Paper Presentation: Zenith, Annual Economic Conclave of Miranda House, New Delhi

1. PAUL KRUGMAN’S NEW TRADE THEORY
St. Xavier’s College, Kolkata
Economics Department
Arunima Paul
Phone: 8013794924, Email: arunima.95@gmail.com
Avipsha Sengupta
Phone: 9830291564 , Email: avipsha.isha@gmail.com
INTRODUCTION:
Pure theory of trade explains inter-industry trade on the basis of the principle of comparative advantage
– technology driven in Classical, and relative factor abundance driven in Neo-Classical theories.
The central assumptions of both the theories are :
1. Perfect competition with constant returns to scale
2. Factor mobility between sectors within the country, and immobility between countries.
Developments of 1950s, 60s and 70s brought about major empirical findings. The Asian Tigers, China etc
started capturing global markets. Major empirical findings suggest that a large part of such trade is intra-
industry. Intra-industry trade led to the development of new trade theories. Consumers love variety and
therefore products are quality differentiated. It led to the development of trade under a monopolistic
competition.
THE SIGNIFICANCE OF INTRA-INDUSTRY TRADE
About one-fourth of world trade consists if intra-industry trade, that is, two-way exchanges of goods
within standard industrial classifications. Intra-industry trade plays a particularly large role in the trade
in manufactured goods among advanced industrial nations, which accounts for most of world trade.
Over time, the industrial countries have become increasingly similar in their levels of technology and in
the availability of capital and skilled labor. Since the major trading nations have similar in technology
and resources, there is often no clear comparative advantage within an industry, and much of
international trade therefore takes the form of two way exchanges within industries-probably driven in
large part by economies of scale-rather than inter-industry specialization driven by comparative
advantage.
ECONOMIES OF SCALE AND MARKET STRUCTURE

2. External economies of scale occur when the cost per unit depends on the size of the industry but not
necessarily on the size of any one firm. Internal economies of scale occur when the cost per unit
depends on the size of an individual firm but not necessarily on that of the industry.
External and internal economies of scale have different implications for the structure of industries. An
industry where economies of scale are purely external will typically consist of many small firms and be
perfectly competitive. On the other hand, internal economies of scale give large firms a cost advantage
over small and lead to an imperfectly competitive market structure. We begin with a model based on
internal economies of scale.
THE THEORY OF IMPERFECT COMPETITION
In imperfect competition, firms are aware that they can influence the prices of their products and that
they can sell more only by reducing their price. Imperfect competition is characteristic both of industries
in which there are only a few major producers and of industries in which each producer’s product is
seen by consumers as strongly differentiated from those of rival firms. Under these circumstances, the
firm sees itself as a price setter, choosing the price of its product rather than a price taker.
When firms are not price takers it is essential to develop additional tools to explain how prices and
outputs are determined. A pure monopoly is the simplest imperfectly competitive market structure-it
describes the market in which a firm faces no competition and the tools that are developed can then be
used to examine more complex market structures.
Underlying the application of the monopolistic competition model to trade is the idea that trade
increases market size. In industries where there are economies of scale both the variety of goods that a
country can produce and the scale of its production are constrained by the size of the market. By trading
with each other and therefore forming an integrated world market that is bigger than any individual
national market, nations are able to loosen their constraints. Each country can specialize in using a
narrower range of products than it would in the absence of trade; on the same hand by buying goods
that it does not make from other countries, each nation can simultaneously increase the variety of
goods available to its consumers. As a result trade offers an opportunity for mutual gain even when
countries do not differ in their resources or technologies.
The monopolistic competition model can be used to show how trade improves the trade-off between
scale and variety faced by individual nations. We will show how in this model a larger market leads to a
lower average price as well as availability of a greater variety of goods. Applying this result to
international trade it is observed that a world market larger than any of the national markets that
comprise it is created by trade. Therefore, integrating market through international trade has the same
effects as growth of a market within a single country.

3. cost and price CC1
CC2
1
P1 2
P2
PP
n1 n2 number of firms, n
The figure shows the effect of an increase in the size of the market on long-run equilibrium. Initially,
equilibrium is at point 1, with a price p1 and number of firms n1. An increase in the size of the market,
measured by industry sales S, shifts the CC curve down from CC1 to CC2, while it has no effect on the PP
curve. The new equilibrium is at point 2: The number of firms increases from n1 to n2, while the price
falls from p1 to p2.
Clearly, consumers would prefer to be part of a large market rather than a small one. At point 2, a
greater variety of products is available at a lower price than at point 1.
International trade can create a larger market. We can illustrate the effects of trade on prices, scale, and
the variety of goods available with a specific example.
Imagine a commodity is produced by a monopolistically competitive industry. More the number of
firms, more intense is their competition, hence lower is the industry price. This relationship is plotted on
a graph and labeled PP. On the other hand, the more firms there are, the less each firm sells and so,
higher is the average cost. This relationship is plotted on the graph and represented by CC.
Let us take a hypothetical example. Let the total cost function be, TC= 750 + 5q. Let Home under autarky
sell 900 units at p= 10. Let the foreign sell 1600 units at p= 8.75. The market being monopolistically
competitive, autarky number of firms in Home = autarky varieties would be given by zero profit solution.
Similarly for the Foreign.
For the Home, p= AC implies 10=750/q + 5 or 5q= 750 or q= 150. Therefore, number of firms= 900/150=
6. For the Foreign, 8.75= 750/q + 5 or 3.75q= 750 or q= 200. So number of firms= 1600/200= 8. Total
number of varieties in the two countries are limited to the respective number of firms.
Let trade occur. 2500 units are now sold at p= 8 (say). Therefore, 8= 750/q + 5 or 3q= 750 or q= 250.
Therefore, number of firms= 2500/250= 10. It follows that trade under monopolistic competition implies
more production by each firm (scale economy), lower price and larger varieties.

