New Trade Theory: Definition, Meaning, Assumptions, and Key Points

What is New Trade Theory?

The New Trade Theory (NTT) is an international trade theory developed by Paul Krugman, a Nobel prize winner that explains the two main points economies of scale and first-mover advantage.

NTT emerged in the late 1970s, and a number of economists pointed out the ability of firms to attain economies of scale that focuses on the role of increasing constant returns to scale and network effects.

New trade theory aimed to explain international trade differently than old trade theory (such as comparative advantage, factor endowment, etc.) which relies on productivity, factor endowments, and structure.

But, NTT explained without differences in factor endowments also international trade occurs because of economies of scale between similar countries. This argues countries should specialize in specific niches to reduce per-unit cost and achieve economies of scale and such specialization will let countries trade with each other.

Assumptions of New Trade Theory

• Specialization increases output, and the ability of firms to enhance economies of scale increases.
• Learning effects are high, in cost savings that come from “Learning by doing”.
• Competitors may emerge because of “First-mover advantages”.
• The role of government becomes significant (Subsidies to firms).
• Economies of scale may make it possible to stop new entrants.

NTT Makes Two Important Points

Economies of Scale

Economies of scale are unit cost reductions associated with a large volume of output. The major source of cost reduction in many industries may include computer software, automobiles, advanced machines, etc.

In a simple sense, economies of scale mean the minimum per-unit cost of production that results from large production due to which fixed costs remain constant.

In the domestic market economies of scale may not be attained because the demand and area are limited as such unit costs are higher without it. But, in the international market, the demand is very high and firms are forced to produce goods in huge quantities.

As such, domestic firms may be able to better attain economies of scale. Each country may be able to specialize in producing a narrower range of products than it would be in the absence of trade.

Each country can simultaneously increase the variety of goods lowering the costs of those goods. Opportunities for mutual gains may be attained even when countries don’t differ in their resource endowments or technology.

First Mover Advantage

First-mover advantages are the economic and strategic advantages that a firm gets from rising early into an industry. May dominate the global market and trade.

The first mover industry can get benefit from a lower cost structure. Economies of scale are significant and represent a substantial proportion of world demand, firms export more quantity and become first movers, which could increase the ability to capture the international market.

For example, Nokia (Home Country – Finland, products – Electrical and electronic equipment) dominated the production and marketing of mobile phone sets.

The first-mover implications depend on consideration of product life-cycle and market imperfection, and ownership advantages.

NTT suggests a country may dominate in the export of goods because it was lucky enough to produce them. The domestic firm enables to gain economies of scale, it becomes the first mover in an industry, discourages subsequent entry of the new firms, and creates barriers to entry to the new firms.

Thus, a first-mover company has various advantages. It will get subsided by the government, conducts economic rationalization, and may get a monopoly within the industry.