New Trade Theory

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21 Aug, 2024

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New trade theory (NTT) refers to modern economic theory that explains international trade based on economies of scale, network effects, and first-mover advantage. It helps decipher the main reason behind globalization and intensive trading between similar economies. In addition, it paves the way for the government's role in the industrialization of a country.

It opposes the old theory of trade promoting constant returns of scale, fixed technology, and the presence of perfect competition. Instead, it says that a first-mover to establish a company in a trade gets the advantage of being dominant and monopolistic. As a result, a poorer nation may continue struggling in specific industries due to a lack of economies of scale in their companies.

What Is New Trade Theory?

New trade theory is an economic model given by Paul Krugman to explain international trade and globalization using the economies of scale, network effects, and first-mover advantage.
It explained the reason for extensive trade between similar countries, developing economies' low industrialization, and giant multinational companies' monopolistic nature.
The main advantage of this theory lies in the globalization of trade, and the disadvantage lies in the development of monopolistic tendencies of giant corporations globally.
The main differences between new and old trade theories have been the returns of scale, fixed technology, and perfect competition, which gets supported by the old theory and rejected by the new theory.

New Trade Theory Explained

The new trade theory of international trade refers to an accumulation of various economic models that focuses mainly on returns of scale, first-mover advantage, and network effects on international trade and globalization. For example, the new trade theory by Paul Krugman has got based on his ideas that analyze trade patterns based on the location of trade activity, for which he received the Nobel Prize in economics in 2008.

Network effects and economies of scale have the potential to be so potent that they could even defeat the more well-known concept of comparative advantage. As a result, some industries might not notice noticeable changes in opportunity costs between the two countries at a particular time. A country, however, may profit from its specialization if it concentrates on a particular industry due to economies of scale and other network advantages.

The new trade theory is a contributing component in explaining the expansion of globalization. It implies that less developed, underdeveloped nations may find it difficult to establish some industries as they enjoy economies of scale like the industrialized world. It is mainly a result of the scale efficiencies existing among mature enterprises and not of any inherent comparative advantage.

Prime Factors

Thus, the main factors of new trade theory are the following:

#1 Economies Of Scale

Under this aspect, goods per unit cost gets reduced when they get produced in huge volumes. It gets aided by IT technology, automobiles, and large-scale production machines. Domestic firms do not use it because of low demand, but when the demand for goods from foreign countries gets highly high, economies of scale reduce the cost of production per unit. Every country has a specific industry with such capability and can lower the cost of production by increasing the variety of goods.

#2 First-Mover Advantage

It attributes to the fact that the earlier a firm gets into producing certain goods, the more economical and strategic benefit it gets over the late entrants. It happens because early entrants' low-cost structures develop into giant firms like NOKIA.

#3 Network Effects

It states that their value increases with increased users of products. An example includes the internet.

Assumptions

Economist Paul Krugman based this theory on certain assumptions. The assumptions of the new trade theory are the following:

With specializations of firms, they increase their economies of scale.
Learning by doing has excellent effects on productivity.
First-mover advantage allows new competitors.
The government's role in industrialization becomes significant.
Economies of scale become a key to stopping new entrants and turning firms into monopolies.
Product differentiation and product specialization become essential in the growth of a firm.

Examples

Let us look at new trade theory examples to understand the topic better.

Example # 1

The first example would deal with the giant mobile phone manufacturer NOKIA. It started its mobile manufacturing in Finland. It had its base in the electrical and electronic equipment manufacturing company. NOKIA brand became the first-ever company to foray into manufacturing mobile and related parts in the 1990s. Due to its strong financials, it implemented economies of scale in mobile phone manufacturing. Finland's government also supported its mobile manufacturing venture.

Thus, for almost 15 years, it had a monopoly in mobile phone manufacturing. However, with time, people started using NOKIA to a great extent, making it a valuable mobile company. Hence, government support, economies of scale, network effects, and first-mover made it the undisputed leader of mobile phones for over a decade.

Example # 2

TESLA is a popular brand in the electric vehicle segment. TESLA had been the early entrant or the first mover into manufacturing electric vehicles (EVs) for the public on a large scale. With time, it transformed from an American EV to a global EV manufacturer. TESLA gained a monopoly in the market by doing the following:

Being the first mover into EV;
Getting subsidies from the American government;
Having economies of scale due to huge funding available; and
Rising value of its cars, creating network effects, led to monopolistic tendencies in the EV manufacturing sector.

Advantages & Disadvantages

Advantages of new trade theory	Disadvantages of new trade theory
It promotes the globalization of production.	It supports economies of scale, allowing a company to grow so that it will exert monopolistic tendencies.
With proper government support, industrialization can take place in a nation.	An early entrant to the trade has all the say and can create an entry of barriers for new entrants.
It encourages similar countries to conduct extensive trade between them	Government support may backfire on trade growth for its lack of information on such issues.
A government's subsidies help local companies to compete with international companies.	Government support may also give rise to the large, powerful business conglomerate that may become inefficient overall and hamper the economy.
After a specific time, local industries would no longer require government support and become competitive without government interference.	Poorer countries may not be able to compete with developed nations as they lack economies of scale.
An early entrant to the trade becomes the most developed and powerful company in a sector.	Already established and powerful corporates make entry barriers too rigid that monopoly starts to hamper the growth of smaller companies.

New Trade Theory vs Old Trade Theory

The new trade and old trade theory has been the pillar of trade theories globally. However, one can observe specific differences between the two, as listed in the table below:

New Trade Theory	Old Trade Theory
This theory says that no country has full employment, and the number of resources gets not homogenous and constant.	It assumes that a particular country has an endless number of resources with full employment in its economy.
The technology used has always been dynamic in goods production.	The technology used in manufacturing remains either fixed or similar technology available to all nations.
It underlines that perfect competition does not exist, and imperfect competition takes over the same competition.	The competition always remains perfect across sectors.
Increasing returns of scale replaced the old constant returns of the scale of production.	Various production activities have their factors as perfectly mobile.
It promulgates the theory that government promotion and intervention in international trade provide ground for new industries to grow and secure industrialization in a country.	Governments have no role in international trade as it depends on international demand and supply.
Trade happens equally among countries with similar economic growth and technological progress levels.	It assumes trade happens equally irrespective of the economy or technology used between the nations.

Frequently Asked Questions (FAQs)

What conclusion can be given to the new trade theory?

One can conclude from the new trade theory that the variety of products brought to the customers for their use from the trade allows customers to benefit from it. It happens because a product monopoly happens, and companies compete with each other using advertisements.

What is best explained through the new trade theory?

The new trade theory focuses on two new aspects of the trade – an increase in returns of scale and first-mover or network advantage formulated in the 1970s & 1980s, respectively.

What is new trade theory of international trade?

New trade theory was propounded in 2003 by Marc Melitz. Multinational firms have better productivity than locally based companies. It is because each country has a different capacity for production for companies.

What are the implications of new trade theory?

It implies that any gain arising out of intra-industry trade happens because of economies of scale in manufacturing products of unique designs instead of the specialization of products related to a specific category.