New New Trade Theory


  • Countries do not trade with each other. Firms do — typically, large firms do. New new trade theory is motivated by this observation, and relies heavily on internal economies of scale.
    • Reminder: Increasing return to scale may be the result of increase in industry’s production (a.k.a. external economies of scale) or increase in firm’s production (a.k.a. internal economies of scale).
    • Large firms with downward sloping average total cost (ATC) are at the center of new new trade models.
  • As large firms, who are expected to be more productive, are more likely to engage in exporting and importing, trade liberalization may lead to an increase in their output, which in turn may reinforce their cost advantage; i.e., their cost per unit declines as they increase their production. Other firms, who are expected to be less productive, either remain domestic or exit.

International trade leads to the concentration of production among the best-performing firms and to the exit of the worst-performing firms. Thus, the overall efficiency of the industry may improve.

  • In this part of our lecture series, we employ Monopolistic Competition models to model the consequences of trade liberalization. For a Monopolistic Competition set-up, we assume that:
    • there are only few firms in the market.
    • firms are capable of differentiating their products from their competitors’.
    • they take their rivals’ prices as given.
  • Firms under Monopolistic Competition sell more when:
    • the total sale for their industry increases (an industry-specific scale effect).
    • the number of firms involved in the industry decreases (lower degrees of competition).
    • their price decreases (a firm-specific demand effect).
    • the average price charged by the rivals increases (greater price competitiveness).
  • Ceteris paribus, as more firms enter a Monopolistic Competitive industry:
    • the ATC for a given firm should increase (CC in graph below), simply because they get to sell less.
    • the price charged by a given firm should decrease (PP in graph below), simply because of increase in competition.
  • The above relationships help us to identify the equilibrium number of firms in that Monopolistic Competitive industry. (Why does the equilibrium number of firms matter? Unlike perfectly competitive set-up, monopoly, and duopoly, the number of firms in monopolistic competition may vary. It is, in fact, a variable that should be determined at equilibrium).

Click here to see the graph in details.

  • How would international trade affect the equilibrium outcome?
    • Trade leads to an increase in market size as a result of new access to foreign markets.
    • Increase in market size may lead to greater sales.
    • Due to internal economies of scale, increase in sales translates into lower average cost.
      • Following a decline in average cost, the CC schedule above rotates southwards.
    • Given the optimal pricing, a decline in average cost leads to greater number of firms and lower prices
      • Greater number of firms imply greater varieties of products (Reminder: firms are able to differentiate their products in this market).
      • Lower prices imply greater purchasing power.
    • Though greater number of firms brings greater varieties, it is unclear where firms are located at: home or foreign country.
      • Consider a case where there is a monopoly at home under autarky. Following trade liberalization, we may have more varieties available at home. Yet, that increase could be the result of many possible changes. For instance, we may still have only the monopolist at home plus few other foreign firms. Alternatively, we may have one marginal domestic firm added (thus, two firms at home: the good old monopolist and the marginal firm) along with few other foreign firms. We may even have a case where the monopolist is forced to exit, and home market is fully served by foreign firms. Therefore, there is no clear proposition about the nationality of firms under free trade. However, there is clear proposition about the increase in varieties that are available at home and foreign market.

Click here to see the graph in details.

International trade also leads to greater varieties of products being available at home and foreign country. This gain is justified under Monopolistic Competition set-up.

  • Under classical models, we ended up with a perfect specialization pattern; e.g., country A exporting soybean, while B is exporting textile products. This is known as Inter-industry Trade. However, under Monopolistic Competition models, like in new new trade theory, there is no need for perfect specialization. Product differentiation allows firms at country A to export, say, vehicles to country B, and at the same time country A may import vehicles from country B. This is known as Intra-industry Trade, which makes up for a large share of international trade.

  • How do firms respond to trade liberalization under new new trade theory framework?
    • Firms differ in their productivity. Each firm is given a particular level of productivity, which is then reflected in their marginal cost of production: the more productive a given firm, the lower their marginal cost.
    • Given demand, more productive firms produce more and price more competitively; i.e.: the more productive a given firm, the greater their optimal supply quantity and the lower their optimal price.
    • Trade liberalization alters the demand function. There are two channels:
      • Greater number of varieties brings vertical intercept down
      • Greater industry size lowers the slope
    • Thus, international trade leads to a more elastic demand function.
      • Changes in demand’s vertical intercept may force some firms to exit, as their marginal cost of production is quite high. Firms that exit are at the bottom of productivity distribution.
      • Among those who survive:
        • The most productive firms (who have the lowest marginal cost) gain in terms of operating profit.
        • Firms in the middle of productivity distribution lose part of their operating profit.
    • The best performing firms find it profitable to export, the ones in the middle of productivity distribution only serve the domestic market, and the least productive firms exit. Therefore, overall industry performance improves.