International Economic Course

Day 3: International New Trade Theory

Presented by:

Anh Duy Nguyen, PhD. International Economics

Duyna@uef.edu.vn
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Agenda
Overview
– Course Overview: Review of Main Trade Theories
– Definition of key terms
– New Trade Theory: Paul Krugman , Nobel Price Winner
(2008)
– Intra- Industry Trade
– The Product Life Cycle Theory: Vernon (1966)
– The Porter’s Diamond of National Advantage (1990s)
Implications of the New Trade Theory
Case study: Development of Silicon Valley

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 Review of Trade Theory
Question: How has international trade theory
evolved? Answer:
❑ Mercantilism (16th and 17th centuries) encouraged exports and discouraged
imports ! Protectionism
❑ Adam Smith (1776) promoted unrestricted free trade.
The Theory of Absolute Advantage : The ability of a country to produce
a product with fewer inputs than another country
❑ David Ricardo (19th century) built on Smith ideas.
The Theory of Comparative Advantage: The
notion that although a country may produce both products more cheaply than
another country, it is relatively better at producing one product than
the other
❑ Eli Heckscher and Bertil Ohlin (20th century ) refined Ricardo’s
work
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Review of Trade Theory

What we learn so far from Trade Theory (cont.)

Question: Why is it beneficial for countries to
engage in free trade?
Answer:
International trade allows a country to:
• Specialize in the manufacture and export of
products that can be produced most efficiently
in that country
• Import products that can be produced more
efficiently in other countries
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 Review of Trade Theory

What we learn so far from Trade Theory (cont.)

Mercantilism makes a case for government involvement in
promoting exports and limiting imports
Smith, Ricardo, and Heckscher-Ohlin promote unrestricted
free trade
Ricardo’s theory of comparative advantage:
– Trade patterns reflect differences in labor productivity
Heckscher and Ohlin
– Comparative advantage reflects differences in national
factor endowments: the extent to which a country is
endowed with resources such as land, labor, and capital
– Countries will:
Export goods that make intensive use of those factors that are locally
abundant
Import goods that make intensive use of factors that are locally scarce

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Review of Trade Theory

What we learn so far from Trade Theory (cont.)

Mercantilism makes a case for government involvement in
promoting exports and limiting imports
– Takes an us-versus-them view of trade
– Other country’s gain is our country’s loss ( Zero sum
Game)
– Export more to “strangers” than we import to
amass treasure, expand kingdom
– Government intervenes to achieve a surplus in exports
Mercantilism weakens country in long run;
enriches only a few
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 Review of Trade Theory

What we learn so far from Trade Theory (cont.)

Adam Smith’s View on Trade:
– Specialization and trade advantage both countries.
– Adam Smith and other classical economists
advocated policy of laissez-faire, or minimal
government interference with economic activity.
– Free trade would cause world resources to be
utilized most efficiently, maximizing world welfare.
▪ In 1770s, Adam Smith argued that import restrictions
would reduce the gains from specialization and make a
nation poorer. He used absolute advantage to explain the
benefits of trade.
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Review of Trade Theory

What we learn so far from Trade Theory (cont.)

Theory of Relative Factor Endowments (Heckscher-
Ohlin): Determinants of comparative advantage ?
o Differences in factor endowments not on differences in
productivity determine patterns of trade (comparative advantage)
o Absolute amounts of factor endowments matter.
o Factor endowments vary among countries
o Products differ according to the types of factors that they need
as inputs
o A country has a comparative advantage in producing products
that intensively use factors of production (resources) it has in
abundance
o Factors of production: labor, capital, land, human
resources, technology
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 Classroom Performance System
.
1/ The comparative advantage model of Ricardo
was based on
a. intraindustry specialization and trade
b. interindustry specialization and trade
c. demand conditions underlying specialization
and trade
d. income conditions underlying specialization
and trade

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Classroom Performance System

5/ Boeing
. aircraft company was able to cover its production
costs of the first ―jumbo jet‖ in the seventies because Boeing
could market it to several foreign airlines in addition to
domestic airlines. This illustrates:
a. How economies of scale make possible a larger variety of
products in international trade.
b. A transfer of wealth from domestic consumers to domestic
producers as the result of trade
c. How a natural monopoly is forced to behave more
competitively with international trade.
d. How a natural monopoly is forced to behave less
competitively with international trade.

