Product Quality Index: A New Way to Classify Intra-industry Trade

Date01 November 2019
Published date01 November 2019
Subject MatterCommentary
07_FTR874227.indd Commentary
Product Quality Index:
Foreign Trade Review
54(4) 408–421, 2019
A New Way to Classify
© 2019 Indian Institute of
Foreign Trade
Intra-industry Trade
Reprints and permissions:
DOI: 10.1177/0015732519874227
L. G. Burange1
Hemangi K. Kelkar1
The increasing intra-industry trade (IIT) gives an impetus to theoretical founda-
tions of new trade theories. For the empirical assessment, the measurement and
segregation of IIT become very essential. On the basis of quality of product, IIT
is segregated into two parts. First is based on qualitative differentiation of the
products known as vertical IIT (VIIT) and the second is based on the differentia-
tion of the products called as horizontal IIT (HIIT). The work of Greenaway,
Hine, and Milner (1994, Weltwirtschaftliches Archiv, 130(1), 77–100), Fontagné and
Freudenberg (1997, Intra-industry trade: Methodological issues reconsidered, Paris:
Centre d’Études Prospectives et d’Informations Internationales) and Azhar and
Elliott (2006, Review of World Economics, 142(3), 476–495) are some of the mile-
stones in the methodological development of IIT. However, these methods are
not free from certain shortcomings. Thus, the article attempts to extend the
measurement technique with product quality index (PQI) to overcome the exist-
ing shortcomings such as arbitrariness of dispersion limit and bias in the classifi-
cation of IIT into HIIT and VIIT.
JEL Code: F140
Intra-industry trade, product differentiation, horizontal intra-industry trade,
vertical intra-industry trade, low-quality intra-industry trade, high-quality intra-
industry trade
1 Mumbai School of Economics and Public Policy, University of Mumbai, Kalina, Mumbai, Maharashtra,
Corresponding author:
Hemangi K. Kelkar, Mumbai School of Economics and Public Policy, University of Mumbai, Ranade Bhavan,
Third Floor, Vidyanagari, Kalina, Mumbai, Maharashtra 400098, India.

Burange and Kelkar 409
Increase in trade within industry paved a way for the complementary approach
for new trade theories. Prior to new trade theories, it is often argued that factor
endowment difference between the countries is crucial for engaging in foreign
trade. However, the growing dominance of intra-industry trade (IIT) proved that
countries with similar factor endowment also gain from trade. In addition to
this, reallocation of resources within the same industry is easier and cheaper as
factors of production and skills of labour remain the same. The literature regard-
ing IIT is concerned with two distinct strands. First aspect focuses on the quan-
titative or volume-based measurement of IIT which examines the problems
arising with given measurement technique, aggregation and issues related with
the changing dynamics of IIT. Second aspect is related with the qualitative or
value-based measurement of IIT. In case of qualitative measurement, the focus
is on the segregation of IIT. On the basis of product quality, IIT is segregated
into horizontally differentiated IIT (HIIT) and vertically differentiated IIT
(VIIT). In case of HIIT, products are close substitutes to each other and differ-
entiable only in their outer attributes. VIIT, on the other hand, is associated with
large differences in the quality of products. Various indices are developed to
segregate IIT into HIIT and VIIT. The issue pertaining to segregation of IIT is
important because it is essential to segregate IIT to measure the appropriate
trade adjustment cost. In addition to this, it is also important to know the quality
of IIT products. This aspect is explained by the ‘quality ladder hypothesis’.
According to the quality ladder theory, the high-income countries export high-
price and high-quality products, while low-income countries export low-quality
and low-price products. With economic development of the country, there is a
shift from low-quality exports to high-quality exports. This implies the qualita-
tive improvement in products traded in foreign trade and considered as the
country is moving up on its ‘quality ladder’ (Ando, 2006). The segregation of
IIT helps to test this hypothesis.
The methodological developments related to segregation of IIT have under-
gone through difficult task of developing the index with which products within
the same industry can be differentiated. The pioneering work in this regard is
made by Abd-el-Rahman (1991). Thereafter, two broadly similar methods have
been developed to differentiate IIT. First method has been suggested by,
Greenaway et al. (1994) (GHM method) based on work of Abd-el-Rahman
(1991). Second is developed by Fontagane and Freudenberg (1997) (FF method)
which is also based on work of Abd-el-Rahman (1991). Furthermore, Azhar and
Elliott (2006) (AE method) criticised FF and GHM methods and developed a
new index to segregate IIT. However, the major drawback of the methods devel-
oped by Greenaway, Hine and Milner, Fontagné and Freudenberg, and Azhar
and Elliott are related with the dispersion percentile (α) to segregate IIT into
HIIT and VIIT. The value of (α) is considered as an arbitrary one. Thus, the
segregation of IIT varies according to the choice of dispersion percentile.
Although the choice of cut-off point is crucial as it leads to change in the pro-
portion of IIT into each category. It is also argued that cut off point may differ

Foreign Trade Review 54(4)
as per the country specific factors such as tariff rate and transportation cost.
Therefore, the choice of cut-off point creates the ambiguity in the empirical
results. Furthermore, the existing GHM, FF and AE indices are based on une-
qual proportion of IIT into HIIT and VIIT. As a result, there is upward (down-
ward) bias in the measurement of VIIT (HIIT). The propose methodology in
tries to overcome these issues.
Based on the work of Azhar and Elliott (2006), the product quality index (PQI)
is developed. PQI helps to remove the randomness in the selection of dispersion
limit. Thus, attempts are made to find out the solution for the measurement prob-
lem and develop a new measurement technique to overcome the existing short-
comings in dispersion percentile. The remaining article is organized as follows:
The second section reviews the theoretical and methodological development
related to HIIT and VIIT. The third section provides the details about the construc-
tion of PQI. The empirical assessment of PQI is presented in the fourth section.
The fifth section concludes the article.
Review of Literature
The theoretical evolution of IIT dates back to the 1960s. The term IIT was
introduced by Balassa (1966) in the year 1966. To measure the extent to which
the export of given commodities is equivalent to the import of the same com-
modities, he developed an index which is known as Balassa index. It was first
attempt to measure IIT. Furthermore, Grubel and Lloyd (1975) (GL method)
made simple modification in Balassa index and created a new milestone in the
methodological development of IIT. At the next stage, theoretical underpinning
related with IIT to focus on the segregation of IIT. The exchange of products
within same industry takes place because of differentiation in the outer attrib-
utes of the products such as colour and packing or the qualitative differences in
the similar looking products. The consumer preferences also play a crucial role
in influencing the demand for IIT...

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