New Trade Theory Essay

Cheap Custom Writing Service

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.


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

This example New Trade Theory Essay is published for educational and informational purposes only. If you need a custom essay or research paper on this topic please use our writing services. offers reliable custom essay writing services that can help you to receive high grades and impress your professors with the quality of each essay or research paper you hand in.

See also:


Always on-time


100% Confidentiality

Special offer!