Question

The literature following the Krugman model has been dubbed “new trade theory”, and the literature on firm heterogeneity following the Melitz model “new new trade theory”. Explain reasons why these names have been used to describe these models, contrasting the features of “classic trade theory” with the newer models.

Answer 1

In the Krugman  model there are two countries. In each country, consumers have a preference for variety but there is a tradeoff between variety and cost, consumers want variety but since there are economies of scale – a firm’s unit costs fall as it produces more – more variety means higher prices.

Thus, Krugman (1979) can be thought of as providing another reason why trade can be beneficial and a fundamental insight into globalization. Moreover, Krugman (1979) began the task of bringing the reasons for comparative advantage within the model. In that paper, Krugman also hypothesizes briefly about what happens when we allow migration within the model.

The Krugman (1991) brings increasing returns together with capital and labor migration and transport costs into one model. Krugman’s (1991) model has become a workhorse of economic geography and international trade. The model is too complex to explain here but the reasons for that complexity are clear to see – when everything becomes "endogenous" small initial differences can make for big effects.

The Melitz model, compared with the old balanced growth path, unilateral trade liberalization increases the masses and revenue shares of exported varieties and the growth rates of all countries for all periods, and welfare of all countries.

The Melitz (2003) model of heterogeneous firms, has become one of the standard theories of international trade since the beginning of this century. Since users of the Melitz model, including the growth literature starting from Baldwin and Robert-Nicoud (2008), largely keep the assumption of symmetric countries, nothing is known about how the reallocation process caused by unilateral trade liberalization affects the growth paths of the liberalizing and partner countries in asymmetric ways. Economic growth is not only important in itself, but it also delivers additional welfare effects that are ignored in static or stationary trade models. It is also important to consider asymmetric countries and unilateral trade liberalization because: “developing countries have significantly larger trade costs, by a factor of two or more in some important categories” (Anderson and Wincoop, 2004 p. 747), and so they have much more room for liberalizing imports than developed countries