ariables Exp. Sign Specification: FE(j) a b Specification: Tobit c d α = 0.25 α = 0.25 (i) (ii) (iii) (i) (i) (ii) (iii) (i) DGDPC (0.02) (0.03) (0.04) DKPL (0.01) (0.01) (0.01) (0.51) (0.10) DHK DGIN (0.42) (0.98) (0.87) (0.67) (0.31) (0.70) (0.76) (0.98) AVGDP -/ (0.02) (0.09) (0.02) (0.02) DGDP -/ (0.83) (0.65) INTER +/ BORD Indstry dmmies Yes Yes Yes Yes R 2 adjsted Log likelihood / # iterations -11 / 38-4 / 39 7 / 43-3 / 40 P-ales from: Linear restrictions e White's test Ramsey's reset test Notes: a There are 792 obserations, 22 indstries and 36 different bilateral trade flows. b The ales in brackets are the p-ales, which are calclated with Arellanos robst standard errors (see Baltagi (1995) and Greene (1997)) and a two-sided t tests. Moreoer, coefficients in bold letters are at least significant at a 10% leel. c We se maximm likelihood estimations with indstry parameters, and we show the marginal effects. The ales in brackets are the p-ales, and coefficients in bold letters are at least significant at a 10% leel. d The heteroskedastic model is defined as σ i 2 = σ 2 (e γ'zi ) 2, where Z i is a sbset of the independent ariables (DGDPC (when sed in regression), DKPL, and AVGDP). e The linear restrictions are AVGDP+INTER = 0, and DGDP+INTER = 0. We fond rather robst reslts in Table 3 aboe, bt what happens if we alter the threshold for horizontal and ertical IIT so that α eqals This change implies that we narrow the allowed ariation band of the nit prices when we decide whether an oerlap in a trade flow is to be defined as a similar qality or not. The oerall pictre of the sign relationship, as we can see in Table A3, is similar to the reslts discssed aboe, both regarding the signs of the coefficients and the reslts from the specification tests. We can also see that the ale of the coefficients decreases, which is as expected since we hae decreased

22 (increased) the olme defined as horizontal (ertical) IIT. Bt we can also see that the explanatory ale falls, and so does the significance of seeral coefficients. This implies that the definition of α is important. A smaller α cold increase the probability of defining an actal horizontal IIT flow as ertical, if we moe the threshold from its "tre" ale. Sch a scenario implies that the explanatory ales of the ariables decrease, and the same is tre if we define an actal ertical IIT flow as horizontal. The argment for this is that ariables with a distinct effect on the distribtion of horizontal and ertical IIT become ineffectie to explain ariations in riit since this measre does not reflect sch a distribtion anymore. Both diision lines sed in this paper spport, howeer, in general the sign relationship deried from the formal model. Bt the econometric interpretation of differences in per capita income and differences in physical capital per worker becomes shaky since their coefficients become less significant, especially in the FE model. Howeer, differences in hman capital, spatial closeness, and market size are still significant in all models. That is, the hypotheses from the theoretical framework are still spported, een thogh we change the threshold. Deconstrcting EU Another robstness test, following Greenaway, Milner and Elliott (1999), is to diide the sample into two different geographical areas, EU-north and EU-soth, that are made p of more homogeneos contries. 19 The reslts that are presented in the paper of Greenaway, Milner and Elliott after sch an exercise challenged the robstness of both contry-specific as well as indstry-specific factors, which to some extent cold be explained by mlticollinearity problems. We can see in Table A5 and A6 that mlticollinearity is a problem for the geographical area defined as EU-soth since many proxies are highly correlated to each other, bt it is not a problem in the area defined as EU-north. We can still see, howeer, that both of the geographical areas show the same pattern regarding the correlation between the proxies and the dependent ariable as the whole sample in Table A4. The reslts from the regressions when we diide EU into two geographical areas are fond in Table A7; and we can see that the reslts from the regression of EU-north are ery similar to the reslts from the whole sample, except for differences in per capita income. That is, we do not find any changes in the sign relationship and the explanatory ale increases to 0.27 compared to 0.26 in the whole sample. The only change is that similarities in per capita 19 Italy, Spain, Portgal, and Greece define EU-soth; while EU-north consists of the other EU members.

23 income does not seems to explain any similarities in demand within a rather homogeneos, regarding the aerage per capita income, grop of contries. Howeer, the regression of EU-soth does not, in first sight, show any reslts that spport the hypotheses since all coefficients are insignificant. Bt, as Table A6 sggests, this is de to mlticollinearity problems. We can find some robst reslts if we se a sbset of all proxy ariables. Frthermore, the interaction term seems to be less important to determine the pattern of the share of horizontal IIT in total IIT. The regression reslts when we exclde differences in income distribtion and the interaction term show a strong spport for that similarities in relatie abndance in hman capital and in per capita income increases the share of horizontal IIT. Bt we can see that the importance of the market size mitigates. The diision of EU into two different geographical areas does not, howeer, contradict or hypotheses, and it seems to nderline that relatie hman capital dissimilarities are important to explain the ariation of the share of horizontal IIT in total IIT. Conclsions and Smmary In this paper we consider a model that integrates ertical and horizontal differentiation in order to link hypotheses regarding the distribtion of ertical and horizontal IIT in bilateral trade flows with an econometric analysis. The adantage of this approach is that we consider two complementary theories of IIT, the New Trade Theory and Faley-type schemes, within the same analysis, which increases the transparency of the empirical analysis and redces problems sch as omitted ariables. This approach leads s to some familiar and some less familiar hypotheses. One hypothesis is that that the share of bilateral horizontal IIT in total IIT (riit) decreases if two trade partners become more dissimilar in their relatie capital endowments, and in this paper we extend this to both physical and hman capital. Another set of hypotheses points ot the importance of the distribtion of both income and consmers between different income strata since this will affect trade throgh the demand pattern. Finally, the model stress the importance of the economic size, and that its relationship with both horizontal and ertical IIT becomes more complex when we allow goods in an indstry to ary within and between qality leels. The econometric reslts spport, in general, the predictions of the model, except for the prediction that a more similar income distribtion increases riit. The reslts strongly spport the hypothesis that differences in relatie capital endowment matters. That is, a greater difference in relatie capital endowments implies that the traded partners are specialised in