GLSD3501 Individual Essay

Alex Huang 1155100775

U.S.-China Trade War and New Trade Theory

In June 2018, the trade war between the U.S. and China began with the U.S. imposing the first round of
tariffs on Chinese products with an approximate $US 34 billion annual trade value followed by Chinese
retaliation with tariffs that were also an approximate $US 34 billion annual trade value 1. Unquestionably,
a trade war between the two largest economies would have a great impact on their economies but also the
global economy. Based on classical and neoclassical trade theories that emphasize the idea of
comparative advantage and factor endowment, countries specialize in the industry where the country has
a comparative advantage over the others and trade with others who have comparative advantages in other
industries. By doing so, a country can allocate resources more efficiently, produce at the optimal point of
its production possibilities frontier (PPF), maximizing production and promote consumption, so a country
as a whole would be better off if it engages in trade based on comparative advantage. This assumption
begs the question of why did U.S. and China engage in a trade war if trade is supposed to be good for the
two countries? To bridge the gap that classical and neoclassical could not fully explain, this paper brings
in the New Trade Theory and geopolitical argument to provide a more complete depiction of the reality of
trade relations between the two biggest economies in the world. I first discuss the origins, dynamics, and
consequences of the trade war, and move on to the discussion of how New Trade Theory and geopolitical
argument complement classical and neoclassical arguments in the context of the U.S.-China trade war.
Finally, I make recommendations on how to navigate a more positive-sum game for all parties engaged in
free trade practices.
In 2018, the United States Trade Representative (USTR) issued a report, outlining China’s unfair
trade practices, including discriminatory Chinese industrial policies and government interventions on
technology transfer and licensing, intellectual property, investments, and activities of the U.S.
companies2. A few months later, the USTR announced that it would adopt the measure of increasing
tariffs to pressure China to fix its unfair practices. The announcement of imposing tariffs on Chinese
products based on Section 301 of the U.S. Trade Act then triggered Chinese retaliation, erupting in the
biggest trade dispute between the two countries with several rounds of a tit-for-tat exchange of tariff
hikes. As the time of the writing, the situation has evolved into a stalemate. Despite the fact that both

1 Bown 2021
2 Qiu, Zhan and Wei 2019

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countries have signed the Phase One trade deal in January 2020, U.S. kept most of the tariffs imposed on
China in place, arguing that China hasn’t fulfilled its promise to meet the conditions of the deal to buy an
additional $200 billion in the U.S. products over the 2017 level through 2021 because of the disruption
caused by the pandemic3. Two parties have a clash of arguments about the ensuing trade war. The Trump
administration with his “America first” agenda focused on several arguments justifying the purposes of
imposing sanctions on China. The first is to reduce the huge annual trade deficit with China which
amounts to $419.2 billion in 20184 and to bring manufacturing jobs back to America. Second, the U.S
aimed to pressure China to stop its unfair trade practices, including discriminatory industrial policies that
heavily subsidy Chinese industries, requests of technology transfer by the U.S. firms as an exchange for
the entry into the Chinese market, and policies that harm U.S. intellectual property rights, which all
together undermine the competitiveness of the U.S firms in China and put them at disadvantage. Finally,
Trump also emphasizes national security concerns, arguing that economic security is fundamental to
national security, labeling China as a “strategic competitor” in the National Security Strategy report
published in December 20175. China’s grand “Made in China 2025” plan that seeks market dominance
and global leadership in a wide range of technologies and manufacturing through the help of government
subsidies could distort Chinese domestic markets and global markets with intensifying preferential
policies and financial support to Chinese firms by the Chinese government. The U.S. believes that China
is using its state power to unfairly alter the competitive dynamics and accumulate great comparative
advantage for China in the global market and undermine the economic competitiveness of the U.S. On the
other hand, China refused any accusations by the American side and rebutted that the charge of China as
an unfair trader is groundless, asserting that the only reason that the U.S. waged a trade war was to
contain China as a threat to the U.S. status as the global leader. China further asserted that unilateral tariff
increases essentially reflect the unilateralism, protectionism, and economic hegemonism of America,
abandoning the basic international consensus on free trade practices and mutual respect and consultation.
Despite accusations from both sides, trade between U.S. and China no doubt has benefitted both parties
greatly for a long time. The two sides have been intensively engaged in intraindustry trade of machines
and electronic products and components that rank high in value amount, promoting global production
integration. China benefits from advanced technology and tech-related products from the U.S., and the
U.S. enjoys low-cost electronic products, components, machines, and consumer goods made in China.
Moreover, China’s economic development and integration of Chinese firms into the global production
value chain are promoted by the trade cooperation between the two, and the U.S. firms invested in China
have continued to serve as good models for China’s technological innovation. Besides, U.S. has gained

3 Hsu 2021
4 Trade deficit with China accounts for 47% of the total US trade deficit in 2018 (Kwan 2019)
5 White House 2017, pp.45

