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New Trade Theory (NTT) is the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Some economists have asked whether it might be effective for a nation to shelter infant industries until they had grown to sufficient size to compete internationally.

New Trade theorists challenge the assumption of diminishing returns to scale, and some argue that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market (via a Network effect).

They wondered whether free trade would have prevented the development of the Japanese auto industries in the 1950s, when quotas and regulations prevented import competition. Japanese companies were encouraged to import foreign production technology but were required to produce 90 percent of parts domestically within five years. It is said that the short-term hardship of Japanese consumers (who were unable to buy the superior vehicles produced by the world market) was more than compensated for by the long-term benefits to producers, who gained time to out-compete their international rivals¹.

Less quantitative forms of this "infant industry" argument against totally free trade have been advanced by trade theorists since at least 1848 (see: History of free trade.)

Although there was nothing particularly 'new' about the idea of protecting 'infant industries' (an idea offered in theory since the 18th century, and in trade policy since the 1880s) what was new in "New Trade Theory" was the rigour of the mathematical economics used to model the increasing returns to scale, and especially the use of the network effect to argue that the formation of important industries was path dependent in a way which industrial planning and judicious tariffs might control.

The model they developed was highly technical, and predicted the possibilities of national specialization-by-industry observed in the industrial world (movies in Hollywood, watches in Switzerland, etc). The story of path-dependent industrial concentrations sometimes leads to monopolistic competition.

The econometric evidence for NTT was mixed, and again; highly technical. Due to the time-scales required and the particular nature of production in each 'monopolizable' sector, statistical judgements have been hard to make. In many ways, there is too limited a dataset to produce a reliable test of the hypothesis which doesn't require arbitrary judgements from the researchers.

Japan is cited as evidence of the benefits of "intelligent" protectionism, but critics of NTT have argued that the empirical support post-war Japan offers for beneficial protectionism is unusual, and that the NTT argument is based on a selective sample of historical cases. Although many examples (like Japanese cars) can be cited where a 'protected' industry subsequently grew to world status, regressions on the outcomes of such "industrial policies" (including the failures) have been less conclusive.

The theory was initially associated with Paul Krugman in the early 1970s; Krugman claims that he heard about monopolitistic compeition from Robert Solow. Looking back in 1996 Krugman wrote that International economics a generation earlier had completely ignored returns to scale "The idea that trade might reflect an overlay of increasing-returns specialization on comparative advantage was not there at all: instead, the ruling idea was that increasing returns would simply alter the pattern of comparative advantage." In 1976, however, MIT-trained economist Victor Norman had worked out the central elements of what can to be known as the Helpman-Krugman theory. He wrote it up (by hand) and showed it to the great monopolistic competition innovator, Avinash Dixit, and they both agreed it wasn't very significant. Indeed Norman never had the paper typed, much less published. Norman formal stake in the race comes from the final chapters of the famous Dixit-Norman book (Theory of International Trade : A Dual, General Equilibrium Approach, ISBN 0-521-29969-1). James Brander, a PhD student at Stanford was undertaking similarly innovative work using models from industrial orgainsation theory -- cross-hauling -- to explain two way trade in similar products.