Chapter 4 Outline

The New Trade Theory

The new trade theory began to emerge in the 1970s. At that time, a number of economists were questioning the assumption of diminishing returns to specialization used in international trade theory.¹⁶ They argued that many industries experience increasing returns to specialization because of the presence of substantial economies of scale. As output expands with specialization, the ability to realize economies of scale increases and so the unit costs of production should decrease. Economies of scale are primarily derived by spreading fixed costs (such as the costs of developing a new product) over a larger output. Consider the commercial jet aircraft industry. The fixed costs of developing a new commercial jet airliner are astronomical. For example, Boeing spent an estimated $5 billion to develop its new 777. The company will have to sell at least 350 of the 777s just to recoup these development costs and break even. Thus, due to the high fixed costs of developing a new jet aircraft, the economies of scale in this industry are substantial.

The new trade theorists further argue that due to the presence of substantial scale economies, world demand will support only a few firms in many industries. This is the case in the commercial jet aircraft industry; estimates suggest that world demand can profitably support only three major manufacturers. For example, the total world demand for 300-seat commercial jet aircraft similar to Boeing's 777 model will probably be only 1,500 aircraft between 1995 and 2005. If we assume that firms must sell at least 500 aircraft to get an acceptable return on their investment (which is reasonable, given the break-even point of 300 aircraft), we can see that the world market can profitably support only three firms!

The new trade theorists argue that countries may export certain products simply because they have a firm that was an early entrant into an industry that will support only a few firms because of substantial economies of scale. Underpinning this argument is the notion of first-mover advantages, which are the economic and strategic advantages that accrue to early entrants into an industry.¹⁷ Because they can gain economies of scale, the early entrants into an industry may get a lock on the world market that discourages subsequent entry. The ability of first movers to reap economies of scale creates a barrier to entry. In the commercial aircraft industry, for example, the presence of Boeing and Airbus Industrie and their economies of scale effectively discourage new entries.

This theory has profound implications. It suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. This is at variance with the Heckscher-Ohlin theory, which suggests that a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. Thus, the new trade theorists argue that the United States leads in exports of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because two of the first movers in the industry, Boeing and McDonnell Douglas, were US firms. However, the new trade theory is not at variance with the theory of comparative advantage. Since economies of scale result in an increase in the efficiency of resource utilization, and hence in productivity, the new trade theory identifies an important source of comparative advantage.

How useful is this theory in explaining trade patterns? It is too early to say; the theory is so new that little supporting empirical work has been done. Consistent with the theory, however, a study by Harvard business historian Alfred Chandler suggests that first-mover advantages are important in explaining the dominance of firms from certain nations in certain industries.¹⁸ Also, many global industries have a very limited number of firms. This is the case with the commercial aircraft industry, the chemical industry, the heavy construction-equipment industry, the heavy truck industry, the tire industry, the consumer electronics industry, and the jet engine industry, to name but a few.

Perhaps the most contentious implication of the new trade theory is the argument that it generates for government intervention and strategic trade policy.¹⁹ New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advantages. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture--rather than firms such as Great Britain's DeHavilland and Hawker Siddely, or Holland's Fokker, all of which could have been--was that Boeing was both lucky and innovative. One way Boeing was lucky is that DeHavilland's Comet jet airliner, introduced two years earlier than Boeing's first jet airliner, the 707, was full of serious technological flaws. Had DeHavilland not made some serious technological mistakes, Great Britain might now be the world's leading exporter of commercial jet aircraft! Boeing's innovativeness was demonstrated by its independent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing's R&D was largely paid for by the US government; the 707 was a spinoff from a government-funded military program. Herein lies a rationale for government intervention. By the sophisticated and judicious use of subsidies, a government may increase the chances of domestic firms becoming first movers in newly emerging industries. If this is possible, and the new trade theory suggests it might be, then we have an economic rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade theories we have reviewed so far. We will consider the policy implications of this issue in Chapter 5.