Ricardo revealed how every country has a comparative advantage, they can produce a good or service at a lower opportunity cost than other countries. Resultantly, global production is maximised if each country specialises in the good or service that they have a comparative advantage in.
But what determines comparative advantage? In Ricardo’s model it is simply geography or naturally resources. Think, for instance, of Portugal and their wine production or England and their comparative advantage in producing cloth. Moreover, in the Heckscher-Ohlin model, it is shown how factor proportions can determine comparative advantage. For example, countries with a lot of labour relative to capital will possess a comparative advantage in producing labour intensive-goods.
However, there are 2 major problems with the comparative advantage theory of international trade. In the Ricardian model and its extensions, the determinants of comparative advantage are outside of the models, countries cannot change them.
Additionally, in reality, countries with similar comparative advantages seem to trade similar goods and services with each other. Why would an economy produce a certain type of good and then exchange it for a similar type of good with another country? Take the automotive industry as an example: the USA produces and exports the Ford Mustang but imports Germany’s BMW M4s. Conventional theories like Ricardo’s struggle to explain this.
However, New Trade Theory brings the determinants of comparative advantage into the model by asserting that international trade patterns are largely determined by economies of scale and network effects.
According to New Trade Theory, network effects refers to the way in which one user of a good/service affects the value of that good/service to others. As more people use a particular good, the value of that good increases, more people demand that good and the network expands. Network effects highlight the fact that consumers like more choices, but they also want goods that have a high utility; it is network effects that offer this increased utility to some goods over others. For instance, Facebook and Twitter became more valuable as their number of users increased.
As for economies of scale, New Trade Theory emphasises how a fall in average costs allows an industry in one economy to enter and compete on the international market. An industry in one economy can gain large economies of scale if it produces a large enough level of output; and it can reach this high level of output either by benefiting from a high enough demand in its domestic market or by entering the market before its competitors and gaining an advantage in research and development.
New Trade Theory therefore explains how an industry in one country can export goods and compete on international markets where similar goods are sold; the goods are slightly different (because of network effects) and prices maybe slightly different (because of different levels of economies of scale). This is why, in our earlier example, some US consumers may import a German BMW M4 rather than buy an American Ford Mustang, they may be influenced by network effects.
Moreover, New Trade Theory explains how a firm can enter an industry before it’s rivals and come to dominate the market. This is because the incumbent firm will benefit from months or years of economies of scale which new firms will not experience. Consequently, the model predicts that large global industries with large economies of scale will be characterised by monopolistic or oligopolistic competition. Resultantly, New Trade Theory seems to explain why, in reality, the most lucrative industries are those with limited competition and dominated by capital-intensive production techniques. For instance, the market for tablets is dominated by Apple.
As for the policy implications of New Trade Theory, it reconfirms the infant industry policy argument. As Alexander Hamilton first argued in 1791, the government must use tariffs to protect key infant industries until they are efficient and ready to compete internationally. Likewise, New Trade Theory asserts that the formation of dominant industries is path dependent and that the government must make judicious use of tariffs to protect these industries so that they can benefit from economies of scale and network effects.
The theory can also help to explain the rise of globalisation. New Trade Theory suggests that the problem between the developed and developing world is not due to any intrinsic comparative advantage, but the economies of scale that the developed world’s firms possess. The industries in LDCs struggle to compete with their rivals in the developed world because they lag too far behind the economies of scale enjoyed by those industries in the developed world.