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great business opportunities in the Chinese market which translate into economic growth, consumer
welfare, and increased enjoyment opportunities in the U.S. market 6. The full impact of this trade war can
only be fully felt in the years to come, but this ongoing quagmire is for sure going to hurt both economies,
and other countries, without having a clear winner. One immediate negative effect was found in the
financial market, reflecting the investors’ anxious reaction towards the trade war. There are several
possible long-term effects. First, China could face a depressed economic growth rate when multinationals
relocate their business operations to other countries to avoid tariff hikes from the U.S. As a latecomer
trying to raise productivity, it would become harder for China to secure technology from overseas to
boost its economic development. Second, the impacts on the U.S. could be severe as well. Chinese
products, such as final consumptions goods, intermediate goods (parts and components), take up a huge
share of U.S. trade with China and many U.S. firms and consumers rely on the low-cost products
imported from China. U.S. productions in China could also be reduced significantly. Eventually, U.S.
would sacrifice its economic efficiency to look for more expensive alternative sources to replace Chinese
imports and lose its market shares in China. Lastly, as the current global economy is closely integrated
and heavily relied on global value and production chain, a disintegration between the two largest
economies would have impacts on other countries as well. When flows of capital, goods, technology,
people, and information become divided between the two blocs, multinationals would lose the economic
efficiency that they could have by optimizing resource allocation through global supply and production
chain.
Based on the discussion in the previous section of the benefits of U.S-China trade and the
negative impacts of trade conflicts between the two, it is without a doubt that, even classical and
neoclassical trade theories fail to fully explain the trade conflicts between U.S. and China, free trade is
still the better equilibrium that can make both countries and global economy better off on a macro-level.
In this section, I will turn to the discussion of the New Trade Theory and geopolitical argument to explain
why trade conflict between the two took place and why sometimes trade could be inefficient under certain
conditions. It is the assumptions that classical and neoclassical theories rest on that make them fall short
for depicting the current trade reality. The Ricardian model postulates that productivity differences and
comparative advantages are the main drivers for international trade and the Hecksher-Ohlin (HO) model
builds on the Ricardian model, arguing that different productivities are caused by variations in factor
endowment which helps predict the patterns of production and trade7. The two models, when put together,
predict that countries engage in inter-industry trade where countries export products in industries with
comparative advantages or abundant endowments. Both theories are built on several common

6 Qiu, Zhan and Wei 2019

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assumptions. First, the market is perfectly competitive. Second, there are no artificial barriers to trade.
Third, the returns to scale are constant. Fourth, trade happens between different industries (inter-industry
trade). Unfortunately, these assumptions do not match with the current reality of international trade, and
this is where the New Trade Theory comes in to provide an alternative explanation of international trade.
In recent decades, intraindustry trade has emerged and continued to grow. Countries tend to trade similar
products belonging to the same industry, and also the bulk of world trade occurs between similar
countries (i.e. between large economies or developed countries). Comparative advantage, a central idea of
classical and neoclassical trade theories, can no longer explain a significant part of world trade where
more than 50% of the merchandise trade is intraindustry and for big economies like the U.S. and China, it
is over two-thirds8. Intraindustry trade essentially means that international trade of products that are made
in the same industry, and on the other hand, interindustry trade is trade that happens between different
industries. With this change of trade patterns, the New Trade Theory introduces the idea of economies of
scale as an alternative rationale for international trade besides comparative advantage, and argues that the
global market is characterized by imperfect competition rather than perfect competition. When a country
opens up to international trade, the markets that firms can sell to increase, and thus firms are allowed to
capitalize on the economies of scale, which is based on the idea of increasing returns to scale 9. So the
idea proposed in the New Trade Theory can be summarized as follows: when a country specializes in a
variety of products in a particular industry, it could gain economies of scale from its specialization and
capitalize it when it engages in trade; another country may also specialize in other variates of the industry,
and therefore intraindustry trade occurs between countries which specialize in different varieties within
the same industry. With increasing returns to scale, as an industry continues to grow and the numbers of
firms increase in the industry, an industry enjoy lower production cost due to two main factors. First, the
total suppliers increase as the numbers of firms increase in an industry (larger domestic production) and a
dense network of input suppliers formed. Second, as the industry continues to grow, it accumulates
knowledge along the way, refining its production techniques through experiences. These altogether
increase the competitiveness of an industry on the global market, but at the same time make it difficult for
new entrants, who have not yet developed their external economies of scale and an accumulation of
knowledge that can bring down production costs for them, to compete with the established industry. This
leads to imperfect competition10, another crucial idea in the New Trade Theory, where the new industry

