New trade theory

New trade theory (NTT) is a collection of economic models in international trade theory which focuses on the role of increasing returns to scale and network effects, which were originally developed in the late 1970s and early 1980s. The main motivation for the development of NTT was that, contrary to what traditional trade models (or "old trade theory") would suggest, the majority of the world trade takes place between countries that are similar in terms of development, structure, and factor endowments. Traditional trade models relied on productivity differences (Ricardian model of comparative advantage) or factor endowment differences (Heckscher–Ohlin model) to explain international trade. New trade theorists relaxed the assumption of constant returns to scale, and showed that increasing returns can drive trade flows between similar countries, without differences in productivity or factor endowments. With increasing returns to scale, countries that are identical still have an incentive to trade with each other. Industries in specific countries concentrate on specific niche products, gaining economies of scale in those niches. Countries then trade these niche products to each other – each specializing in a particular industry or niche product. Trade allows the countries to benefit from larger economies of scale. Some have used NTT to argue that using protectionist measures to build up a large industrial base in certain promising industries will then allow those industries to dominate the world market. Less quantitative forms of a similar "infant industry" argument against free trade have been advanced by previous trade theorists. Although aspects of trade with increasing returns had been worked out earlier, especially in work by Avinash Dixit, new trade theory is associated with Paul Krugman's work in the late 1970s, developing into what is known as the Dixit-Stiglitz-Krugman trade model and the Helpman–Krugman model.