The comparative advantage theory developed by Ricardo was based on constant returns to specialisation. However, it is more realistic to assume diminishing returns to specialisation. Diminishing returns to specialisation takes place when more units of resources are required to produce each additional unit.
The new trade theory, also known as strategic trade theory, emerged in the 1970s when economists were questioning the assumption of diminishing returns to specialisation in international trade.
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According to them, increasing returns to specialisation may exist in some industries. Economies of scale help them to achieve increasing returns through expansion of output. The output required to attain significant scale economies represents a substantial proportion of total world demand of that product.
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The world market under such a situation can support only a very few firms based in a limited number of countries. And that the firms first to establish enjoy the first-mover advantage. Such firms enjoy national competitive advantage and deter other firms to enter the industry.
National governments have evolved strategic trade policies to help industries in which national competitive advantage can be achieved. These kinds of policies move the market from perfect competition to managed competition.
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This theory mainly applies to oligopolistic industries such as the aerospace industry (in which the US helped Boeing Company by providing with R&D grants and lucrative defence contracts, while European governments helped Airbus Industries through subsidies) and liquid display screens (Japanese government helped in a big way).
Let us understand it with the help of an example. To develop Boeing 777 jetliner Boeing Company spent $5 billion. If Boeing manufactures 100 aircrafts the fixed cost will be $50 million per unit. If the variable cost is $70 million per unit, the total cost will be $120 million per Boeing 777.
However, if the production is 500 units then per unit cost will decline to $80 million. Thus the scale economies are significant. Apart from economies of scale, learning effects (saving of cost from learning by doing repetitive job) also exist. Learning effects are very important when a technologically complex job is done again and again.
It has been confirmed that every time the accumulated output of airframes was doubled, unit costs declined to 80% of their previous level. For the production of such aircrafts the world demand is large enough to support only a limited number of firms. The US is the leading exporter of Boeing jetliners not because of factor endowment (Heckscher-Ohlin theory) but because of first-mover advantage.
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The proactive role of the governments is thus justified. However, the WTO rules prescribe that no subsidies be given ad these create barriers to free trade.