October, 2018

I. The Emergence and Development of the Modern International Trade

Theory or the New Trade Theory (NTT)

International trade cannot be explained neatly by one single theory.

Furthermore, our understandings of international trade theories continue to
evolve. Thus, international trade is complex and is impacted by numerous and
often – changing factors.

Modern theories of trade emerged after World War II and these theories were
developed in large part by Business School Professors, not economists.
Moreover, many of these theories are firm – based as opposed to country -
based traditional theories of the classical and neoclassical schools.

I.1. What area the Factors that Led to the Emergence and
Development of the New Trade Theories?

i) The rise of transnational corporations

ii) Economic globalization
iii) The improvement and development of the
multilateral trading system
iv) Challenges to the traditional theory of international
trade. In other words, the traditional trade theory has
not convincingly explained the phenomenon of many
important aspects of international trade.
v) Specifically, the traditional trade theories focused on
inter – industry trade between the developed and
developing countries as opposed to intra-industry
trade between developed countries. In addition, the
former is based on the restrictive assumptions of
constant returns to scale and perfect competition,
while the latter is based on economies of scale and
imperfect completion.

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 (Please read about economies of scale and how they
arise)
vi) The development of the theory of industrial
organization
vii) The theory of the “New Economic Geography” also
plays a role in the NTT. For a long time, international
economists more or less ignored such concepts as
distance, space and transportation costs. The new
economic geography is the emergence of large
agglomerations (that is, firms in related fields of
business cluster together and, thus their cost of
production declines) which relies on increasing
returns to scale and transportation costs. The whole
approach has a distinct general equilibrium flavor.
The interactions between different markets, between
firms and their suppliers and customers, and the dual
role of workers as production factors and consumers
are emphasized. The gravity model of international
trade by Jan Tinbergen in 1962 is an example.
I.2. The List of Modern Trade Theories/New Trade Theories
(NTTs)

The new trade theory (NTT) is a collection of economic models in

international trade which focuses in the role of increasing returns to
scale and network effects, which were developed in the late 1970s and
early 1980s. Network effect is a phenomenon whereby a good or
service become more valuable when more people use. However, if too
many people use the good or service, negative network effect can
occur, such as congestion. This decreases the utility for users.
Therefore, providers of goods and services which use a network
effect must ensure that capacity can be increased sufficiently to
accommodate all users. The internet is a good example.
The following list comprises the new trade theories:
i) The Gravity Model
ii) Intra – Industry Trade
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 iii) Technology Gap Theory
iv) Product Life – Cycle Theory
v) Country Similarity Theory/Overlapping Demand Theory
vi) Global Strategic Rivalry Theory
vii) National Competitive Advantage Theory

i) The Gravity Model

The gravity model of trade in international economics predicts

that bilateral trade flows are based on economic sizes (often
using GDP measurements) and distance between two units.
The model was first used by Jan Tinbergen in 1962. Jan
Tinbergen (April 12, 1908 – June 9, 1994) was a Dutch
Economist, who was awarded the first Bank of Sweden Prize in
Economic Sciences in Memory of Alfred Nobel (the Nobel
Memorial Prize in Economic Sciences) in 1969. He shared the
prize with a Norwegian Economist, Ragnar Frisch (1895 –
1973), for having developed and applied dynamic models for
the analysis of economic processes.
The gravity model has also some application in international
relations to evaluate the impact of treaties and alliances on
trade as well as to test the effectiveness of trade agreements
and organizations such as the North American Free Trade
Agreement (NAFTA) and the World Trade Organization
(WTO).

ii) Intra – Industry Trade (IIT)

Intra – Industry trade refers to the exchange of differentiated

or similar products belonging to the same industry. In other
words, it is a simultaneous export and import of similar
products. It sometimes is referred to as two – way trade.
Examples of this kind of trade include automobiles, foodstuffs
and beverages, computers and minerals

