Answer to Question #15644 in Economics of Enterprise for Tammy Firman

Question

Explain how advocates of strategic trade policy differ from the classical free traders in their treatment of externalities

Answer 1

Advocates of strategic trade policy recognize that the classical argument for free trade considered externalities at length. The difference, they maintain, is that the classical theory was based on perfect competition and thus could not appreciate the most likely source of the externality, whereas modern theories based on imperfect competition can. The externality in question is the ability of companies to capture the fruits of expensive innovation. Classical theory based on perfect competition neglected this factor because large fixed costs arc involved in innovation and research and development, and such costs ensure that the number of competitors in an industry will be small.