The Development and Application of the New Trade Theory and Its Impact on International Trade - Essay Example

Trade Theories Affiliation Introduction As Robert Gilpin said, “trade is the oldest and most important nexus among nations”. Trade theories are concepts of economic thought that aim to explain why and how nations engage in international trade and the welfare repercussions of that trade. Trade theories have been evolving over the last few centuries. Traditional trade theories argued that nations gained from exporting products and services that they were comparatively good at producing while importing goods and services that other nations were relatively good at manufacturing, but actual trade patterns did not match that theory (Petersen & Rajan, 2006). The trade theories stated that with increased international trade, countries would embrace specialization, widen product gaps and therefore increase trading among nations. Recent trade theories focus on the trading behaviour of individual companies, making a close link between trade and productivity. The unit of trade is considered to be the firm and not industries (Klug, 2005). The new theories share some attributes with the traditional theories but embrace the firms within industries with a focus on productivity (Francová & Breveníková, 2012). This essay will examine the development and application of the new trade theory and its impact on international trade. History of Trade Theory David Ricardo created the Ricardian model in the 18th century. The model was based on the theory of comparative advantage. The model was rooted in free trade and competition without government interference. The main reason for trade in the Ricardian model is difference in technological advancement. The Ricardian model opposed regulations and tariffs in international trade. The Ricardian model also states that trading is advantageous for all countries involved in trade. The model similarly suggests that developed nations can compete with low wage countries. The Hecksher-Ohlin model replaced the Ricardian model. Eli Hecksher and Bertil Ohlin developed the Hecksher-Ohlin model. This model states that countries with equal access to technology have the same industrial productivity levels and will trade due to differences in resource endowments. Countries will trade in products that they can easily and amply produce. By not having to depend on internal markets, countries can take advantage of elastic demand (Schott, 2007). Figure 1 below compares the differences in production between Angola and Botswana due to differences in resource availability (UoW, 2000). Figure 1: Hecksher-Ohlin Model. Comparison of trade between Angola and Botswana Source: University of Washington, A Two Factor World: The Hecksher-Ohlin Model, digital image, The Hecksher-Ohlin model assumes that the charges of commodities are the same everywhere and that world trade is unrestrained and has no tariffs and exchange control. The Hecksher-Ohlin model was popular for most of the 20th century until it was replaced by Krugman’s new trade theory. The new trade theories states that trade is based on comparative advantage but the source of the advantage is subtle and in most times does not even occur in autarky but develops with the opening of trade (Perdikis & Kerr, 2008). International trade is attributed to significant economies of scale and network existent in key industries. Early entry into a specific industry grants one firm competitive advantage over newer entrants. The theory also suggests that governments have a role in supporting new industries and promoting the growth of key industrial sectors (Neary, 2009). New New Trade Theory International trade entered a new phase in the 21st century. The next major theory after the new trade theory was the new new trade theory that was introduced in the early 2000s. In the new, new trade theory, the unit of economic analysis changed from industries to firms. Figure 2 below compares old and new trade theories (Economics, 2008). The New new trade theory shares many characteristics with the monopolistic competition models from new trade theories but introduces alterations in company attributes within the industry especially as regards productivity. In this trade environment, the increased trade compels inefficient firms out of competition and within industrial relocation of resources from low productivity to high productivity companies (Ayumu, 2013). Figure 2: Comparison of Old and New Trade Theories. Source: Rate Economics, New Trade Theory, digital image Melitz incepted a revolution in global trade theories by incepting an analytical framework within heterogeneous organizations that was a considerable improvement over the new trade theory. This theory drew its basis from the original one-sector model that is bent on monopolistic competition. In the Melitz model, only a few highly productive companies are involved in trade. The model explains that firms produce a variety of distinguished products. When the enactment of few trade barriers encourages competition on an international scale, low-productivity firms that had been protected before by the trade barriers are obliged to withdraw from the market and get replaced with highly productive firms (Macfie, 2004). As a result, the average productivity of a nation on a larges scale rises. Exporting firms only sell a small share of their products and imported inputs only account for a small percentage of the company inputs. Firms that export and firms that use imported inputs tend to be bigger, highly productive and have more capital. The exporting firms also utilize skilled labor and pay higher wages than companies that do not participate in international trade (Melitz, 2008). Trade displays significant dynamism in terms of changes in extent of existing trade flows and in terms of the emergence of new trade flows. New products are introduced to the market or the products already under export get diversified in new markets. Trade liberalization grows productivity mainly because of within-industry reallocations rather than inter-industry reallocations (Schott, 2007). Resources are relocated from firms of low productivity to higher productivity firms. Firms entering international trade tend to adopt newer, more efficient technologies to increase efficiency and productivity. The fact that businesses must commit substantial resources to enter and maintain a presence in foreign markets (through exports, imports, or foreign direct investment) also infers that the risks and uncertainties present in