4. Thus it is clear that everyone is better off as a result of integration.
A little intervention from us at this juncture does not seem to be too adventurous. Assuming total cost,
C= F + c.q, demand function of a firm q= S[1/n-b(P-P0)] where F= fixed cost, S= total market, n= number
of firms, b= price responsiveness of demand, P= price charged by the firm and P0= average price of all
the firms. We can establish that n= (S/b.F)^0.5. It follows that if the number of varieties increases
because of trade higher demand elasticity implies bigger b such that when S rises (F remaining the
same), n need not rise. This possibility seems to have been overlooked by Krugman’s model.
THE THEORY OF EXTERNAL ECONOMIES
For a variety of reasons, it is often the case that concentrating production of an industry in one or a few
locations reduces the industry’s costs, even if the individual firms in the industry remain small. When
economies of scale apply at the level of the industry rather than at the level of the individual firm, they
are called external economies.
External economies, like economies of scale that are internal to firms, play an important role in
international trade, but they may be quite different in their effects. In particular, external economies
can cause countries to get “locked in” to undesirable patterns of specialization and can even lead losses
from international trade.
When there are external economies of scale a country that has large production in some industry will
tend, other things equal, to have low cost of producing that good. This gives rise to an obvious circularity
since a country that can produce a good cheaply will also therefore tend to produce a lot of that good.
Strong external economies tend to confirm existing patterns of inter industry trade, whatever their
original sources: countries that start out as large producers in certain industries, for whatever reason
tend to remain large producers, they may do so even if some other country could potentially produce
the goods more cheaply.
Price, cost (per watch)
CO
1
P1 2 AC1
D AC2 Qty of watches produced & demanded
Q1

5. The average cost curve for Country 2, AC2 lies below the average cost curve of Country 1. Thus Country 2
could potentially supply the world market more cheaply than Country 1. If the industry of Country 1 gets
established first, however it may be able to sell watches at price P1 which is below the cost C0 that an
individual firm of Country 2 would face if it began production on its own. So a pattern of specialization
established by historical accident may persist even new producers could potentially have lower costs.
DUMPING
In imperfectly competitive markets firms sometimes charge one price for a good when that good is
exported and a different price for the same good when it is sold domestically. In general the practice of
charging different customers different prices is called price discrimination. The most common form of
price discrimination in international trade is ‘dumping’, a pricing practice in which a firm charges a lower
price for exported goods than it does for the same goods sold domestically. Dumping can occur only if
two conditions are met. First, the industry must be imperfectly competitive, so that firms prices rather
than taking market prices as given. Second, markets must be segmented so that domestic residence
cannot easily purchase goods intended for export. Given these conditions, a monopolistic firm may find
that it is profitable to engage in dumping.
The diagram below shows a monopolist that faces a demand curve DDOM for domestic sales but which
can also sell as much as it likes at the export price PFOR. Since an additional unit can always be sold at
PFOR, the firm increases output until the marginal cost equals PFOR. This profit maximizing output is shown
as QMONOPOLY. Since the firm’s marginal cost at QMONOPOLY is PFOR, it sells out on the domestic market up to
the point where marginal revenue equals PFOR. This profit maximizing level of domestic sales is shown as
QDOM. The rest of its output QMONOPOLY – QDOM is exported.
The price at which domestic consumers demand QDOM is PDOM. Since PDOM > PFOR, the firm sells exports at a
lower price than it charges domestic consumers.
PRICE
PDOM MC
PFOR DFOR=MRFOR
DDOM
MRDOM
QDOM QMONOPOLY QUANTITY
Domestic sales Exports
Total Output