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 Classroom Performance System
.
6/ Intraindustry trade can be explained by all of the
following except
a. high transportation costs as a proportion of
product value
b. Different growing seasons of the year for
agricultural products
c. product differentiation for goods such as
automobiles
d. high per capita incomes in exporting
countries

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Classroom Performance System

.
8/ By reducing the volume of trade,
transportation costs tend to
a. stop the process of product price equalization and
factor price equalization before they are complete
b. ensure that the process of product price equalization
and factor price equalization are complete
c. eliminate all of the feasible gains from international
trade
d. maximize all of the feasible gains from international
trade

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 Classroom Performance System
.
9/ Intra-industry trade theory
a. explains why the United States might export autos and
import clothing
b. explains why the United States might export and
import differentiated versions of the same product, such as
different types of autos
c. assumes that transport costs are very low or do not
exist
d. ignores seasonal considerations for agricultural goods

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Classroom Performance System

.
10/ Declining costs per unit of output results
from international trade especially if:
a. International trade affords producers
monopoly power.
b. National governments levy import tariffs
and quotas.
c. Producing goods entails increasing costs.
d. economies of scale exist for producers.

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 New Trade Theory
New Trade Theory
– Developed in the early 1980s
– Most prominent contributor was Paul Krugman, now a
New York Times columnist
Krugman won the Nobel prize (2008 ) in economics for
showing trade is caused not only by comparative
advantages, but also by external and internal
economies of scale.
Krugman showed that trade is possible & mutually
beneficial in the case of two completely identical countries

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Additional Causes of
International Trade
New Trade Theory:
There are some aspects of trade that are not readily
explained by the theory of comparative advantage. Why, for
instance, do countries trade the same kinds of goods
between each other (intra-industry trade)? This seems
intuitively to contradict what we have learned about
comparative advantage
Here we will focus on two aspects: Economies of
scale and product differentiation
This will give us a more complete understanding of the
flows of trade
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 New Trade Theory
Assumptions of New Trade Theory:
In late 1980s, Helpman/Krugman coined the imperfectly
competitive framework as the “new trade theory”
One or more of
– Increasing returns to scale
– Imperfect competition
Monopoly (one seller)
Oligopoly (few sellers)
Monopolistic competition (many sellers, but each with some
market power)
– Product differentiation
None of these were allowed in the Ricardian and H-O
Models
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Definitions
imperfect competition –
firms are price setters;
firms face downward
sloping demand curves

pure monopoly –
industry with only 1 firm

oligopoly –
industry with only a few firms

intra-industry trade (ITT)–two way

exchange of similar goods
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 Definitions
dynamic increasing returns to scale
(dynamic economies of scale) –
average costs fall as cumulative
output over time rises

compare with:
increasing returns to scale
(economies of scale) –
o average costs fall as current output
rises
o increases in output are more than
proportional to increases in inputs
o F(aK,aL) > aF(K,L)
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Definitions : Economies of Scale

With constant return to scale, input use and total cost rise in
the same proportion as output
– Average cost is constant: total cost divided by number
of units produced is constant
With scale economies, output quantity goes up by a larger
proportion than does total cost
– Average cost per unit of output is decreasing
Note that eventually, we will always face increasing marginal costs.
Constant average costs imply:
– All factors are perfectly divisible
– The prices of factors do not increase as demand for them
increases
– Both implications demonstrably false!
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 Definitions : Economies of Scale

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Economies of Scale and Trade

How does economies of scale affect

international trade?
Since prices rise for exporting industries after trade
opens, the point of decreasing average costs might shift
farther into the future
For the individual firm, a greater size may become
profitable as the indivisible factors can be utilized more
intensively, and there might be a tendency to concentration
in greater firms
For industries as a whole, greater investment in the
production of export goods may lead to greater external
economies of scale, more clusters forming and so on

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Monopolistic competition:

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 Intra-Industry Trade
Net trade for an industry is the difference between exports and
imports of the industry’s product(s)
Inter-industry trade: A country exports products in some
industries and imports products in other industries
Intra-industry trade: Two-way trade in which a
country both exports and imports the same or very
similar products (i.e., products in the same industry)

Intra-industry trade is an important part of

international trade – but how can that be, when
comparative advantage is the driver of trade?