the international market are enormous (Melitz & Redding, 2012). Since the firm has to shoulder a fixed cost of operation, a company stays in trade only if its operating profits are high enough to bear this fixed cost. In a free market, a firm derives profit from internal and international sales but it faces flexible and destination-specific fixed costs of exporting (Johns, 2005). In equilibrium, some companies remain in the industry serving only domestic markets while other companies sell domestically and internationally. Helpman improved on this model by devising an estimation method that takes into account the lack of trade among nation pairs, estimations of intensive and extensive margins of trade and makes adjustments for selection bias (Helpman, 2013). Why Shift in Trade Theories to Firm Behaviour is Surprising Exports account for a large share of the gross domestic production in most countries in the world. However, in the 21st century it was studied that only a small percentage of companies actually engaged in export. Traditional and new trade theories could not explain how exporting firms were only a few highly productive firms. Comparative advantage had little success in explaining these patterns. The huge impact from the liberalization of the industry also needed expounding (Barnes, 2013). Exporting industries did not export to all countries as implied by the new trade theory. The new trade theory implied that theoretical cost advantage and import-competing industries experienced productivity gains following trade liberalization in spite of the reduced magnitude of production. It was also observed that exporters had higher productivity than firms that sold domestically (Helpman, 2013). Therefore, the new new trade theory was developed by economists to try and explain these deficiencies. The unit of economic analysis was changed from the industry to firms. The theory drew its inspiration from dynamic industrial models of firm entry, innovation, growth and death (Ayumu, 2013). This was surprising because all along, the theories had centered on industries as trade metrics. It was also unexpected because all the firm properties both within and across the industry were incorporated into the trade theory. This theory could address the increasing complexity of global strategies that multinational firms were applying (Melitz, 2008). The shift to firm behavior was made possible by the availability of extensive firm level data in the 21st century. Quantitative analysis was required for assessing the magnitude of the influence of trade liberalization. To accomplish this, firm-level statistics were needed in order to calculate the distribution of productivity by industry relative to the limit of export market entry in the event of elimination of trade barriers and exit from the market. The technology in use in current industrial models more advanced than it was a decade back. Research and development, which is crucial to supporting export performance by producing new products to introduce into the market as old ones become outdated, is not uniformly distributed across firms. Technological advancements were concentrated in firms that tended to be large and operated internationally. Factors contributed to the design of the new, new trade theories (Schott, 2007). Conclusion Trade theories are concepts of economic thought that seek to explain why and how nations engage in international trade and the welfare repercussions of that trade. Trade theories have evolved over time. The Ricardian model stated that countries traded because of the gaps in technology within a free market. The Hecksher-Ohlin model stated that countries with same levels of technology traded because of difference in resource endowment. Krugman’s new trade theory trade is based on comparative advantage and that the reasons for international trade are significant economies of scale and network effects that exist in key industries. The new, new trade theory designed by Melitz changed the focus from the industry to the firm. In the model, only a few highly productive companies are involved in international trade while the less productive trade internally. The new new trade theory shares many characteristics with the monopolistic competition models from older trade theories. The shift from industry was surprising because individual firm data was not available before and quantitative analysis was not possible. One flaw with new new trade theory is that it does not take into account the impact that political restrictions have on economic logic. The new, new trade theory is relevant in developed countries but its applicability in developing nations is debatable. Old theories are more relevant in developing nations. References Ayumu, T., 2013. What is "New" New Trade Theory, s.l.: Reaserch Institute of Economy, Trade and Industry. Barnes, T. (n.d.). Theories of interregional trade and theories of value. Environment and Planning A, 729-746. 
 
 Francová, Z., & Breveníková, D. (2012). Towards the Importance of Theories of Trade as Part of Trade Science. Studia Commercialia Bratislavensia. 
 Helpman, E., 2013. Foreign Trade and Investment: Firm Level Persepectives. s.l.:Havard University. Johns, R. (2005). International trade theories and the evolving international economy. New York: St. Martins Press. Klug, A., & Young, W. (2006). Theories of international trade. London: Routledge. 
 Macfie, A. (2004). Theories of the trade cycle,. London: Macmillan. 
 Melitz, M. J., 2008. The Impact of Trade of Intra-Industry Reallocations and Aggregate Industry Productivity. s.l.:Econometrica. Melitz, M. J. & Redding, S. J., 2012. Heteregemous Firms and Trade. Cambridge, MA: National Bureau of Economic Research. Neary, P. J., 2009. Putting the "New" into New Trade Theory: Paul Krugmans Nobel Memorial Prize in Economic. University of Oxford ed. s.l.:Department of Economics. New trade theories: A look at the empirical evidence: Report of a conference. (1994). London: Centre for Economic Policy Research. Perdikis, N., & Kerr, W. (2008). Trade theories and empirical evidence. Manchester, UK: Manchester University Press. Petersen, M., & Rajan, R. (2006). Trade credit: Theories and evidence. Cambridge, MA: National Bureau of Economic Research. 
 Rate Economics, New Trade Theory, digital image, viewed 28 November 2014, Schott, P. K., 2007. Journal of Economic Persepectives. In: Firms in International Trade. s.l.:s.n., pp. 105-130. University of Washington, A Two Factor World: The Hecksher-Ohlin Model, digital image, Viewed 28 November 2014, Read More