As discussed in Chapter 3, perhaps the most controversial issue in the measurement of IIT relates to the definition of “industry” employed in compiling the data base. Sceptics such as Finger (1975), Lipsey (1976) and Rayment (1976) have argued that almost all measured IIT is purely a statistical artefact brought about by “categorical aggregation”. In this appendix, we provide a systematic analysis of this potential problem by identifying its sources and quantifying its effect on the measurement of IIT.

Categorical aggregation has two conceptually distinct components, which we will call “product misclassification” and “aggregation bias”. Finger (1975), Lipsey (1976) and Rayment (1976) emphasise the product misclassification aspect, arguing that the problem lies with trade data classification systems which group data within heterogeneous categories. To rectify this problem, they suggest regrouping the basic data such that the resulting categories conform more closely to the theoretical construct of an industry.

The definition of an “industry” with respect to product homogeneity is still under dispute, however (Lloyd 1989). For instance, Finger (1975) defines an industry as one where the products produced are similar with respect to their factor intensities. Falvey (1981), on the other hand, concentrates on the specificity of factors and defines an industry by the range of products that a certain type of capital equipment can produce. While these definitions concentrate on the production side, Lancaster's (1980) definition focuses on consumption: “a product class in which all products, actual and potential, possess the same characteristics, different products within the group being defined as products having these characteristics in different proportions” (p. 153).

It is clear from the discussion above that there is no unique criteria for regrouping the data. Furthermore, none of these definitions deal adequately with the problem of how to allocate trade in parts and components in any reclassified scheme. All in all, it is unclear if the arduous task of regrouping would yield any improvement upon established trade classification systems.