Strategic trade theory:

Based on research into imperfectly competitive industries, some of the new theoretical  research suggests  that it is  possible to increase national wealth with specific types of government intervention in  trade relations. The research  is referred to as Strategic Trade theory. The strategic trade theory acknowledged the  use  of trade policies, including tariffs, subsidies, and even export- subsidies,  in the context of imperfect competition and/or increasing  returns to scale to  alter the outcome of international competition in a country's favour, usually by allowing its firms to capture a  larger share of  industry profits. It came as a critique of fiee trade from the perspective of increasing returns to scale. It was treated akin  to 'infant industry' argument with quantitative  rigour.

The  theory has been associated with Branderand Spencer  and Krugrnan. Unlike the other models, the strategic  trade theory  tried to capture  the real life phenomenon of markets having small number of firms,  i.e. absence of perfect competition. These  theories  could explain behaviour  of  firms with  the help of oligopolistic models. This  allowed  for consideration  of s  trategic interdependence between firms  in the industry. Each firm in the market knows that it is  sufficiently  large for  its decisions to affect the profits of other firms.  It must then consider how its competitors are likely  to react to its decisions. The view it takes of  its competitors'  reactions is usually described as  its  conjectural variation.

As you must have learnt  in MEC-001 course, which is on micro-economics that  there is no  'universally preferred'  form of oligopolistic model. A major difference  between  alternative models is the form of conjectural variation assumed to influence a firm's  decisions. Many duopoly models (a version of which  is oligopoly)  make  the assumption that the competitors  exhibit  'Cournot behaviour'. That is, each firm takes the other's output as given when it makes decisions about  its own output; that is, output is  the firm's strategic variable. In simple Cournot duopoly models with one home firm and one foreign firm, it was shown that (a) identical firms based  in different countries would have an incentive to export the same product to each other's markets (IIT in identical products);  (b)  export  subsidies and import  tariffs could  raise a country's welfare.

Many countries seem keen to abandon free trade, at least if this can be accomplished without retaliation. Although such behaviour is inconsistent with the standard competitive model, the theory of strategic trade policy provides a possible explanation. In the presence of oligopoly there are economic rents (extra-normal profits) to be captured and creating a tilted playing field may be in  the  national interest. According to de Meza (1986), countries with the lowest production  costs choose the highest export subsidies. The principle involved is that  since the motivation to subsidise is to shift profits to home firms, the location with the most profitable  firms (i.e.  the country where costs are lowest) will set the highest subsidies. The strategic trade theory has another feature in as much as it also could take into account protection to strategic sectors  in a country aimed at increasing its share in the global trade for instance, the case of Japanese cars. Some other examples of such  industries include aerospace,  advanced materials, computers and supercomputers, semiconductors  and microprocessors,  and bio-chemicals. In this context, "strategic"  refers to the oligopolistic character of the industry and not its military significance. To sum up, strategic trade theory focuses on industries where markets do not work perfectly on account of economies of scale, high technological  barriers  to entry, and production processes marked by a high level of learning-by-doing.