The New Trade Theory

Intra-Industry Trade
25–50% of world trade is intra-
industry trade.
The lion’s share of intra-industry
trade is manufactured goods among
advanced industrial nations.
IIT is prevalent in higher income
countries: higher income
generates taste for variety
IIT is driven by product
differentiation
IIT is driven by scale economies

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New Trade Theory Concept

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 New Trade Theory
Implications of the New Trade Theory
1. Countries may export the same good to each
other
2. Countries may lose from trade
3. More and broader reasons for countries
to gain from trade
4. New rationales for using policy to affect
trade

More on each of these…

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The New Trade Theory

1. Countries may export the same good to each other
intra-industry trade (ITT)–two way exchange of similar goods
Example: US both exports and imports cars

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 http://www.census.gov/foreign-trade/statistics/country/
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Intra-Industry Trade:
Measuring Intra-Industry Trade (IIT)
IIT is the total trade in the product that is not net
trade
IIT = (X + M) - | X – M |
Where X is the value of exports and M is the value of
imports of the product / group of products in question
– Definition of the “product” important for size of IIT
– The broader the definition, the greater IIT will be
Empirically, intra-industry trade is more important
for trade in manufactured goods than it is for trade in
agricultural products and raw materials

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 Intra-Industry Trade for the United
States, Selected Products, 2012
U.S. Exports U.S. Imports Total Trade Net Trade Intra-Industry IIT
(X) (M) (X+M) (X-M) Trade Share
$million $millions $millions $millions $millions (%)
Perfumes (55310) 1,723 1,962 3,684 (−)239 3,445 93.5

Cosmetics (55320) 3,710 3,058 6,768 (+)651 6,117 90.4

Clothes washing
machines (77511)
205 308 512 (−)103 410 79.9

Electronic
Microcircuits (77640)
33,483 27,490 60,973 (+)5,993 54,979 90.2

Automobiles(78120) 53,901 149,142 203,042 (−)95,241 107,802 53.1

Photographic
cameras(88111) 323 134 456 (+)189 267 58.6

Books and brochures

(89219)
2,414 1,712 4,126 (+)701 3,425 83.0

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Intra Industry Trade

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 The New Trade Theory

Explanations for IIT

– Definitions of “industry” may be too large, and include
Different, but similar, products
– Toyotas
– Fords
Goods at different stages of processing
– Autos
– Auto parts

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 The New Trade Theory

Explanations for IIT

– Same good sold across different borders
– Why ? What is the main motive for Trade ?

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The New Trade Theory

Explanations for IIT

– Differentiated products – the same, but advertised as different (brands of
jeans)

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 Intra-Industry Trade:
What Explains Intra-Industry Trade?

Product differentiation an important driver: many types

and different qualities of the same kind of product are
produced around the world.
– Car manufacturing, for instance: German, Japanese, Korean, French,
etc., cars are all sold in Germany
– Wine: Germany both exports wine and imports wine
Seasonal goods also play a role: temperate and
Mediterranean countries may produce and export some
seasonal goods in the summer and fall and import similar
goods in the winter months
More generally, we can say that if the world market is
sufficiently integrated, then there is no distinction between it
and domestic markets. Producers in different locations may have
similar advantages, and buyers all over the world may choose
between different producers, no matter location

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How important is IIT in non-food

manufactured products for different countries?

Country 1989 2005 2012

United States 55.3 58.3 63.6
Canada 54.3 63.2 55.4
Japan 27.8 41.2 38
Germany 62.6 67.5 67.2
France 71.3 73.9 71.5
United Kingdom 69.0 71.7 71.6

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 The New Trade Theory

Explanations for IIT

– Identical products sold by firms from different
countries into each other’s markets
– What are the main trading goods between Germany
and France ?

