Critics and extensions of conventional trade theory

The approach adopted by the critics is basically one of analysing the outcomes and trade implications of the behaviour of firms operating in conditions which fall short of the ideals of perfect competition (monopolistic competition, imperfect competition, increasing returns to scale). Much of the literature in this category represents sympathetic attempts to relax the basic assumptions of the H-O model and test its robustness (Kierzkowski, 1987).⁸ In this context, monopolistic competition and other forms of imperfect competition have come to be central to the literature on trade theory' largely reflecting the persistence of intra-industry trade in reality. At one extreme there are those who equate countries to single firms, analyse their oligopolistic interactions, and attempt to link the instruments and concepts of industrial organization with the general equilibrium model (Caves, 1980; Brander, 1981; Brander and Krugman, 1983).⁹ Other analyses have tried to formalize equilibrium trade patterns, with endogenous technological change and monopolistic competition as the innovative intermediate inputs (Ethier, 1979; Krugman, 1987; Grossman and Helpman, 1989, 1990a).¹⁰

The link between trade theory and industrial organization was first proposed simultaneously by Dixit and Norman (1980), Krugman (1979) and Lancaster (1980).¹¹ It has even been suggested that it is the contribution by Dixit and Stiglitz (1977) and Lancaster (1979)¹² that provided the foundations for a theoretical framework for analysing economies of scale and product differentiation in a general equilibrium setting (Greenway, 1991).¹³ Since then, developments in this area have taken two directions: modelling the role of economies of scale and analysing market structures. In the latter case various forms of imperfect competition are taken as a starting point and the possibilities of strategic behaviour and interactions between firms are treated in the analysis.

Grappling with the presence of economies of scale

Economies of scale have recently come to be seen as more important (e.g. Scherer, 1980).¹⁴ Various explanations for this trend have been given in the literature (e.g. Helpman and Krugman, 1985; Alcorta, 1994).¹⁵ First, where industries produce multiple products, many products may be produced at less than optimal scale. Second, there may be important economies of multi-product operation which are not captured by plant-based estimates of scale economies. Third, there may be important dynamic scale economies internal to firms.

The existence of economies of scale provides an incentive for international specialization and trade. This incentive may complement the explanatory power of differences in factor proportions, and may even give rise to trade in the absence of such differences (Helpman and Krugman, 1985). Except under special circumstances, a world of increasing returns to scale will not be a world of perfectly competitive markets. However, in the absence of a generally accepted theory of imperfect competition, the admission of economies of scale would make it difficult to generalize on trade. More specifically, the presence of economies of scale implies that the H-O model can guarantee neither gains from trade nor the existence and uniqueness of a free trade equilibrium. The problem is that the persistent presence of economies of scale is inherently inconsistent with competitive equilibrium, as marginal cost pricing would in that case imply losses. Thus the admission of economies of scale calls for an analysis based on a market structure that allows prices above marginal cost. It is in this context that more explicit consideration has been given to alternative market structures in the analysis of international trade.

Three different approaches to the analysis of increasing returns to scale under alternative market structures (other than perfect competition) can be identified in the literature: the Marshallian approach, the Chamberlinian approach and the Cournot approach (Krugman, 1987).

The Marshallian approach

In the Marshallian approach, increasing returns to scale are wholly external to the firm. In this special case the competitive model is still operative at the level of the firm.¹⁶ Economies of scale are then introduced in the general equilibrium models in ways which allow for the existence of a competitive equilibrium. However, the laissez faire competitive equilibrium is no longer Pareto optimal, to the extent that the private marginal rate of transformation deviates from the social marginal rate of transformation of any two commodities. It is in response to this rather undesirable outcome (for the advocates of free trade) that considerable literature on trade has grappled with the problem of optimal tariff policies.

It has been shown that working from the allocation of resources to production and trade rather than the other way round clarifies the role of economies of scale in determining the pattern of specialization and trade (Ethier, 1979, 1982).¹⁷ If external economies arise from economies of scale in the production of intermediate goods which are cheaply tradable, it is argued, economies of scale should apply at the international rather than national level. Economies of scale arising from increased specialization (rather than from plant size) depend (at the aggregate level) on the size of the world market rather than on geographical concentration of industry (at national level). Such international increasing returns to scale were shown to be free of the recurrent indeterminacy and multiple equilibria characteristic of national increasing returns to scale. This implies the possibility of a theory of intra-industry trade in intermediate goods in accordance with the basic H-O model. Intra-industry trade in manufactures is viewed as complementary to international factor movements as predicted by the H-O trade theory. However, the basic assumptions, that economies of scale arise solely from fixed costs and that intermediate components are symmetric, can be questioned on empirical grounds.¹⁸

There is a possibility that external economies may arise from the inability of firms to appropriate knowledge completely. In such cases information may be viewed as an externality. However, innovative industries will ordinarily not be perfectly competitive. An emphasis on the generation of knowledge calls for a dynamic rather than a static model. The question of the applicable unit of analysis arises. If external economies are assumed to result from the incomplete appropriability of knowledge, the applicable unit for the analysis of externalities will depend on the details of how innovations diffuse: are they likely to be confined to a local area, to a nation, or are they international? Recent advances in information and communications technologies are likely to tilt the relevant unit of analysis towards the international arena.