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 Interest in this phenomenon was largely stimulated by woks
done in the 1970s on the impact of the formation of the
European Economic Community (EEC) on trade flows within
the member countries. The original study was that by
Verdoorn on the change in the pattern of trade of the Benelux
countries (that is, Belgium, the Netherlands, and
Luxembourg). The title of the study was “The Intra – Bloc
Trade of Benelux” by Verdoorn, P. J. (1960), in Robinson (ed.)
(1980). Balassa also made an analysis of the product
composition of trade for EEC members and found that trade
was in similar goods. Grubel and Lloyd estimated that 71% of
the increase in trade between the EEC countries from 1959 to
1967 was intra – industry trade. (See, for example, Sodersten
and Reed, Chapter 8)
Recent contributors to the analysis of IIT include Krugman
(1979), Lancaster (1980), and Helpman (1981). In 2008,
Krugman won the Nobel Memorial Prize in Economic Sciences
for his contribution to New Trade Theory and New Economic
Geography. In his contribution, Krugman explained the
patterns of international trade, and the geographic
concentration of wealth, by examining the effects of economies
of scale and consumer preference for diverse goods and
services. Krugman is ranked among the most influential
economic thinkers in the United States.

There are two major forms of product differentiation: i)

Horizontal differentiation based on certain characteristics or
attributes such as, for example, color and taste of a wine, and
ii) Vertical differentiation based on quality which appeals to
consumers’ income or purchasing power.

There are at least three major reasons for product

differentiation:

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 a) Producers attempt to distinguish their products in the
minds of the consumers in order to achieve brand
loyalty. Similarly, consumers want a broad range of
characteristics in a product from which to choose.
b) Transport costs could play a role in causing intra –
industry trade, especially if the product has large bulk
relative to its value. In other words, the ‘New Economic
Geography” play a role in the NTTs. Thus, transport
costs are accounted for in the NTTs.
c) Differing distributions of income can lead to intra –
industry trade.

iii) Technology Gap Theory

The technology gap theory describes an advantage enjoyed by

an industrial country that introduces new product in a market.
As a consequence of research activity and entrepreneurship,
new goods are produced and the innovating country enjoys a
monopoly until the other countries learn to produce these
goods. In the meantime, these other countries have to import
the goods. Thus, international trade is created for the time
necessary to imitate the new goods.

According to Michael V. Posner’s (1961) hypothesis, the same

technology is not available to all countries (note that the H – O
theory assumed the same technology). Thus, there is a delay in
the transmission/diffusion/dissemination of technology from
one country to another.

There are two components of lags: imitation lag and demand

lag. Imitation lag is defined as the length of time, for example,
15 months, that elapses between the product’s introduction in,
say, country I and the appearance of the version produced by
firms in, say, country II. The imitation lag includes a learning
period during which the firm in country II must acquire
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 technology and know – how in order to produce the product.
In addition, it takes time to purchase inputs, install equipment,
process the inputs bring the finished product to the market,
etc. The demand lag is the length of time between the product’s
appearance in country I and its acceptance by consumers in
country II as a good substitute for the product they are
currently consuming. This lag may arise from loyalty to the
existing consumption bundle, inertia, and delays in
information flows. Brand loyalty is the tendency of some
consumers to continue buying the same brand of goods than
competing brands. Suppose the demand lag is 4 months. A key
feature of the Posner theory is the comparison of the imitation
lag with the demand lag. According to the example given
above, the net lag is 15 months – 4 months = 11 months. During
the 11 – month period, country I will export the product to
country II. Before this period, country II had no real demand
for the product. After this period, firms in country II are also
producing and supplying the product so that the demand in
country I diminish.

