The New Trade Theory

Base of International Trade Theories – Why

countries trade?
Reasons for Trade
Classical Theories New Trade Theory
Differences in Resource
availability or Economies of Scale
Resource Productivity

Comparative advantage Imperfect Competition

assuming Perfect (monopolistic competition or
Competition oligopoly market structure)

Constant/Diminishing
Returns to Scale Increasing Returns to Scale
 The New Trade Theory
• Emerged in the 1970s by a number of economists
• Countries do not necessarily specialize and trade solely
to take advantage of their differences in resource
endowments or technology
• They also trade because of increasing returns that makes
specialization advantageous in some industries
• New trade theorists introduce industrial organization
view into trade theory and include real-life imperfect
competition in international trade
• Argue that because of economies of scale, there are
increasing returns to specialization in many industries
“New Trade Theory”
In late 1980s, Helpman/Krugman coined the imperfectly
competitive framework as the “new trade theory”
Theorists noted that much trade is dominated by a small
number of large firms & this raised the following question:
could increasing returns cause trade? (as opposed to
exogenous differences in technology or factor endowments)
They also noted that trade in differentiated products is more
important than homogeneous goods trade. Theorists argued
that increasing returns (which typically leads to imperfect
competition) could be as fundamental a cause of international
trade as comparative advantage.
Intra-industry trade cannot be explained by Ricardian or H-O
models.
4
“New Trade Theory”-2
 New Trade Theory emphasizes:
 1) increasing returns, i.e., f (tx 1 , tx2) > t f (x1,x2)
2) imperfect competition
3) differentiated products
 Economies of scale means average cost of production declines as the # of
units increases.
 Internal scale economies (Helpman & Krugman): AC declines with output of
individual firm – may be due to fixed costs associated with starting a firm.
 External scale economies (Markusen & Melvin): AC declines as the size of the
industry grows.
 This literature shows that increasing returns raises the gains from
international trade.
 Presence of economies of scale & imperfect competition raises the question:
are their new arguments against free trade? Could there be new reasons for
government intervention through import restrictions, export subsidies, etc
 Brander/Spencer showed (with a duopoly model) that a gov’t may be able to
shift profits from foreign to domestic exporters through an export subsidy

5
Intra-Industry Trade & the Krugman Model (1980)

1. Trade models based on comparative advantage focus on:

 Trade between dissimilar countries (different technologies,
factor endowments, etc)
 Inter-industry trade : trade in different commodities
2. Krugman noticed:
 Considerable Intra-Industry trade (i.e., trade in similar goods):
Grubel & Lloyd showed this many years ago.
 Large amount of trade among similar economies.
3. Krugman showed that trade is possible & mutually
beneficial in the case of two completely identical
countries

6
Krugman Model cont
4. Krugman assumptions:
 2 identical economies (home (H) & foreign (F)) in terms of
technology & preferences
 One nontraded factor of production (labor) & equal endowment
across countries LH = LF
 Large number of competitors but many varieties of goods (i.e,
differentiation). Each firm produces its own variety. Each firm acts
as a monopolist (monop. competition) – goods are substitutes so
price falls as more firms enter the market. In equib. p = AC.
 Consumer preferences: homothetic & identical across countries
 Consumer preferences: love of variety & diminishing marginal utility
associated with the consumption of extra units. Consumption of
more varieties yields higher utility – “city lights” effect.
 Trade is of the intra-industry type - exchange of varieties of the
same differentiated good.
7
Krugman cont 2
5. In Krugman type model (monopolistic competition &
internal scale economies) the gains from trade arise
due to:
a) larger number of varieties available to consumers
(i.e., more choice)
b) larger production of each individual variety,
resulting in a larger real income (lower prices due to
increased market size and increased competition).
c) No income distribution effects – everybody gains.

