The new trade theory and its relevance for developing countries

Recent developments in trade theory - the result of applying modelsthat embody imperfect competition and increasing returns to scale - suggest an activist role for government in trade policy and threaten to undermine the case for trade liberalization. But the new modelling of international trade lacks theoretical robustness. It is particularly sensitive to assumptions about competitive behavior and the number of firms. Economists'criticism also focuses on the size of the excess profits that oligopolistic firms are alleged to earn, the partial equilibrium nature of the analysis, and the identification of the market failure and the choice of instrument. The normative prescriptions that arise from the new trade theory are also criticized in terms of political economy issues: the potential for foreign retaliation, inefficient government intervention, special interests'capture of policy, the problem of moral hazard, and possibly inimical redistributive effects. The limits of the new trade theory are particularly acute for developing countries because of their small economies, their limited ability to shift profits, the nature of their trade, and the greater chance for special interests to capture trade policy. Paradoxically, empirical work has shown that the gains from trade are much bigger under imperfectly competitive markets which actually strengthens the case for trade liberalization.