8 Gerber 2017
9 Increasing returns to scale is the idea that when either a firm increases in size or an industry grow in size, the
average cost of production falls, and thus marginal profits increase when producing each products; economies of
scale include internal economies of scale (when a firm increases in size)and external economies of scale (when an
industry grows in size). In my discussion of trade conflict between the U.S. and China, I only focus on the idea of
external economies of scale.
10 One example of imperfect competition is monopolistic competition

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cannot compete with the existing one on the same level and be forced to exit the market even the new
industry might be more efficient than the existing one. Imperfect competition explains why the market is
not always efficient, and thus trade might not always lead to an optimal outcome for parties involved.
This kind of situation is where governments could come in and assist their firms to grow their scale to
compete with foreign firms through the use of strategic trade policy and industrial policy. Strategic trade
policy and industrial policy by the governments, if used properly, can protect infant industries in their
initial development stage from foreign competitors, allowing them to grow their economies of scale to be
able to compete with others in the market. However, strategic trade policy could also function as de facto
protective trade policy, a type of non-tariff trade barrier. China’s strategic trade policy is not so much
about protecting infant industries, but a trade barrier that supports Chinese ambition to gain monopolistic
advantages in the global martlet. The U.S. accusations of China’s unfair trade practices— government
subsidies and entry regulations— are particularly relevant here. The Chinese government has been
attempting to shift profits from foreign firms to domestic firms through the exercise of state power, as
they try to catch up with the U.S. With industrial policies heavily subsidizing across nearly all industries
and with the grand “Made in China 2025” plan, China managed to alter the comparative dynamic
allowing Chinese firm to be more competitive in face of U.S. counterparts and, in the long run, gain
monopolistic advantages in the areas of advanced manufacturing and technology. Despite fact that the use
of strategic trade policy could mitigate imperfect competition and the overall welfare of a country, free
trade is still the better option, as it provides a good market equilibrium and is closer to the efficiency
frontier11. Free trade is also a simple enough set of rules for countries to follow and to avoid a prisoners’
dilemma where countries could have the incentive to deviate from practicing free trade and adopt
protective trade policies, keeping mutually harmful actions to a minimum. In the U.S.-China trade
conflict, it is evident that distorted and unfavorable non-tariff trade barriers, such as excessive
government industrial policies and unfair entry regulations, triggered retaliation from the U.S. side when
U.S. considered China was unfavorably increasing its competitiveness at the expense of the U.S. And
when both sides went into a spiral, they both lose, as they impose more trade barriers on each other,
moving away from free trade good equilibrium. On top of insights provided by the New Trade Theory on
the U.S.-China trade war, geopolitical argument can also assist in understanding of the case. Economic
theories mostly do not consider geopolitical influences on trade relations between countries, but
geopolitical factors do matter. Since the rise of China after its economic liberation, and especially after
Chinese president Xi Jin Ping came to power, the two countries have been involved in geopolitical and
economic competition. China harbors the ambition to grow into the leading global economic powerhouse,
which is evident in its Belt and Road Initiative (BRI) and the “Made in China 2025” agenda and attempts

11 Ossa 2014

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to build expansive geopolitical influence across the globe. The U.S., as the only global hegemon with the
greatest economic power since the end of World War II, unquestionably perceives the rise of China as
intolerable. Although it is not explicitly spelled out in the U.S. official arguments for initiating a trade war
against China, there is a strong indication that a trade war could be a means of containing Chinese
economic development.
The New Trade Theory more accurately depicts the reality of international trade by including the
ideas of imperfect competition, the prevalence of intraindustry trade, the concept of economics of scale,
and non-tariff trade barriers. With this more accurate depiction provided, the trade conflict between U.S.
and China is better understood. Unlike classical and neoclassical theories predict, the market does not
always produce the most efficient outcomes and trade does not always make everyone better off because
of a couple of reasons. First, economies of scale might lead to an imperfect competition where the new
industry would be forced out of the market even when they are more efficient than the existing ones.
Moreover, countries might have the incentives to deviate from free trade good equilibrium to adopt
distorted non-tariffs trade barriers to alter comparative dynamics, allowing their domestic firms to gain
competitiveness at the expense of others. Such strategic trade policy might invite retaliation from others
and even result in a trade war that makes everyone worse off, as demonstrated in the U.S.-China trade
war. The New Trade Theory also points to some recommendations on how to navigate a positive-sum
game of international trade. Governments can use industrial policy appropriately in the initial stage to
help the new industry to avoid monopolistic competition and gain economies of scale, increasing their
competitiveness on the market. Governments should also continue to invest in innovation and
technological development domestically to assist industries to maintain their competitiveness. And as
soon as the new industry is competitive enough, governments should leave the work to market
mechanisms and refrain from deviating the free trade equilibrium by adopting market-distorting
protective trade policies that might invite retaliation and make everyone worse off. Theoretically,
international trade does make every country better off, and in reality, it will make most parties better off
when countries are committed to following the rules of free trade and governments adopt appropriate
strategic trade policy only when necessary.

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 Word count: 2999

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