Explain the Modern Theory of Trade

The modem theory of trade rejects classical and Neo-classical model of perfect competition and constant returns to scale. Modern theory takes a more pragmatic approach emphasizing a market structure having monopolistic or oligopolistic character and economy of scale in production.

The first basic approach of modern theory of trade is market imperfection. Modern theory of trade emphasizes that there is market imperfection. According to this approach the market imperfections are structural i.e. imperfections of monopolistic nature. Market imperfections arise from the specific advantage also known as ownership advantages enjoyed by an enterprise. These advantages include innovation of superior technology, access to capital, control of distribution system, superior management, differentiated products.

Product differentiation means that products, which can be substituted for one-another, are differentiated from each-other in terms of brand name, color, shape, quality etc. Imperfect competition creates rents and trade policy could shift rents from the foreign country to the home country.

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For example, the imposition of quotas will increase domestic prices and thus can create rents for foreign producers the home country government may try to counter balance it with a subsidy to domestic producers, so as to put pressure on foreign producers.

The essence of almost all the modern theories of trade is economy of scale i.e. increasing returns to scale. Increasing returns to scale provide a justification for trade for reasons other than comparative advantage since firms will have the incentive to produce and export in order to lower costs by attaining greater scale economies.

Trade will take place between two countries having the same technology and factor endowments simply due to economy of scale. As a result of economy of scale even intra-industry trade i.e. trade in the same industry located in two countries is possible. Product differentiation can result in intra-industry trade since within the same industry, the same product can have different brand identities. For example, the USA will export Ford Escort (automobiles), but will import BMWs.

Modern theory states that just as industries within a country differentiate their products to capture a domestic market, they do differentiate their products to please the wide variety of tastes that exist worldwide.

The Japanese automobile industry, for example, began producing small fuel efficient cars long before U.S. automobile makers did. In doing so, they developed expertise in creating products that attracted a devoted following and considerable brand loyalty. BMWs, made only in Germany, and Volos made only in Sweden, also have their champions in many countries.

Just as product differentiation is a natural response to diverse preferences within an economy, it is also a natural response to diverse across economies. Modern theory of product differentiation is not inconsistent with the theory of comparative advantage. Product differentiation is itself a source of comparative advantage.

Classical and neoclassical trade theories have become obsolete in the light of modern theories of trade. Modern theories of trade predict an increase in domestic producer surplus (and a decrease in domestic consumer surplus) as a result of price or quantity restrictions.

Modern theories adopt the viewpoint of “managed’ or “strategic” trade policies which seek to maximize the home country’s welfare at the possible expense of foreign countries welfare. Modern theories of trade explain the involvement of multinational enterprises (MNEs) in foreign countries and foreign direct investment.