8
Economies of Scale and International
Trade:
•Definitions:
• Economies of Scale: Reduction of average cost as a
result of increasing the output
• Increasing Returns: a unit increase in inputs results
in more than one unit increase in output
• Economies of scale is an important source of
increasing returns to specialization
• New Trade Theory supports the Comparative Advantage
theory by identifying economies of scale as an
important source of comparative advantage
 The New Trade Theory
• Domestic market may not be big enough to realize
economies of scale for certain products
Ex: the aerospace industry dominated by Boeing and
Airbus
How do they achieve economies of scale?
• First-mover Advantage: New Trade Theory suggests that a
country may predominate in the export of a good simply
because it was lucky enough to have one or more firms
among the first to produce that good
• First mover’s ability to benefit from increasing returns
creates a barrier to entry
Ex: Microsoft operating systems, Apple’s iPod, Google, etc.
 Economies of Scale and Market Structure
How international trade take place?
• When there is economies of scale, large firms have cost
advantage over small ones and lead to imperfectly
competitive market structure (ACLarge < ACSmall)
• Each country specializes in producing a restricted range
of goods taking advantage of economies of scale
• Helps them to produce these goods more efficiently than
if tried to produce everything by itself
• Specialized economies trade with each other, making
possible to consume the full range of goods (variety of
consumption)
Theory of Imperfect Competition
Characteristics
• A few major producers
• Differentiated products
• Firm is a ‘price setter’ not ‘price taker’
• Firms can sell more only by reducing their prices
(downward slopping demand curve)
 Monopolistic Competition and Trade
• In autarky, variety of goods and scale of production are
constrained by size of the market
• Trade increases market size
• Each country specializes in a narrower range of
products
• Trade offers mutual gain when countries do not differ in
resources or technologies
• Trade makes available variety of goods to the consumers
of each country
 Economies of Scale and Comparative
Advantage
What will be the pattern of trade that results from the
economies of scale?
• Two countries – Japan and India
• Japan capital abundant
• Two products – Steel and Rice
• Suppose Steel is a monopolistic competitive sector (each
firm’s product is differentiated from others)
• Japan will be still the net exporter of Steel and importer
of Rice
 Intra and Inter Industry Trade
• Suppose, Steel producers in India produces product
different from that of Japan’s Steel producers
• Some Japan consumers prefer Indian varieties
• So, Japan import as well as export within Steel
sector
• Trade in monopolistic competition model consists of
two parts:-
– Intra-industry trade – two-way trade within a
sector
– Inter-industry trade – trade between two sectors
Pattern of Trade
– Inter-industry trade: (Steel for Rice) reflects
comparative advantage or H-O Theorem
– Intra-industry trade (Steel for Steel) depends on
economies of scale creating increasing returns due to
specialization within the industry
– The pattern of intra-industry trade is unpredictable
– The relative importance of intra-industry and inter-
industry trade depends on how similar countries are
China exports textiles to India, but also imports
textiles which can be produced only using the skills
in India. Is it comparative advantage or advantage
due to economies of scale?
 Why Intra-industry trade matters?
• About ¼ of world trade consists of intra-industry trade
• Countries are becoming increasingly similar in their level
of technology and availability of capital and skilled labour
• Allows countries to benefit from larger markets
• More prevalent between countries that are similar in
relative factor supplies (capital-labour ratios), skill levels
and so on.
 Dumping
• An important consequence of imperfect competition on
international trade
• Firms do not necessarily charge the same price for goods
that are exported and those that are sold to domestic
buyers – known as price discrimination
• Dumping – the most common form of price discrimination
in international trade
• A pricing practice in which a firm charges a lower price for
exported goods than for the same goods sold domestically
• Major reason: differences in the responsiveness (elasticity)
of sales to price in the export and domestic markets
 New Trade Theory: Summary
• Suggests that nations may benefit from trade even when
they do not differ in resource endowments or technology
• Assumes economies of scale due to increasing returns
• Trade helps nations to specialize in products in which they
have economies of scale
• In autarky, size of the market limits the variety of goods
that a country can produce and the scale of production
 New Trade Theory: Summary
• By trade, each nation may able to specialize in
producing a narrower range of products than in autarky
• Yet they can increase the variety of goods for
consumption at a lower cost
• Thus, trade offers mutual gain when countries do not
differ in their resource endowments or technology
 New Trade Theory: Summary
• Also argue that if world market offers economies of scale
with substantial proportion of world market, then only
limited number of firms based in a limited number of
countries will produce those products
• First-mover Advantage: The firm which enter first may
gain an advantage
• A country may dominate in the export of particular
product where economies of scale exist because it is the
home for first mover firm