New Trade Theory

Limits of traditional theory

Ricardo's comparative advantage and the Heckscher–Ohlin theory explain trade by differences between countries in technology or in endowments of capital and labor. On this view trade should occur between dissimilar countries and involve different industries' products. Yet after the Second World War much world trade took place among advanced economies with similar endowments, and within the same industries, cars for cars. Grubel and Lloyd (1975) developed an index measuring the share of such intra-industry trade and showed it to be large. The Leontief paradox (1953), the finding that capital-abundant America exported labor-intensive goods, also cast doubt on traditional theory.

The core of Krugman's model

Paul Krugman (1979, 1980) applied the monopolistic competition model of Dixit and Stiglitz (1977) to international trade. Because of fixed costs, each firm enjoys economies of scale, with average cost falling as output rises, and consumers value variety. A single national market cannot efficiently support many varieties, but when trade integrates markets each firm produces at larger scale and consumers enjoy more varieties. Trade exchanging different brands is therefore beneficial even between two identical countries. The gains come from lower prices and greater variety; Broda and Weinstein (2006) estimated the welfare gain from growth in imported varieties in the United States at about 2.6 percent of GDP. The home market effect explains why countries with large demand tend to become net exporters of scale-economy industries. Helpman and Krugman (1985) integrated the theory with comparative advantage.

Policy implications and later developments

With scale economies and imperfect competition, government intervention can potentially benefit the home country. Using game theory, Brander and Spencer (1985) proposed strategic trade policy: in oligopolistic industries, export subsidies can shift market share from foreign rivals and raise domestic profits. Krugman (1987) himself stressed, however, that because of limited information, retaliation and rent seeking, free trade remains a good rule of thumb. Krugman (1991) combined the framework with transport costs to found new economic geography, explaining how industries concentrate in particular regions. Marc Melitz (2003) introduced firms of differing productivity within an industry: on opening to trade, only the most productive firms export and the least productive exit, raising industry-wide productivity, the so-called new new trade theory. Bernard and colleagues (2007) assembled firm-level evidence that a small number of large firms account for most exports.

FAQ

What is new trade theory in simple terms?

Similar countries buy and sell the same kinds of goods not because they are good at different things but because mass production lowers costs and consumers want variety.

How does new trade theory differ from comparative advantage?

Comparative advantage traces trade to differences in technology or resources, while new trade theory shows trade can arise from scale economies and product differentiation even without such differences; the two are complementary.

Sources reviewed: 2026-10-26

References

1. Krugman, P. R. (1979). Increasing returns, monopolistic competition, and international trade. Journal of International Economics, 9(4), 469–479.
2. Krugman, P. (1980). Scale economies, product differentiation, and the pattern of trade. American Economic Review, 70(5), 950–959.
3. Dixit, A. K., & Stiglitz, J. E. (1977). Monopolistic competition and optimum product diversity. American Economic Review, 67(3), 297–308.
4. Helpman, E., & Krugman, P. R. (1985). Market Structure and Foreign Trade. Cambridge, MA: MIT Press.
5. Grubel, H. G., & Lloyd, P. J. (1975). Intra-Industry Trade: The Theory and Measurement of International Trade in Differentiated Products. London: Macmillan.
6. Brander, J. A., & Spencer, B. J. (1985). Export subsidies and international market share rivalry. Journal of International Economics, 18(1–2), 83–100.
7. Krugman, P. (1991). Increasing returns and economic geography. Journal of Political Economy, 99(3), 483–499.
8. Melitz, M. J. (2003). The impact of trade on intra-industry reallocations and aggregate industry productivity. Econometrica, 71(6), 1695–1725.
9. Bernard, A. B., Jensen, J. B., Redding, S. J., & Schott, P. K. (2007). Firms in international trade. Journal of Economic Perspectives, 21(3), 105–130.
10. Krugman, P. R. (1987). Is free trade passé? Journal of Economic Perspectives, 1(2), 131–144.
11. Leontief, W. (1953). Domestic production and foreign trade: The American capital position re-examined. Proceedings of the American Philosophical Society, 97(4), 332–349.
12. Broda, C., & Weinstein, D. E. (2006). Globalization and the gains from variety. Quarterly Journal of Economics, 121(2), 541–585.
13. Royal Swedish Academy of Sciences. (2008). Trade and Geography: Economies of Scale, Differentiated Products and Transport Costs (Scientific background on the Sveriges Riksbank Prize in Economic Sciences). Stockholm.