New Trade Theory

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 [Page 1208]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 first-mover 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 Heck-scher-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-inter-nalization (OLI) paradigm of international business growth associated with John Dunning.

Geography and Economic Activity

In Krugmans 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.

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