The Chamberlinian approach

In the Chamberlinian approach, the possibility of product differentiation and product variety is introduced into the analysis. The resulting interaction between demand for product variety and economies of scale leads to intra-industry trade (Helpman, 1981; Lancaster, 1980).¹⁹ Similar results have been demonstrated for differentiated intermediate goods to satisfy the demands of producers who use these diverse intermediate inputs (Ethier, 1982). Developments to the Chamberlinian approach have taken two directions. The first has assumed that each consumer has a taste for largely different varieties of product (e.g. Dixit and Stiglitz, 1977; Dixit and Norman, 1980). The second has approached product differentiation by positing a primary demand for the attributes of varieties (e.g. Lancaster, 1980). Both approaches introduce the possibility that the response to market expansion may be greater product variety. Consequently, gains from trade may occur in the form of greater choice of product varieties and in the form of lower prices. It has been shown that these basic results and their implications are retained even when demand for variety is allowed for at the level of the firm (Dixit and Norman, 1980).

The Cournot approach

The Cournot approach invokes economies of scale to explain the existence of oligopolies and treats imperfect competition as the main actor. An extension of the H-O model along these lines has introduced increasing returns to scale into the analysis and related it to the role of protection. This extension has opened up the possibility that protection of the domestic market can help the local producer to generate a higher level of output resulting in enhanced competitiveness in terms of lower average costs (Krugman, 1984).²⁰ This approach shows the effect of trade on increasing competition and demonstrates the possibility of interpenetration of markets, because oligopolists perceive a higher elasticity of demand for exports than for domestic sales.

The real world, characterized by economies of scale, the accumulation of knowledge and the dynamics of innovations, is not incompatible with the ideals of free trade. But if the analysis of such dynamic phenomena is formalized in static models there is a risk of major potential pitfalls where static and dynamic analyses are mixed (Helpman and Krugman, 1985). If a static model has to be used as a proxy for a dynamic world, it should be viewed as a representation of the whole time path of that world and not a snapshot at a point in time. In particular, the comparison of equilibria involved in comparative statics exercises should be understood as a comparison between alternative histories and not a change that takes place over time. Using static models to think dynamically is even more risky in imperfectly competitive markets, in which games over time can have many possibilities not seen in one-period games.

Trade theory and various market structures

The analysis of trade issues in the context of a variety of market structures has explored several issues which could not have been addressed adequately in the framework of the perfectly competitive model. The most notable approaches to the analysis of various market structures include: trade policy and the power of domestic firms, the role of price discrimination and dumping, and the role of governments in giving domestic firms a competitive advantage. Another group of analysts raise questions of the implications of the link between market structures and trade theories for new arguments for protectionism. Further extensions along these lines have attempted to capture more complex insights such as the role of intermediate goods (Ethier, 1982), non-traded goods (Helpman and Krugman, 1985), market size effects (Krugman, 1980; Helpman and Krugman, 1985)²¹ and attempts to demonstrate that economies of scope and/or vertical integration lead to the emergence of multi-activity firms such as multinational corporations (Helpman and Krugman, 1985).

The literature within this strand has basically examined alternative theories of market structures which deviate from perfect competition (Helpman and Krugman, 1985). Such analyses assumed various kinds of imperfectly competitive market structures such as contestable markets²² (Baumol et al., 1982),²³ Cournot oligopoly and monopolistic competition. ²⁴ Two main strands can be identified here: those assuming various forms of Chamberlinian monopolistic competition and those analysing various forms of oligopoly.

Various models based on Chamberlinian monopolistic competition have been developed, mainly analysing the interaction between economies of scale, product differentiation and different forms of monopolistic competition (Krugman, 1987). These models have demonstrated welfare gains from increased product variety and from lower prices. Essentially, however, the insights of the H-O model are shown to hold quite well under conditions of product differentiation and such economies of scale.

The question which the analysts of various forms of oligopoly have asked is whether firms with market power act in a cooperative or non-cooperative manner. Since formal cartel and price-fixing arrangements are generally not legal, such cooperation arrangements are to a large extent tacit. Partly for this reason, the theory of cooperative behaviour in oligopolistic industries is not well developed. Most of the contributors on this subject have therefore restricted their analysis of markets to non-cooperative behaviour.

The outcome of non-cooperative behaviour by firms has largely depended on the strategic variables with which the game is played and the conditions of entry into and exit from the industry. Most theoretical work on oligopoly has tended to take as the strategic variable either outputs (the Cournot assumption) or prices (the Betrand assumption). In more general terms, various forms of market imperfection permit firms to earn returns exceeding those that are tenable in purely competitive industries, suggesting that trade policy can be used to influence the share of international profits accruing to domestic firms (and in that way to the economy). For instance, subsidies can be used to shift profits in favour of domestic firms, implying enhancement of their strategic position versus foreign rivals in competition for world markets.

Cournot's equilibrium is tenable when each firm is doing its best to maximize profit by choosing its output level, given the output levels of its rivals. In equilibrium, no aggressive threat by any firm is likely to be believed by its rivals. However, if one firm manages to reduce its costs (or get a subsidy), a new equilibrium would be set at a higher level of output and market share for that firm. Reference has also been made to the strategic use of R&D expenditure (or subsidies) to lower costs and shift the reaction curve outward. These results open up the possibility that government action can alter the outcome of the strategic game played by rival firms. It is in this context that possibilities for strategic trade policy have been proposed. The policy of protection to promote exports is one outcome of the presence of economies of scale. Movement down the firm's learning curve, leading to higher output (facilitated by protection) and falling marginal costs, is expected to enhance the firm's competitive position in world markets (Krugman, 1984).