By the time country II had managed to produce and supply the

product, Country I may have introduced still newer products
and newer production processes. Thus, country I is able to
export these products based on the new technology gap
established. Therefore, the central point in the technology gap
model is that trade focuses on new products.
iv) Product Life – Cycle Theory

This is a generalization and extension of the technology gap

model. The product life –cycle theory is an economic theory
that was developed by Raymond Vernon, a Harvard Business
School Professor, in the 1960s. The theory originated in the
field of marketing. The theory suggests that early in the
product’s life – cycle, all the parts and labor associated with
that product come from the area in which it was invented.
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 After the product becomes adopted and used in the world
market, production gradually moves away from the point of
origin. In some situations, the product becomes an item that is
imported by its original country of invention. A commonly
used example of this is the invention, growth and production of
the personal computer (PC) with respect to the USA. The
model applies to labor – saving and capital – using product
that (at least at first) cater to high – income groups. In
addition, the model demonstrates dynamic comparative
advantage. In other words, the country that has the
comparative advantage in the production of the good changes
from the innovating (developed) country to the developing
countries.
There are at least three major stages in the product life – cycle
theory: i) New product, ii) Maturing product and iii)
Standardized product. In the new product stage, the new
product, for example, PC is produced and consumed in the
USA and, thus no export trade. In the maturing product stage,
mass production techniques are developed and foreign demand
in developed countries expands. Thus, the USA exports PCs to
other developed countries. In the standardized product stage,
production moves to developing regions. Today, the PC is in
the standardized product stage, and the majority of
manufacturing and production process is done in low – cost
countries in Asia and Mexico. Thus, these countries will export
the product to developed countries. (Note: Please see the
graphical representations of the product life – cycle model in
high – income countries as well as in low – income countries)

v) Country Similarity Theory/Overlapping Demand

Theory

This theory was pioneered by Swedish economist Steffan

Linder in 1961. The theory proposed that consumers in
countries that are in the same or similar stage of development
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 would have similar preferences. In other words, consumer
preferences largely depend on their income levels and the
country’s per capita income levels. Consequently, countries
with high per capita income will need high – quality
manufactured goods (luxury goods), while countries with low
per capita income would be on the low quality of products
(necessity). Lindel’s hypothesis postulates that as countries’
per capita income levels close, the structure of their demand
would overlap.
vi) Global Strategic Rivalry Theory
The theory was pioneered by Paul Krugman and Kelvin
Lancaster in the 1980s. It focused on multinational companies
(MNCs) and their effort to gain a competitive advantage
against other global firms in their industry. According to the
theory, the critical ways that firms can obtain a sustainable
competitive advantage are called the barriers to entry for that
industry. The barriers to entry refer to the obstacles a new
firm may face when trying to enter into an industry or new
market. The barriers to entry that corporations may seek to
optimize include:
a) Research and development,
b) The ownership of intellectual property rights,
c) Economies of scale,
d) Unique business process or method as well as
exclusive experience in the industry, and
e) The control of resources or favorable access to raw
material
vii) National Competitive Advantage Theory
The theory was pioneered by Michael Porter of Harvard
Business School in the 1990s. Porter’s theory sates that a
nation’s competitiveness in an industry depends on the
capacity to innovate and update. To explain his theory, Porter
identified four determinants that can be linked together:
i) Local market resources and capabilities – factor
conditions,
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 ii) Local market demand conditions – a sophisticated
home market is critical to ensuring ongoing
innovation. In other words, demanding consumers
(for example, USA) will force US software companies
to continuously innovate, thus creating a sustainable
competitive advantage in software products and
services,
iii) Local suppliers and complementary industries. That
is, strong, efficient supporting and related industries
to provide the inputs required by the industry.
Certain industries cluster geographically, which
provide efficiency and productivity, and
iv) Local firm characteristics. These may include firm
strategy, industry structure, and industry rivalry.
For example, a healthy level of rivalry between local
firms spurs innovation and competitiveness.

In addition to the above four, Porter also noted the role of

the government via action and policies.

II. Some Concluding Remarks on International Trade Theories

i) Some of the trade theories may occasionally be

contradicted by real – world events. As a result, it is not
clear that any one theory is dominant around the world
ii) Factors of production are not neatly distributed between
countries
iii) In practice, governments and companies use a
combination of different theories to both interpret trend
and develop strategy
iv) Theories have evolved over time, and they will continue
to change and adapt as new factors impact international
trade.