New Trade Theory: Topics in New Trade Theory
Traditional trade theory shows that small countries (those that cannot influenceworldmarket prices) typically havenothing to gain from pursuing an active trade policy. This seems at odds with the empirical observation that trade intervention is widespread across countries and industries.Although bothmonopolistic competition and oligopolymodels can provide additional reasons for active trade policy (see Helpman and Krugman 1989;Rivera-Batiz andOliva 2003), the literature on what is known as strategic trade policy has focused more on oligopoly. Using active trade policy, the domestic government can alter the strategic position of domestic firms against foreign competitors and help them capture additional rents. Oligopoly models can also be used to explainwhy a government may prefer tariffs over quotas or other nontariff barriers and vice versa; in contrast, tariffs and quotas are usually equivalent in the perfect competition model. Although imperfect competition can be used to show why active trade policymaymake sense, this does not imply that free trade should be abandoned. In the absence of correct information about market structure and cost, governments can easily lower welfare by using active trade policy. Recent research, using asymmetric information models, has investigated whether governments can induce firms to reveal this information. Models of imperfect competition can also be employed to explain multinational corporations, outsourcing, and the exporting decision of firms. Summarizing Dunning (1988), multinational corporations arise due to three reasons (OLI theory):
1. Ownership advantage: Knowledge capital (headquarter services) can be used at the same time by different production facilities.
2. Location advantage: Having a subsidiary in a foreign market makes sense when the market is large and trade costs are high (for horizontal firms) orwhentrade costs are low and factor prices differ substantially across countries (for vertical firms).
3. Internalization advantage: Transfer of knowledge-based assets in order to have other firms produce inputs for one’s own firm is risky.
This last point leads to the question of firm organization; namely, when would firm A want to build a subsidiary instead of outsourcing production to another firm B? The answer depends on transaction costs. Letting firmB produce the required input may be more efficient in terms of production costs, but problems may arise because of input specificity and the related holdup problem. Suppose the input that firm B manufactures can be used only by firm A. Assuming incomplete contracts, firm A can then force firm B to sell below production value (holdup problem). Foreseeing this, firmBmay be tempted to produce an input that is not well suited for A but can be more easily sold to other firms. Grossman and Helpman (2002) and Antras (2003), among others, have integrated the transaction cost approach into a monopolistic competition trade model to investigate when outsourcing will occur.
In reality, only a small fraction of firms actually export. The question of which firms will export can be addressed in a monopolistic competition model, where different firms have different variable costs and face per unit transportation costs and fixed costs of exporting (Melitz 2003). In this framework, it can be shown that when a country opens up to trade, less productive firmswill exit themarket and only amore productive subset of the remaining firms will decide to export.
New Growth Theory (Grossman and Helpman 1991) and New Economic Geography (Fujita, Krugman, and Venables 1999) are closely related to theNewTrade Theory since they also heavily rely on the Dixit-Stiglitz model of monopolistic competition and emphasize the importance of trade. These theories are usually not considered part of the New Trade Theory, however, and are thus not discussed here any further.
TheNew Trade Theory, based on the concepts of imperfect competition and increasing returns to scale, complements traditional trade theories and has contributed substantially to a better understanding of the world economy and its patterns of trade.