Modern Trade Theories

The orthodox neo-classical trade theories are the basis of trade advocated by WTO and GATT. However, the comparative advantage and specialization do not explain many real world trade patterns. As well, the assumptions of these theories are very simplistic compared to the real world competitive and other economic factors such as returns to scale, the impact of demand by income levels, sizes of firms involved in trade etc. These limitations of the orthodox neo-classical trade policy gave birth to modern trade theories and trade policies as well government assistance to industry in international trade.

The assumptions of Modern Trade Theories

The modern trade theories relax the assumptions of the orthodox trade theories. The assumptions of modern trade theory are:

Non identical preferences by consumers

Not constant return to scale but economies of scale

Imperfect and other competitive market structure

The existence of externalities as opposed to no externalities assumed by the orthodox trade theory

The State of Modern Trade theories

At the present moment modern trade theories are not consistent. However, they are important building blocks to create a consistent modern trade theory. For example  the Linder hypothesis about preferences, models with economies of scale and strategic trade policy even they are not consistent they are important building blocks to create a consistent modern trade theory, which can assist firms and government to devise policies and practices in the area of international trade.

Linder Model of Preferences

In an essay on trade and transformation Staffan Burenstam (1961), he modeled preferences as Follows:

Demand is an important determinant of trade

A countries production varieties is primarily determined by domestic demand

These varieties can be traded with contries with similar demand patterns

Demand is related to income levels

Trade can happen between similar countries not dissimilar countries alone

The orthodox or neo-classical or Ricardo’s comparative free trade theory cannot explain the reality of trade with similar countries and intra-industry trade. However, as shown above the Linder Model of modern trade theory has the explanatory power, which can explain why trade occurs between similar demand preferences and produces the same goods and services.

The impact of Economies of scale and competitive strategies

The real world does not have perfect markets. In a real world there exist big companies, medium companies and small companies in a particular industrial sector internationally. As well the sizes of countries vary considerably. That is in practice it is not easy for some companies from smaller countries in particular to compete with big countries and with big companies. This is due partially due to economies of scale advantages of big companies compared to smaller companies. This forces companies and governments to consider particularly in smaller countries to consider the implication of strategic trade policy to compete with bigger companies and with bigger countries.