New Trade Theory
Well, relatively new at least
In our last article on the gravity theory of trade, we looked at the relationship between the imports/exports among 2 countries and the distance between them and the relative size of their economies. Today’s piece is going to be on a new trade theory, one that conveniently happens to be called the new trade theory (NTT). This outlook isn’t necessarily at odds with that of the gravity model, but just emphasizes different factors in explaining international trade patterns.
Some backstory
Theories antecedent to the NTT revolved around the idea of comparative advantage, with the Ricardian and Heckshcer-Ohlin models being the preeminent ones in this regard. Just to quickly recap what this all means, comparative advantage is simply a country’s ability to produce something at a lower opportunity cost than other countries. David Ricardo, a British economist from the 18th century, applied this idea of comparative advantage to technological differences that economies have access to. In other words, the main reason trade occurs at all between countries is because of technological differences between them.
While the Heckscher-Ohlin model still operates on the premise of comparative advantage, it turns attention to differences in factor endowments – the land, labor, capital, and entrepreneurship that a country possesses and can use for producing stuff – in the role of giving one country a comparative advantage over another in the production of a given good.
The logical conclusion of both these theories is that trade will, in large part, occur between countries with significantly different characteristics. If trade takes place the way the Ricardian or Heckscher-Ohlin models says it does, then we’d expect to see countries with an assorted set of technological abilities or factor endowments to be trading partners. In the 20th century, however, more and more countries began trading with economically similar nations, a phenomenon that’s difficult to explain purely on the grounds of comparative advantage.
An unlikely influence
Meanwhile in the field of microeconomics, economists Avinash Dixit and Joseph Stiglitz developed a model of monopolistic competition (when several companies offer products or services that are similar, but not perfect, substitutes), one meant to serve as an alternative to the neoclassical explanation of monopolistic competition.
What Dixit and Stiglitz essentially showed was that when firms have increasing returns to scale, the entry of new firms becomes less than is socially optimal. This is when an increase in the company’s inputs leads to a more than proportionate increase in their output. For a new firm to achieve increasing returns to scale, especially when facing massive pre-existing competitors (that likely already have increasing returns to scale), is very difficult. This is why we rarely see new entrants in say, the soda market - seldom will a startup be able to compete with the productive capacities of Coca Cola or Pepsi.
The soda market illustrates another insight that Dixit and Sitglitz shed light upon. Coca Cola and Pepsi are both incredibly powerful brands, ones that consumers implicitly trust when they see. But despite their brand strength, the demand for their products is elastic, meaning it can change a lot with even a small price change.
The main advantage that a company like Coca Cola or Pepsi has over a smaller brand is the brand’s power, but this pales in comparison to the importance of the product’s pricing. If Pepsi were to suddenly raise the price of their cans to $20 each, it’s unlikely that their customers would have much of a problem with switching over to Coke. What this suggests is that people don’t necessarily have a strong preference for diversity when it comes to soda.
But what about the other extreme, wherein consumers have a strong preference for diversity? Think of cars and laptops - seldom are people willing to simply choose their purchases in these areas based purely on what’s cheaper. Cases like these, according to Dixit and Stglitz, could lead to the opposite problem: the entry of firms being greater than what is socially optimal, thereby spreading the market’s resources too thin as more resources are allocated towards satisfying the diversity preference at the expense of producing enough of each product.
Enter Krugman
So, where does international trade fall into all this? To answer that, we have to turn to the new trade theory’s brainchild, Paul Krugman; Nobel Laureate, former professor at MIT and Princeton, and perhaps the most influential economist of the 21st century (so far, at least). Krugman’s theory for trade between similar countries involved 2 assumptions:
Achieving an economy of scale (cost advantages that occur when production becomes efficient) provides a competitive advantage for the firm in question
Consumers like variety in what they consume
Germany and South Korea: neither country has any particular advantage over each other when it comes to car manufacturing, but both are among the largest automotive manufacturers in the world. That’s because consumers enjoy product diversity when selecting a vehicle, and there’s a huge difference between an Audi and a Porsche. This strong preference for variety (which Krugman modeled the way Dixit and Stiglitz did) in the international markets is why countries exporting tens of billions of dollars worth of cars will also be importing comparable amounts - consumers also enjoy non-native brands. As such, countries with similar economic characteristics end up specializing in certain brands of products rather than types of products.
