New Trade Theory: Reasons for Developing New Trade Theory
The New Trade Theory originated in the late 1970s and early 1980s when advances in the industrial organization literature were incorporated into trade theory. It was developed to explain four major stylized facts (Helpman and Krugman 1985):
Fact 1: The increase in the trade to income ratio, and the high and increasing percentage of trade taking place between industrialized nations, even though these countries are seemingly becoming more similar.
Traditional models predict that trade benefits increase themore different trading partners are. This is puzzling because, in reality, trade is much more prevalent between quite similar countries, in particular between industrialized nations. For example, in 2005, the United States exported (imported) $186.4 ($308.8) billion worth of goods and services to (from) the European Union. In the same period, the U.S. export (import) value to (from) Africa was only $15.5 ($65.2) billion (Census FT900 Report).
Fact 2: The high percentage of intraindustry trade, particularly between industrialized nations.
Traditional trade theories cannot explain the existence of intraindustry trade. In the Ricardian and the Heckscher-Ohlin models, only interindustry trade takes place. That is, if one country exports cars to another country, it does not import cars from the same country. In contrast, trade statistics for industrialized nations consistently reveal intraindustry trade to account for well above 50 percent of total trade. Although part of this may just be an aggregation problem, that is, different products are aggregated into one industry so that actual interindustry trade appears as intraindustry trade, it is clearly not the whole story.
Fact 3: Intrafirm transactions and foreign direct investment by multinational firms.
In the constant returns perfect competitionworld of the traditional theories, it is essentially impossible to talk about the scope of activities carried out within firms because there is no true concept of ‘‘a firm,’’ the number and size of firms being indeterminate.
Fact 4: Trade liberalization and the associated increase in factor productivity in spite of only limited resource reallocation.
According to the traditional theories, trade liberalization results in substantial factor reallocation, most notably in the Ricardian model, where one industry closes down completely and all resources concentrate in the industry for which a country has a comparative advantage. The effect is qualitatively similar in the Heckscher-Ohlin framework, except that specialization is incomplete. In reality, however, trade liberalization seems to cause rather limited resource reallocation.
Some, usually nonacademic, literature claims that the raison d’eˆtre of the New Trade Theory is to provide arguments against free trade. Although there is research showing that active trade policy may improve welfare under imperfect competition, these findings are usually too assumption-dependent to warrant a recommendation for a widespread deviation from free trade.
Models in the New Trade Theory can be distinguished by the type of imperfect competition. The first approach uses the monopolistic competition model with differentiated goods, typically as proposed by Dixit and Stiglitz (1977). Research in this area began with seminal articles by Krugman (1979, 1980, 1981). The second approach, starting with Brander (1981) and Brander and Krugman (1983), uses an oligopolistic setup.