Trade Theory
Why Industrial Organisation Matters

The incorporation of details of industrial organisation into the study of international trade has recently been the subject of a fast-growing literature. Whereas the conventional theory of trade deals almost exclusively with perfect competition and non- increasing returns to scale, the new literature attempts to incorporate features such as imperfect competition, increasing returns to scale and product differentiation into explanations of trade behaviour. In Discussion Paper No. 74, Research Fellow Tony Venables surveys these new results.

Adding imperfect competition to trade theory generates new insights for our understanding of both positive or analytical and normative or welfare aspects of trade. For example, intra- industry trade does not fit readily into conventional trade theory but is easily explained by models of trade between economies which each contain imperfectly competitive industries. In the Discussion Paper, Venables reviews these models and their predictions for the volume and pattern of intra-industry trade.

Conventional trade theory emphasises the gains from trade which arise from the exploitation of each economy's comparative advantage. With imperfect competition and increasing returns to scale, trade may affect welfare by changing the degree of competition, the scale at which firms operate, and the number of product varieties available in the trading economies. These are also sources of potential gains from trade, over and above those analyzed by the conventional theory. With imperfect competition, However, we cannot in general be sure that these potential gains are actually realised in the market equilibrium which results from trade. Venables therefore examines the extent to which free trade achieves these potential benefits, under a variety of assumptions concerning competition and market structure.

In the presence of imperfect competition there is generally scope for the active use of policy to raise welfare. If imports and exports are supplied by imperfectly competitive firms, then even 'small' economies may be able to use policy to change their terms of trade. Policy may also raise welfare by correcting distortions in the domestic economy. Venables discusses the roles of both commercial and industrial policy, and he shows that the effects of policy are quite sensitive to assumptions concerning the nature of competition and market structure in the industry concerned. He also discusses the effects of one country's policy on other countries and the role of coordinated commercial and industrial policy.


International Trade, Trade and Industrial Policy and Imperfect Competition; A Survey.
A Venables

Discussion Paper No. 74, October 1985 (IT)