New Trade Theory Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Associated with economists Paul Krugman and Elhanan Helpman, new trade theory makes two major points: (1) through economies of scale, trade can increase the variety of goods available to consumers and decrease the average costs of those goods, and (2) in those industries in which the output required to attain economies of scale represents a significant proportion of world demand, the global market may be able to support only a small number of enterprises.

New trade theory predicts that when nations trade with one another, individual national markets are combined into a far larger world market in which better economies of scale are available to individual firms. Further, each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, thus affecting both absolute advantage and comparative advantage. By buying goods from other countries, each nation can simultaneously increase the variety of goods available to consumers and lower the costs of those goods, offering an opportunity for mutual gain even when countries do not differ in their resource endowments or technology, irrespective of absolute or comparative advantage.

Developed in the late 1970s and 1980s, new trade theory was motivated by the failure of more traditional theories to explain why, since World War II, the ratio of trade to gross domestic product (GDP) has increased, why trade has become more concentrated among industrialized countries, and why trade among industrialized countries is largely intraindustry trade.

In the early post–World War II period, the United States accounted for much of the world’s income and consumption. As the distribution of national income becomes more equal, new trade theory predicts that trade volumes should rise. The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, may explain the pattern of trade observed since World War II. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a firstmover advantage. Hence, new trade theory identifies first-mover advantage as an important source of comparative advantage.

Variances With Other Theories

By extension, new trade theory suggests that the economies of scale produced by trade can change comparative advantages for trading nations. New trade theory, however, is at variance with the Heckscher-Ohlin theory, which suggests that a country will predominate in the export of a product when it is particularly well endowed with those factors used extensively in its manufacture.

By stressing the influence of first-mover advantage, rather than labor/price advantage or location advantage, on comparative advantage, new trade theory has triggered a reaction from proponents of both neoclassical trade theory and the ownership-location-internalization (OLI) paradigm of international business growth associated with John Dunning.

Geography And Economic Activity

In Krugman’s model, the location of economic activity is not an issue. Trade costs are zero, so firms are indifferent about the location of their production sites. Initial conditions play a pivotal role in determining the allocation of production.

In new trade theory, as in neoclassical trade theory, this role for geography is determined outside the model. Where geography does matter is in the incursion of transport costs in trade among nations and in consumer demand, which influences market size. The combination of transportation costs and market size causes countries to produce those goods and services for which local demand is relatively high.

Government Intervention In Trade

New trade theory has also stimulated renewed interest in the merits of government intervention in international trade. Most neoclassical economists regard the optimum tariff argument as the only theoretically sound argument for limited government intervention, subject to a large number of constraints. If a country is large enough in the world markets, for example, a tariff will improve the country’s terms of trade to the extent that favorable terms outweigh loss of volume and higher production costs. This argument is the so-called optimum tariff argument.

New trade theorists argue that government intervention in trade may be more beneficial than previously thought, because the normal assumptions of perfect competition do not apply and because the market is dominated by a comparatively small number of large firms. Here, increasing national welfare by improving the terms of trade is a justifiable motive for export subsidies or tariff protection, among other instruments that effectively shift monopoly profits from the foreign to the domestic producer.

Problems In Government Intervention

The problem for government is how to persuade the foreign firm to cut its output while the home producer increases its output without provoking a price war. As Nigel Grimwade argued, if the foreign producer does reduce his output, he loses at the expense of the home producer; if he leaves output unchanged and cuts price, he can hope that the home producer will change his mind when he sees that the decision to increase output has served merely to disadvantage himself.

If the government of the home country intervenes by granting an export subsidy to the home producer, reduced marginal cost will prompt the home producer to raise output, even if the foreign producer takes no immediate action. To ensure that the price is not forced down, the foreign producer will reduce his output. As a result of the government subsidy, the profits of the home producer have increased at the expense of the foreign producer, allowing the homecountry producer to enjoy a welfare advantage that is passed on to its trading partners and consumers.

Bibliography:

Salvador Barrios, Holger Görg, and Eric Strobl, “Multinational Enterprises and New Trade Theory: Evidence for the Convergence Hypothesis,” Open Economies Review (v.14/4, 2003);
Steven Brakman, Harry Garretsen, and Charles Van Marrewijk, An Introduction to Geographical Economies: Trade, Location and Growth (Cambridge University Press, 2001);
Arnaud Costinot and Ivana Komunjer, What Goods to Countries Trade? New Ricardian Predictions (National Bureau of Economic Research, 2007);
Sonali Deraniyagala and Ben Fine, “New Trade Theory Versus Old Trade Policy: A Continuing Enigma,” Cambridge Journal of Economics (v.25/6, 2001);
John H. Dunning, Regions, Globalization and the Knowledge Based Economy (Oxford University Press, 2002);
Nigel Grimwade, International Trade: New Patterns of Trade, Production and Investment (Routledge, 2000);
J. Lloyd and Hyun-H. Oon Lee, Frontiers of Research in IntraIndustry Trade (Palgrave Macmillan, 2002);
Thomas I. Palley, “Institutionalism and New Trade Theory: Rethinking Comparative Advantage and Trade Policy,” Journal of Economic Issues (v.42/1, 2008);
Anway Shaikh, Globalization and the Myths of Free Trade: History, Theory, and Empirical Evidence (Routledge, 2007).

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