Economies of Scale and Intra-Industry Trade

Classical theories struggle to explain why Germany both exports cars to France and imports cars from France, or why similar rich countries trade so much with each other. In 1979 Paul Krugman showed that economies of scale and consumers' love of variety can explain this intra-industry trade. When producing a model is cheaper at large volumes, each firm specializes in a few varieties and sells them worldwide, while consumers enjoy more choice than any one national market could support.

This 'new trade theory' also suggested that history and luck matter: an industry may cluster in one place simply because it started there and grew efficient, as with aircraft at Seattle and Toulouse. That created a theoretical case for strategic trade policy, in which governments support firms in industries with large scale economies. Krugman himself cautioned that such policies are hard to apply well, and later work emphasized differences between individual firms, since only the most productive tend to export.