The main takeaway from this point is that countries gain trade not only because consumers have access to more efficient production processes through the access to larger markets (which is what Ricardo highlighted), but because consumers also have access to a larger variety of the same type of product.
As for where economies of scale come into play here, it mostly has to do with how being an early entrant in a market can lead to that firm becoming the dominant one. The logic behind this observation is simple: the first firms gain substantial economies of scale before all subsequent enterers, acting as a barrier to entry. The larger the economy of scale, the more limited the competition will become. Therefore, global industries which, almost by default, involve massive economies of scale, will lead to a form of monopolistic competition.
This is why very lucrative and profitable industries, such as automobile manufacturing, are dominated by more developed countries, because these were the first countries to get in on the action and thus acquire the necessary economies of scale.
In summary, the reasons for trade occurring between 2 given countries often go beyond just differences in technological ability and factor endowments; product brands and economies of scale also play an important role in determining trade patterns.
New economic geography
Here’s the official stated reason for Krugman’s 2008 Nobel Prize:
...for his analysis of trade patterns and location of economic activity…
Krugman didn’t stop at trade patterns with the modeling strategy he employed in his new trade theory. Turns out they fit quite neatly into the sub-field of economic geography and lead to some valuable insights, which were documented in Krugman’s "Increasing Returns and Economic Geography", his most cited academic paper.
In addition to the importance of product brands and economies of scale in explaining international trade patterns, Krugman’s NTT also discovered what’s called the “home market effect.” The main idea behind this theory is that large countries will be net exporters of goods with high transportation costs and strong economies of scale.
Why is this the case? 2 reasons; firstly, because we’re dealing with products that have strong economies of scale (i.e. automobiles), it makes sense for a firm to just concentrate their production in a single place and have that one factory produce as much as possible. Secondly, transportation costs provide an incentive for the production of a good to be in a location with a high demand for that good (in order to reduce transportation and thus, the costs that come along with it). Wealthier countries and/or those with large populations, which generally have a higher demand for these kinds of products, then end up being those who lead production. This link between the size of the market and its respective exports is missed by comparative advantage models.
Now here’s how the home market effect applies to economic geography: unlike agriculture, the manufacturing of products like cars isn’t as restricted by the land production takes place on. Similar to countries in the context of international trade, manufacturing firms will set themselves up in areas where there’s a high demand for their products. But because the production of the good is so nearby, the demand for that good will in turn increase.
A cycle of greater manufacturing and greater demand ensues, increasing the nearby areas’ populations due to the more highly developed infrastructure. Eventually, manufacturing and a substantial share of the urban population will concentrate themselves in a specific geographic area.
Econ IRL
Children following their parents’ footsteps with respect to careers or fields of study is almost a classic story at this point, and it can be easy to see why. If your parents went into medicine for university, you have unparalleled access to insider information on what you need to do to get in, a rough idea of what to expect in terms of curriculum and coursework, and perhaps even connections through your parents to other individuals who could help you in your post-secondary career and beyond. But how much do all these perks influence the “inheritance” so to speak of fields of study? That’s the ultimate question behind this week’s paper, and it didn’t take long for the author to find some pretty strong correlations, but with a lot of variation depending on the field: kids of parents with law degrees are 3 times as likely to also have degrees in law, whereas with children of dentists are more than 5 times as likely to earn the same degrees.
To demonstrate causality, the author looked at university program applicants that are either above or below cutoffs to different fields and compared it to the likelihood that their kids would also enroll in those same fields. Intriguingly, the causal relationship held strong, with parental enrollment in a given field increasing the chances that their child will earn a degree in the same field to nearly 10% (again, varying from field to field).
So why do kids choose to follow their parents? Well, part of the answer could be that the chances of a child doing so is larger when:
The parent works in an occupation that’s commonly associated with their degree
When the parent earns well
This suggests that it’s not necessarily the degree per se that gets kids to follow their parents, but the career occupation. Additionally, after controlling the dataset for gender, the researcher finds that sons and daughters actually tend to follow the parent of the same gender more often, indicating that how strong of a role model a parent is towards their kid(s) in turn influences how likely that kid is in following their parent’s post-secondary footsteps.
‘Till next time,
SoBasically