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New Trade Theory

Implications of the New Trade Theory

Intra- Industry Trade can be explained by:
Taste of Variety and Differentiated Products
o People have a tremendous diversity of taste and are willing to
pay for it at the marketplace.
▪ Product differentiation and variety of taste
leads to specialization and imperfect
competition.
o Taking advantage from division of labor in industries
that exhibit economies of scale we can consume a
larger variety of products and services on a lower cost.

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 New Trade Theory
Implications of the New Trade Theory
2. Countries may lose from trade

– This is not actually likely, but it wasn’t even

possible in the Ricardian and H-O Models
– One story: small country may be forced to
specialize in an industry with decreasing
returns to scale

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New Trade Theory

Implications of the New Trade Theory
3. More and broader reasons for countries to gain
from trade
– New gains from each new assumption:
Cost reductions due to scale economies
Reduced market distortions due to increased
competition
Consumer benefit from access to more
variety
– Implication:
It is possible for all people in a
country to gain from trade
Contrast to H-O Model and Stolper-Samuelson Theorem, where
somebody must lose
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 Implications of the New Trade Theory
3. More and broader reasons for countries to gain from trade

New Trade Theory

Implications of the New Trade Theory
4. New rationales for using policy to affect trade
– Called “Strategic Trade Policy” – See Krugman
article
– How?
If some industries are better to have than others (due
perhaps to scale economies), “industrial policy”
may promote these industries
If imperfectly competitive firms earn profits, trade
policy may be used to get more profit for a country’s
own firms

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 New Trade Theory

Implications of the New Trade Theory

4. New rationales for using policy to restrict trade
– But note Krugman’s conclusion: These
arguments are not likely to be usable:
Empirical difficulties: Hard to know where to
intervene
Entry: Benefits will be dissipated by new
firms
General equilibrium: Help in some sectors
hurts others
Retaliation: Other countries may react
Political economy: Industries lobby for help
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New Trade Theory: The Product Life Cycle

Theory
Raymond Vernon (mid-1960s ) proposed the product
life-cycle theory suggesting that as products mature both the
location of sales and the optimal production location will change
affecting the flow and direction of trade
In the mid-1960s, the wealth and size of the U.S. market
gave a strong incentive to U.S. firms to develop new
products.
Main ideas: Vernon’s Premises
– Technical innovations leading to new and profitable products
require large quantities of capital and skilled labor
– The product and the methods for manufacture go through
three stages of maturation
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 Stages of the Product Cycle
One interesting hypothesis is that new products pass
through a series of stages in the course of their
development, and their comparative advantage position
changes as they move through this product cycle.

The New Product

The Maturing Product

The Standardized Product 49

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Stages of the Product Cycle

Some countries seem to have ability to supply a

constant flow of new products: innovation –
imitation.
Product cycle: new product maturing
product standard product.

the comparative advantage of production

changes during the product cycle.

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 New Trade Theory: The Product Life Cycle
Theory
Raymond Vernon (mid-1960s ) proposed the
product life-cycle theory:

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New Trade Theory: The Product

Life Cycle Theory

Domestic production
Exports,
domestic I II III IV
production
(X-M)D

Imports, Time
foreign
production
Foreign production

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 New Trade Theory: The Product Life Cycle
Theory (Vernon, mid-1960s)

The Product Life Cycle and Trade Implications:

Increased emphasis on technology’s impact on
product cost
Explained international investment
Limitations
– Most appropriate for technology-based products
– Some products not easily characterized by stages of maturity
– Most relevant to products produced through mass production

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International Product Life-Cycle (Vernon)

➢ Most new products conceived / produced in the US in 20th
century
➢ US firms kept production close to their market initially
Aid decisions; minimize risk of new product introductions
Demand not based on price; low product cost not an issue
➢ Limited initial demand in other advanced countries initially
Exports more attractive than overseas production
➢ When demand increases in advanced countries, production
follows
➢ With demand expansion in secondary markets
Product becomes standardized
production moves to low production cost areas
Product now imported to US and to advanced countries

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 New Trade Theory: Porter’s Diamond

The Porter’s Diamond of National Advantage:

Extends and adapts traditional theory of comparative
advantage to take account of three factors:
▪ International competitive advantage is about
companies not countries—the role of the national
environment is providing a home base for the
company.
▪ Sustained competitive advantage depends upon
dynamic factors-- innovation and the upgrading of
resources and capabilities
▪ The critical role of the national environment is its
impact upon the dynamics of innovation and
upgrading.

