The New Trade Theory
Another paradigm shift came with the emergence of the new trade theory, where the advances made in the theory of industrial organization were extended to the international trade arena by Paul Krugman, Elhanan Helpman, Gene Grossman, Wilfred Ethier, James Brander, Barbara Spencer, Kelvin Lancaster and others.
For the pioneers of this new paradigm, the mainstream H-O-S theory symbolized the “homeostatic” view that “there is a natural pattern of specialization and trade, determined by underlying characteristics of countries, and that automatic forces tend to restore this natural pattern” (Krugman 1987: 41). The new theory instead invoked production based on increasing returns to scale, external economies, differentiated products and the associated imperfectly competitive market structures such as monopolistic competition, oligopoly and the existence of multinational corporations. Trade could be shown to arise even between economies that are identical with respect to factor endowments and technical knowledge, so that some of its models dispense altogether with the notion of comparative advantage.One of the ironies underlying the new trade theory that challenged the ascendency of the mainstream Heckscher-Ohlin theory is that Ohlin himself anticipated it in his 1933 book. In chapter 3, titled “Another condition of interregional trade”, he noted that “the economies of large-scale production make interregional division of labour profitable, irrespective of differences in the prices of the factors of production. In other words, the advantages of specialization resulting from large-scale production encourage interregional trade” (Ohlin 1967: 37). His anticipation of the new trade theory is remarkable for its details as well as its general thrust. Thanks to economies of scale, even regions with identical factor endowments gain from trade, and the particular industries in which each region specializes are arbitrary.
In his words, “The character of this trade will be entirely a matter of chance if factor equipment is everywhere the same, for it doesn’t matter whether a certain region specializes in one commodity or another, just as uniformly endowed individuals can with equal advantage specialize in any kind of work” (ibid.: 38). Ohlin also remarked on the importance of history and accident in moulding comparative advantage, a factor subsequently noted by Krugman. Some authors refer to this phenomenon as hysteresis, and provide examples such as the fact that production or research activity can become concentrated in the country that acquires a technological lead in an industry. According to Ohlin, “when certain industries have once been established in a place, there is a tendency for them to remain there. Friction of various kinds here is responsible” (ibid.: 39).Unlike the H-O-S theory with its agreed list of underlying assumptions, the new trade theory is characterized by great heterogeneity in the models of its practitioners. This very diversity makes it difficult to generalize about the brave new world it opened for international trade theorists. An assessment of its implications for whether comparative advantage is still relevant to the explanation of trade flows and what forms it takes reveals a variety of viewpoints, including Krugman’s quoted earlier that it provides a theoretical scaffolding for “noncomparative-advantage trade”. An undoubted achievement was to provide a satisfactory explanation of the intra-industry trade that characterizes most of the advanced economies and many of the developing ones. In diametrical opposition to the prediction of the H-O-S theory where differential factor endowments lead to inter-industry trade, the volume of intra-industry trade has been shown to be greater, the more similar are the trading countries’ factor endowments. Moreover, the new trade theory highlighted an important additional source of gains from trade: a greater variety of products and lower prices due to a higher scale of output.
Because of the similarity of factor endowments, intra-industry trade softens the impact of trade on the gains or losses of particular factors of production, in contrast to inter-industry trade and the predictions of the Stolper-Samuelson theorem where one of the factors always loses from trade.Some models of the new trade theory based on dynamic comparative advantage feature increases in productivity via a Smithian division of labour, depicted by learning- by-doing where cumulative past output determines current productivity. As Krugman (1987: 47) observes:
Like a river that digs its own bed deeper, a pattern of specialization, once established, will induce relative productivity changes that strengthen the forces preserving that pattern. Clearly, history matters here even for the long run... Comparative advantage is “created” over time by the dynamics of learning, rather than arising from underlying national characteristics”.
Such models of created comparative advantage are sophisticated versions of the infant industry argument reviewed above. Other models are hybrid ones that combine the novel insights into the determinants of trade with traditional explanations based on factor endowments and hence on comparative advantage, and allow room for policy intervention to garner for a country the advantages of specialization in high-technology goods.
In conclusion, some of the trade that characterizes the models of the new trade theory is intra-industry in nature and can indeed be described a la Krugman as non-comparativeadvantage trade since it takes place even between countries with identical factor endowments. Other models accord an explicit role to the creation of comparative advantage via learning by doing, research and development (R&D) expenditure, or government policy. Unlike in the textbook presentations of the Ricardian and H-O-S models, comparative advantage is typically dynamic in nature and reminiscent of the way it was envisaged by Adam Smith and some of the “creators” of comparative advantage discussed above. The fact that the new trade theory often blends the insights of Smith and Ricardo shows, as argued in Maneschi (2002), that a suitably interpreted comparative advantage retains a vital role in trade theory, wherein both Smith and Ricardo should be accorded places of honour.