International Economics

Lecture 4
New Approaches to Trade
Theory
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Problems with H-O Model
 Some of the assumptions in the H-O
model are not realistic
 The world does not have:

1- perfect competition,

2- identical preferences,

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Problems with H-O Model
3- When defining comparative advantage, the
Ricardian model and the Heckscher-Ohlin
model both assume constant returns to
scale:
 But a firm or industry may have increasing
returns to scale or economies of scale:

Larger is more efficient: the cost per unit
of output falls as a firm or industry
increases output.
Types of Economies of Scale
 Economies of scale could mean either that larger
firms or that a larger industry (e.g., one made of
more firms) is more efficient.
 Internal economies of scale occur when the cost
per unit of output depends on the size of a firm.
 External economies of scale occur when cost per
unit of output depends on the size of the industry.
Types of Economies of Scale
(cont.)
 External economies of scale may result if a larger
industry allows for more efficient provision of
services or equipment to firms in the industry.

Many small firms that are competitive may comprise a
large industry and benefit from services or equipment
efficiently provided to the large group
of firms.
 Internal economies of scale result when
large firms have a cost advantage over small firms,
which leads to an imperfectly competitive market.
Problems with H-O Model cont.

4- This theory seems to explain quite well

the trade between industrialized and
developing countries, but a far larger
volume of trade takes place among
industrialized countries that often have
similar relative factor endowments

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Problems with H-O Model cont
5- Technological Gap and Product Cycle

Heckscher-Ohlin theory is static

Some economists have suggested that
perhaps the composition of trade
depends on dynamic factors, such as
technological change

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New Trade Theories
 New trade theories base international
trade on:
 - economies of scale,
 - imperfect competition,
 - and differences in the development and
spread of new technologies over time
among nations.

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 New Trade Theories cont.:
1. Intra-Industry Trade
 Product differentiation and variety of taste
 Border trade when countries share a long
border

BA
Country A
CA
CB
Country B BB

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 Index of Intra-industry trade
 Index of Intra-industry trade (Grubel Lloyd
Index-1975)
IIITi= 1 – [(|EXi - IMi|) / (EXi + IMi )]
IIIT~ 1: strong intra-industry trade
IIIT~ 0: weak intra-industry trade
 Inter-industry trade

IINTi= 1-IIITi
6-10
Index of Intra-industry trade

6-11
 New Trade Theories cont.:
2. Product Cycle

 One interesting hypothesis is that new

products pass through a series of stages in
the course of their development, and their
comparative advantage position changes as
they move through this product cycle

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 Domestic production

Exports,
New Trade domestic
I II III IV
Theories: production
3. Product
(X-M) D
Cycle cont.
Time

Imports,
foreign Foreign production
production

I Product development and sale in domestic market

II Growth in exports as foreign demand springs up
III Decline in exports as foreign firms begin to produce
for their home markets
IV Country becomes a net importer as foreign prices 13 fall
 New Trade Theories cont.:
3.The Gravity Equation

 Why does one country trade a great deal with

one trading partner and far less with others?

 Compare, for example, Vietnam trading with

Asian countries... and on the other hand with
some African countries

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New Trade Theories cont.:
3.The Gravity Equation cont.

Tij  f (GDPi , GDPj , POPi, POPj, R)

RR ==Resistance
Resistance variables
variables

According to this formula a country's trade

shares are

a) positively related to the size of other

national economies (measured as
GDP) 15
 TTi
i  f (GNP , R ),
New Trade Theories cont.: TTtot  f (GNPi , R ),
tot
i

3.The Gravity Equation cont.

b) and negatively related to so-called
resistance variables, factors that
discourage a particular trade flow
such factors can be transportation
cost, trade barriers that are not the
same for all trading partners, among
others

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New Trade Theories cont.:
4. Economies of Scale in
Imperfectly Competitive Markets
 Dumping:

Hypothesis:
• Firms is a monopolist in the
domestic market but a small
competitive firm in
foreign markets

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Dumping
 New Trade Theories cont.:
5. External Economies of Scale

 Internal scale economies occur when a firm's

AC falls as the output of the firm increases
 External scale economies occur when firms
AC falls when the output of the industry
increases

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New Trade Theories cont.:
5. External Economies of Scale cont.
AC
The advantage of a long-established
industry where scale economies are
important
ACC •

ACJ • ACJapan

ACChina

QC QJ QCars Cumulative

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