Intra-Industry Trade Theory in Vertically Differentiated Products

This paper presents a theory of international trade in a two sector, one factor economy in which one sector is vertically differentiated. The paper shows that trade arises from the cost differences in goods in this sector between countries. Furthermore, this trade is characterized as inter-industry trade when cost differences are uniform and intra-industry trade when cost differences are biased. Uniform cost differences occur when there is a difference in labor productivity in the homogeneous goods or a difference in the fixed cost required for the differentiated goods between countries. Biased cost differences result from changes in the parameter of the cost function representing the rate of change in cost in relation to quality. In both cases, an economy with either of these types of trade is more efficient than an autarkic economy because production is increased.