A paper (pdf) from Professor Elhanan Helpman surveys an exciting recent strand of international trade theory literature. The new approach models choices by individual firms in monopolistically competitive markets and considers the relationships amongst firm productivity, trade costs, and average productivity levels. A particularly striking aspect is the degree to which traditional Ricardian features emerge from models emphasizing heterogeneity within and across industries.

New developments in the world economy have called for new developments in the theory of international trade and foreign directed investment, designed to better understand the shifts in trade and investment patterns and the reorganization of production across national boarders… [T]heoretical refinements have focused on the individual firm, studying its choices in response to its own characteristics, the nature of the industry in which it operates, and the opportunities afforded by foreign trade and investment. Important among these choices are modes of serving foreign markets
and sourcing strategies.

But the theory went beyond the individual firm, studying the implications of firm behavior for the structure of an industry, and, by implication, structural differences across industries. These variations deliver new explanations for trade structure and patterns of FDI, both within and across industries. For example, they identify new sources of comparative advantage, such as the degree of heterogeneity within industries and the quality of contracting institutions.

Heterogeneity plays a key role in this literature in two ways. First, there is heterogeneity as a result of productivity differences across firms within industries, because some firms happen to be luckier than others. Second, there is heterogeneity in organizational form. The two are related, however, because differences in productivity induce different choices for the organization of production and distribution. In this theory, trade and FDI patterns are jointly determined with organizational structures, such as sourcing and integration strategies.

That’s the title of a recent working paper by Frederic Robert-Nicoud and Marco Fugazza. The abstract:

This paper uses a combination of Ethier (1982) and Melitz (2003) models to show that liberalizing trade among developing countries, so-called South-South trade, could contribute to improve the access to international markets of would-be exporters of developing countries. Lower trade barriers among developing countries has the effect of lowering the price of intermediate inputs and eventually allows exporters in those countries to serve international markets. We also compare unilateral and multilateral South-South trade liberalization and find that the latter unambiguously reduces the price of intermediates in all participating countries, whereas the former has ambiguous effects.

The argument is only theoretical at this point, as the authors are in the process of gathering data to test their model.

What elements must be present for protectionism a la the infant industry argument to improve national welfare? Here’s a brief sketch:

(1) Firms can dynamically improve their productivity through learning-by-doing or economies of scale.

(2) There must be a domestic market failure and the first-best governmental intervention to remedy that failure must be unavailable. (Bhagwati & Ramaswami 1963)

(3) The bureaucracy must be technically competent so as to identify the industries that may benefit from protection as well as the degree and duration of protection that would be optimal. (Krueger 1997)

(4) The bureaucracy must be sufficiently insulated so as to resist capture by special interests. Otherwise, the industry will likely receive protection until it is a senile elder in diapers. (Krugman 1987)

(5) The protection must not merely bring later entrants forward in time, which would actually hurt the pioneering firm (Baldwin 1969).

(6) The gains from protection must not be countered by the potential for immiserizing growth when productivity increases in the protected sector, as described by Johnson (1967).

What other circumstances (market or government) are relevant to the potential for infant industry protection to be good policy?

It looks like the Wikipedia entry on “new trade theory” could use some work. For example, the initial summary currently reads:

New Trade Theory (NTT) is the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Beginning in the 1970s some economists asked whether it might be effective for a nation to shelter infant industries until they had grown to sufficient size to compete internationally.

New trade theory is a methodological alternative to pure trade theory, not a critique of a policy position. New trade theory explains international trade in terms of monopolistic competition, whereas traditional theory assumes perfect competition.

For example, under pure trade theory, two absolutely identical countries (with identical factor endowments) would not gain from trade (especially in the presence of international transport costs). Under new trade theory, however, gains from trade would occur due to increasing returns to scale. This is the classic argument from Adam Smith that specialization is limited by the extent of the market, and that greater specialization results in greater productivity.

The long dominance of Ricardo over Smith – of comparative advantage over increasing returns – was largely due to the belief that the alternative was necessarily a mess. In effect, the theory of international trade followed the perceived line of least mathematical resistance. [Paul Krugman, Rethinking International Trade, p.4]

The wikipedia entry is misleading, because it emphasizes the possibility for protectionism to be welfare-improving under new trade theory, rather than the nature and content of the theory itself. The importance of new trade theory is its examination of how models featuring imperfectly competitive markets both reinforce and alter our traditional views of trade, not the fact that it might breathe new life into the infant industry argument (unless one is not a theorist, but a protectionist hunting for a theory).

Traditional theory is the usual basis for advocating free trade… the new trade theory suggests a more complex view. The potential gains from trade are even larger in a world of increasing returns, and thus, in a way, the case for free trade is all the stronger. On the other hand… new trade models show that it is possible (not certain) that such tools as export subsidies, temporary tariffs, and so on, may shift world specialization in a way favorable to the protecting nation. [Rethinking International Trade, p.3]

Thus, new trade theory provides an explanation for international trade wholly independent of comparative advantage. The Wikipedia entry summary ought to emphasize that Adam Smith’s contributions to international economics complement those of David Ricardo, rather than obsessing over the potential for free trade to be sub-optimal.

[New trade theory is not my specialty. Please note any errors or contrasting interpretations in the comments. Thanks.]