New trade theory: scale, variety and intra-industry trade

Two facts about world trade since the 1950s don’t fit the theories so far:

• Most trade is between rich countries with similar technology and endowments, not between rich and poor.
• Much of it is two-way trade in the same kind of good: cars for cars, wine for wine, machines for machines. This is intra-industry trade (CUET 2021), and trade in differentiated products is intra-industry trade (Hyderabad 2012). Trade of cloth for wine, in different industries, is inter-industry trade.

Comparative advantage explains inter-industry trade. Intra-industry trade needs another reason, and the main one came from Paul Krugman in 1979.

Krugman combined two ideas (Hyderabad 2013, 2015; UGC NET 2024):

• Economies of scale. Making a car model has large fixed costs: design, tooling, a factory. The more units a firm makes, the lower its cost per unit. So no country makes every model; each firm makes a few models in large numbers.
• Love of variety. Consumers want choice. Firms differentiate their products and compete under monopolistic competition, each with a little market power over its own variety.

Put two identical countries together and trade happens anyway. Each country’s firms make different varieties for a market twice the size, at lower average cost, and consumers in both countries get more varieties to choose from. The benefit of increased variety is the implication CUET 2021 asked for. The gains come from scale and variety, not from differences. Hence Krugman’s summary: countries trade because they are different and because of economies of scale.

UGC NET 2025 asked you to match four models of intra-industry trade to what drives them:

Herbert Grubel and Peter Lloyd (1975) measured how much of a country’s trade in one industry is two-way. If exports and imports are equal, the index is 1. If trade goes one way only, it is 0.

Heckscher–Ohlin assumes everyone has the same technology. Two theories drop that assumption for new products.

The technology gap (M. V. Posner, 1961). A country that invents a product exports it until others learn to copy it. Trade lasts as long as the imitation lag is longer than the demand lag, the time before foreign consumers want the new good. A country that keeps innovating keeps exporting.

The product cycle (Raymond Vernon, 1966) adds that a product’s technology matures. A new product needs skilled engineers and close contact with customers, so it is made in the rich country that invented it. Once it is standardised, it can be made with unskilled labour, and production moves to where labour is cheap. The innovator ends up importing what it invented.

In the five-stage version, the imitating country starts selling more cheaply than the innovator in third markets in stage IV, and in the innovator’s own market in stage V (UGC NET 2025). Radios, televisions and computers all followed the pattern.

Staffan Burenstam Linder (An Essay on Trade and Transformation, 1961) argued that manufactures are first made for the home market, and exported to countries with similar tastes. Tastes depend largely on income, so countries with similar incomes have overlapping demand, and trade more manufactures with each other. That fits trade between rich countries, though it is hard to tell apart from the gravity model below. For primary products, Linder accepted Heckscher–Ohlin.

Jan Tinbergen borrowed Newton’s law of gravity in 1962: trade between two countries rises with their economic size and falls with the distance between them. It isn’t a theory of why countries trade, but it predicts how much they trade remarkably well. The components are the two countries’ GDPs and the distance between them (UGC NET 2024).

CUET and UGC NET ask you to put theories in order almost every year. The whole module on one line: