Nobel Prize for Economics 2008 - Paul Krugman

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008 "for his analysis of trade patterns and location of economic activity"

Summary: The Nobel committee gave Krugman the prize for work growing out of a model, on increasing returns to trade, which he introduced in a paper in the Journal of International Economics in 1979. Krugman's approach is based on the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Meanwhile, consumers demand a varied supply of goods. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another.

Background:

Until the end of the 1970s, the Heckscher-Ohlin theory for which Bertil Ohlin won the prize--Eli Heckscher died before the Nobel Prize in economics was instituted--dominated the field. This theory explained well why labor-abundant countries such as South Korea and Taiwan would export labor-intensive products such apparel, toys and footwear and capital-abundant countries such as the United States would export machinery and aircraft.

But it could not satisfactorily explain the two-way trade that was widely known to exist: Many countries exported automobiles and televisions, but they also imported them. The Heckscher-Ohlin theory also did not adequately explain why rich entities such as Europe and the United States, which had very similar endowments of capital and labor, traded more intensively than those with very dissimilar endowments. While descriptive explanations of these phenomena existed, a tight theory explaining them was lacking.

Starting in 1979, Krugman published a series of papers that successfully tackled these and many other related questions. He postulated that consumers like variety in what they consume. For the same expenditure, their satisfaction is greater if they have a larger variety of products available. This creates the incentive for firms to produce a large variety of products. But the production of a new variety has setup costs. This leads to declining per-unit costs as a larger quantity of the variety is produced and places a limit on the number of varieties the market can profitably supply. A firm produces a new variety only if it can capture a large enough market to allow profitable sales.

This seemingly simple structure gives rise to a tight theory that leads to rich implications: Countries gain from trade not only because larger market allows them to better exploit scale economies, but also because consumers can access a larger variety of products. And even identical economies can gain from trade through scale economies and a larger variety of products. The theory also brought imperfect competition into a formal trade model.

In subsequent work, Krugman combined this simple model of product differentiation and scale economies with transport costs. Scale economies push toward production in one location to minimize costs and then shipping the product to the locations where consumers are. But transport costs push toward locating production near consumers. These opposing forces give rise to large concentrations of populations such as those along the East Coast corridor of the United States.

Detail: Product Diversity and Monopolistically Competitive Trade

The traditional theory of international trade began with David Ricardo, and reached its peak in the mid-1960s. This theory explained trade in terms of comparative advantage: each country would export the good that it could produce at lower relative cost in autarky (definition: a policy of national self-sufficiency and nonreliance on imports or economic aid). Comparative advantage in turn was explained in terms of differences among countries. The Heckscher-Ohlin model, based on relative differences of primary factor endowments, came to dominate textbooks as well as research papers. Here each country had comparative advantage in the good that used relatively more intensively its relatively more abundant factor.

This theory had several further implications.

First, we should see the largest volume of trade between countries that are most different in their endowments, for example industrialized and less developed countries.

Second, the opening or liberalization of trade should lead to conflict between the owners of different factors of production. Since exporting a capital-intensive good to import a labor-intensive good is like exporting capital-and importing labor by proxy, trade indirectly faces domestic labor with greater market competition and laborers end up losers.

Finally, a group of countries stand to gain most in the aggregate by forming a bloc with more liberal trade within it (such as a free trade area or a customs union) if they are complementary in their factor endowments, so they can produce different commodities when trade expanded.

Just as the dominance of the Heckscher-Ohlin model became complete, disquieting observations contrary to all of these implications began to accumulate.

Since the second world war, the fastest growing component of trade was between industrial countries with very similar factor endowments. The European Common Market brought together countries that were not complementary in their factor endowments. Much of this trade expansion seemed to occur with relatively little distributive conflict within each country. Finally, in many emerging industries, one could not point to a clear comparative advantage for any country. Many patterns of production and trade seemed matters of chance; in fact there was a lot of two-way trade in very similar products such as automobiles.

Many different explanations for these facts were offered, and new ones are still being attempted. But the approach that Krugman helped pioneer in a pathbreaking series of papers (16], [17] and (18] was the most drastic departure from Ricardian tradition.

The new view in fact went back to an even older tradition, namely Adam Smith's idea that division of labor lowers unit costs. Scale economies internal to firms are incompatible with the perfect competition that was assumed in all traditional models. Many economists throughout the history of the subject had mentioned scale economies as a cause of trade, but they did not have, and could not develop, the tools that would implement this view in models that could yield its logical implications. Krugman found the necessary techniques, and wielded them with such skill and finesse that led not just to a new paradigm, but to a synthesis of the old and the new views of trade.

The scale economies were internal to firms, but sufficiently moderate to ensure the survival of a large number of firms in the free-entry equilibrium of a group producing close but not perfect substitute products. Thus the market structure was that of Chamberlinian monopolistic competition.

When such a sector expands, it does so through some combination of an increase in the number of firms (greater product variety) and the size of each firm (greater scale economies).

Suppose all the products in the group require the same factor proportions. Let there be another sector, operating under constant returns to scale and perfect competition. When two such countries start to trade, their inter-industry trade (exports of the competitive sector against net imports of the Chamberlinian sector) are still governed by the factor endowment differences as in Heckscher-Ohlin.

But when we examine the Chamberlinian sect or more closely, we see that the two countries produce disjoint sets of varieties; the choice of which ones are produced in which country is arbitrary. Each supplies the whole world's demand for the ones it produces, so we get two-way intra-industry trade. If the countries have identical factor endowments, there is no inter-industry trade (each produces an amount of the competitive good equal to its own consumption of it), but lots of intra-industry trade. All these results fit very well with the observations on the growing pattern of trade among industrial European countries cited above.

Even more remarkable is the implication for gains from trade.

The availability of greater variety of goods in the Chamberlinian sector at lower unit costs is a benefit to all income-earners. This can be enough to outweigh the conflict over incomes (factor prices) themselves. Then trade liberalization can command general consent. This is more likely the more similar the economies. This again squares with the observation that the formation of the European Economic Community in its initial stage, when the members were very similar economies, generated much less distributional conflict. A similar more recent observation is that the US-Canada free trade agreement produced only minor local complaints of a distributive nature, whereas the expansion of that agreement to include Mexico is proving more controversial.

In all, Krugman's contribution to the development of the monopolistic competition model of intra-industry trade was a remarkable achievement for one so young.