6. The analysis of external economy as the basis of trade seems to be too simplistic in terms of the cost
functions. The results will differ if the cost functions are any of the following:
AC2 AC1
AC1 AC2
RECIPROCAL DUMPING
The analysis of dumping suggests that price discrimination can actually give rise to international trade.
Suppose there are two monopolies, each producing the same good, one in Home and one in Foreign. To
simplify the analysis let us assume that both firms have the same marginal cost. If we introduce the
possibility of dumping, however trade may emerge. Each firm will limit the quantity it sells in its home
market recognizing that if it tries to sell more it will drive down the price on its existing domestic sales. If
a firm can sell a little bit in the other market, however, it will add to its profit even if the price is lower
than in the domestic market.
If both firms do this, however, the result will be the emergence of trade even though there was no initial
difference in the price of the goods in the two markets. Even more peculiarly, there will be two-way
trade in the same product. The situation in which dumping leads to two-way trade is known as
reciprocal dumping.
CONCLUSION: OLD AND NEW, SOME RECONCILATION
This designation derives from the fact that in these theories, the departure from the orthodox theory is
kept minimum (in particular the assumption of perfect competition is maintained) and the conclusion is
obtained that the intra-industry trade conforms to the traditional statement of Heckscher-Ohlin
theorem.
We shall introduce a model given by Falvey (1981) which initially says that each industry does no longer
produce a single homogenous output but instead can engage in production of a range of products
differentiated by quality. The second point of departure from the orthodox theory is the nature of
capital: the capital stock is no longer homogenous but consists of capital equipments specific to each
industry. Because of its specificity, the capital stock is immobile among industries but of course freely
mobile in the production of the various qualities within each industry.

7. For simplicity, let us limit the analysis to a single industry
❖ This industry owns a certain amount of specific capital (whose rate of return R adjusts in order
to maintain the full employment of the capital stock) and can employ a desirable amount of
labor at current wage rate W.
❖ The industry under consideration produces a continuum of different qualities of product with
CRS technology.
❖ In order to define quality Falvey introduced a numerical index α, such that greater values of α
implied greater qualities, and assumes that the production of higher-quality goods requires a
correspondingly higher quantity of capital per unit of labor. It is now possible to define the
measurement units in such a way that the production of a good quality α requires one units of
labor and α units of capital. Given the assumption of perfect competition, for any quality, the
price equals the unit cost of production, namely
P1(α) = W1 + αR1
P2(α) = W2 + αR2
Where the subscripts 1 and 2 refer as usual to the two countries, whose technology is assumes
identical. Without loss of generality we can assume that W1>W2. It follows that international
trade requires R1<R2: in the opposite case in fact we see from the above equations that country
2 can produce any quality of the commodity at a cost which is lower than in country 1, so that
there would be no scope for international trade. Assuming then R1<R2 it follows that a certain
subset of qualities will be produced in country 1 at a lower cost than in country 2 and vice versa
for the other subsets. To identify these two subsets let us use a diagram where there are two
linear price-cost relationships given in the two previous equations.
P(α) R2(α)
P2(α)
W1
W2 ά
Let us note that Ri is the slope of line pi, p2 line is steeper than p1 sine R2>R1. We see from the diagram
that prices are equal in the two countries. In correspondence to the ‘marginal quality’ ά where country 2
has a comparative cost advantage over country 1 for lower quality products (α<ά); conversely, country 1
has a comparative cost advantage for a higher quality products (α>ά).
If we now make the plausible assumption that in both countries there is a demand for both lower quality
and higher quality products, it follows that, in the typical situation of free trade with no transport costs,

8. there will be international trade in the products of the industry considered: country 1 will export higher
quality products to country 2. Since we are dealing with products of the same industry, what has taken
place is indeed intra-industrial trade.
So we see such a trade follows the lines of Heckscher-Ohlin theorem as can be easily shown given the
assumptions made on the returns to the factors of production, we have R1/W1 < R2/W2 which means that
country 1 is capital abundant relative to country 2 according to the price definition of relative factor
abundance. Now since higher values of α means higher qualities and values of the capital/labor ratio.
We observe that country 1, the capital abundant country exports capital intensive products.
It is worthwhile emphasizing the fact that a plausible model of intra-industry trade has been produced
with a minimum of departure from the orthodox theory: apart from product differentiation, it has not
been necessary to introduce economies of scale or monopolistic competition and other models too.
After everything is said and done two precautions are in order. We do not live in the world of perfect
information. Firms under monopolistic competition do advertise to inform the buyers. But misleading
advertisements are hardly rare. In such cases two problems appear, namely : the problem of Moral
Hazard and the problem of Adverse Selection. When the firms are taking the benefit of scale economy,
total number of firms in the globe is going down. It is possible that firms producing cleaner goods (at
higher cost) exit the market. The society wants to avoid dirty goods. However, firms producing dirty
goods at lower cost survive. Trade may not be welfare augmenting under such a situation and yet the
old order changeth yielding place to the new and we look forward to the best hoping that scale
economy would not reduce the global economy to a sink for pollution.
REFERENCES:
• International economics theory and policy by Krugman Obstfeld
• Gandolfo : International Economic Theory
• Caves, Jones and Frankel : World, Trade and Payments
• Peter Kenen : International Economy
• Soddersteen and Reed : International Economics