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Porter’s Diamond Porter Contends that a

nation's characteristics
have a major impact
Government Structure & on its firms performance.
Rivalry of Firms

Factor Demand
Conditions Conditions

Related and
Support Industry Chance

Adapted From: Porter, M.E., (1990), The Competitive Advantage of Nations,

Free Press, Cited in de Wit, B & Meyer, R, (1998), “Strategy Process, Content
Context, an International Perspective” 2nd Ed, West.p, pp 775.

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 New Trade Theory: Porter’s Diamond

Competitive Advantage for Companies:

Organizations that are successful in highly
competitive home markets should succeed in
international markets
Success requires an international plan,
resources, marketing mix adaptation
Conflict between “standardization” and
“customization”

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New Trade Theory: Porter’s Diamond

What Is Porter’s Diamond Of Competitive

Advantage?
Michael Porter (1990) tried to explain why a nation
achieves international success in a particular industry
– identified four attributes that promote or impede the creation of
competitive advantage
1/ Factor endowments - a nation’s position in factors of
production necessary to compete in a given industry
– can lead to competitive advantage
– can be either basic (natural resources, climate, location) or
advanced (skilled labor, infrastructure, technological know-
how

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 New Trade Theory: Porter’s Diamond

What Is Porter’s Diamond Of Competitive

Advantage?
2. Demand conditions - the nature of home demand for
the industry’s product or service
– influences the development of capabilities
– sophisticated and demanding customers
pressure firms to be competitive
3. Relating and supporting industries - the presence or
absence of supplier industries and related industries
that are internationally competitive
– can spill over and contribute to other industries
– successful industries tend to be grouped in clusters in
countries

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New Trade Theory: Porter’s Diamond

What Is Porter’s Diamond Of Competitive

Advantage?
4. Firm strategy, structure, and rivalry - the conditions
governing how companies are created, organized, and
managed, and the nature of domestic rivalry
– different management ideologies affect the development of
national competitive advantage
– vigorous domestic rivalry creates pressures to innovate, to
improve quality, to reduce costs, and to invest in upgrading
advanced features

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 Home Diamond
(Porter, M.E. 1990)
Firm Strategy
Structure, &
Rivalry
• Do management & organisational
structures in nation match industry needs?
• Does industry attract outstanding talent?
• Do investors goals meet industry needs?
• Are there capable domestic rivals?

Factor conditions: Demand conditions:

• Does the nation have advanced • Are the nations buyers sophisticated
factors of production? & demanding?
• Are there advanced factor creating • Does the nation have unusual needs?
mechanisms? E.g. 1st rate University • Do home \customer needs emulate
research, Top grade Universities. those elsewhere?
• Are selective factor conditions • Does the nation have sophisticated
indicators of foreign circumstances? distribution channels

Demand conditions:
• Does the nation have world-class
supply industries
• Are there strong related industries
Adapted From: Porter, M.E., (1990), The Competitive Advantage of Nations, Free Press, Cited in de Wit, B & Meyer, R, (1998),
“Strategy Process, Content Context, an International Perspective” 2nd Ed, West.p, pp 775.

Development of Silicon Valley

+ Presence
of Excellent +
Universities
+ 1
More skilled
labour.
+ Presence
of skilled
+ 5 labour
force.

+
Additional
support firms 2 +
Incoming
electronics
+ firms.

4 Component
manufacturers
attracted. +
3
Drawn by Rulzion Rattray.

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 New Trade Theory: Sumary

Fundamentals First-Mover Advantage

Gains from Economic and

specialization and strategic advantage
increasing Formidable barrier
economies of scale to market entry for
Barriers to entry potential rivals
Role of Country’s export
government and home-based
firm
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