THE NEW TRADE THEORY Emerged in the 1970

THE NEW TRADE THEORY

• Emerged in the 1970 s 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

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.

• 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 i. Pod, 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

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

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 interindustry trade depends on how similar countries are

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