Paul Krugman's winning of the Nobel Prize in economics – Contributions to international trade theory

Jota Ishikawa 31 January 2009

a

A

"Kita--!" ("It's here!" or "It's finally come!")

This TV commercial phrase was made into a popular buzzword by a Japanese comedian impersonating a famous actor. Though not quite the same as on TV, the "here" has finally arrived for Paul Krugman in his winning the Nobel Prize in Economic Sciences. Krugman won for establishing new international trade theory and new economic geography . The geography could be considered an extension of the theory, but the establishment of “new trade theory” itself is worth the Nobel Prize. It is the first time since James E. Meade and Bertil Ohlin in 1977 that the Nobel Prize has been awarded for an accomplishment in international trade theory. This is truly a pleasure for a researcher with the same field of specialisation. I would like to offer my sincere congratulations to Krugman. Not only Meade and Ohlin, but other award winners such as Paul A. Samuelson (1970), Wassily Leontief (1973) and Robert A. Mundell (1999) also made important contributions to the field of the international trade. However, their contributions were only "one of " their many outstanding achievements, and their contributions to international trade theory were not why they won the Nobel.

A rare single prize winner

Although there is no reason to complain about Krugman's achievement, as I discuss later, quite a number of economists expressed doubt about his winning the Nobel individually, given that joint awarding of the prize has been considered natural in recent years. If establishing a new trade theory is emphasised as the reason for winning, it would be no surprise for any of a host of other economists, such as Avinash Dixit, Victor D. Norman, James A. Brander, or Elhanan Helpman, to win. By the same token, if establishment of new economic geography was the key, Masahisa Fujita or Anthony J. Venables could certainly receive a similar appraisal as pioneers in the field.

Also, since Krugman has been critical of the Republican administration under President George W. Bush, apparently quite a number of Republican supporters were hostile to his winning the Nobel Prize just before the presidential election. Krugman's outspoken attitude is said to have made him many enemies, and some speculated he would not be able to win the Nobel. Interestingly, Krugman served on the Council of Economic Advisers (CEA) in the Reagan administration. He was also regarded as a leading candidate for CEA chairman due to the significant role he played in the election of Bill Clinton in 1992, but his outspoken conduct toward Clinton's Secretary of Labour Robert B. Reich jettisoned his chances.

Krugman is also interested in Asian economies, including Japan. He strongly recommended "inflation targeting policy" as a countermeasure against recession in Japan after the burst of the bubble economy. This set off a policy debate. He is famous for asserting before the outbreak of the Asian currency crisis in 1997 that the rapid growth of Asia at that time was merely a result of the expanded input of factors of production, such as capital and labour, and that it might not last long.

The accomplishments of Paul Krugman

  • Establishment of intra-industry trade theory

Let's review Krugman's accomplishments. A look at current international trade reveals active trade in goods within the same industry, so-called intra-industry trade. Intra-industry trade is often observed between developed countries. While traditional trade theories such as the Ricardian and Heckscher-Ohlin models are useful for explaining trade in goods across industries, so-called inter-industry trade, they are unable to provide a good explanation for intra-industry trade. Establishing a theory for that type of trade is one of Krugman's accomplishments. His theory consists mainly of two models; one uses monopolistic competition models and the other oligopolistic models. Overviews of these models are given in two textbooks Krugman co-authored with Elhanan Helpman (Helpman and Krugman 1985, 1989).

Ohlin and other economists had already pointed out that economies of scale play an important role in trade. But traditional trade theories assume perfect competition and were unable to convincingly incorporate economies of scale that bring imperfect competition. In the late 1970s, imperfect competition and economies of scale were incorporated into formal models by Krugman (1979, 1980), Dixit and Norman (1980), Lancaster (1980) and Brander (1981) to explain intra-industry trade. However, it seems that both Krugman and the Prize Committee of the Royal Swedish Academy of Sciences place a larger emphasis on intra-industry trade theory based on monopolistic competition models than that based on the oligopolistic models.

The monopolistic competition models are characterised by economies of scale and differentiated close substitutes. The essence of intra-industry trade theory based on the monopolistic competition models is as follows. Under economies of scale, costs will not decline unless a certain amount of volume is produced. In other words, if we try to produce many varieties of a certain good (such as an automobile), costs will become too high as the quantity of production of each variety will be small. In such a case, however, if two countries manufacture automobiles of different varieties and trade these automobiles with each other, consumers will benefit because the variety of consumable products will increase. Also, if the production quantity increases as a result of trade, costs will decline due to economies of scale.

  • Establishment of the new economic geography

The new economic geography, also called spatial economics, is essentially a domain that studies reasons for economic concentration and dispersion. A textbook Krugman co-authored with Fujita and Venables (Fujita, Krugman and Venables 1999) emphasises the role of transportation costs, and its analysis centres on the effect of a decline in these costs on agglomeration and dispersion. Krugman said he took clues for establishing the new economic geography from The Competitive Advantage of Nations, written by Michael E. Porter at Harvard Business School in 1985, which focuses on the role of local industrial clustering under international competition. However, Krugman (1979) had already mentioned that the movement of production factors could lead to agglomeration, which marked the beginning of the new economic geography.

Krugman (1991) presented a so-called core-periphery model and built a foundation for establishing the new economic geography as an area of mainstream economics. Although the core-periphery model is also based on a monopolistic competition model, it emphasises the role of external economies more than new trade theory does. The essence of the core-periphery model is that firms strive to be located in a large market to use economies of scale and save on transportation costs. At the same time, workers also try to move to a large market where they can earn a higher real wage and consume a greater variety of goods. Both incentives act to accelerate the pace of agglomeration of firms and workers in a large market.

The new economic geography attracted particular attention in Europe because many people, including the general public, were concerned about the effects European integration would have on the location of firms and labour movement. Until just a few years ago, when I attended international conferences on international trade theory in Europe, many of the papers presented were based on the core-periphery model.

Conclusion

It appears that Krugman steadily built up his academic carrier, but he too seems to have struggled in many ways. It is difficult for a nameless young economist to first gain acceptance in academic circles, even if he or she has a very innovative idea. However, once recognised, he may be able to quickly vault to stardom. Krugman was no exception. Acceptance proved challenging at the beginning for his intra-industry trade model, though Krugman’s MIT supervisor, Rudiger Dornbusch, seemed to value it. I believe Krugman's toughness in overcoming adversity and the brilliance of his ideas have shaped how we know him today.

This column originally appeared in Japanese in the December 2008 issue of the Keizai Seminar.

References

Brander, J. (1981), “Intra-Industry Trade in Identical Commodities”, Journal of International Economics 11, 1-14.

Dixit, A. and V. Norman (1980), Theory of International Trade: A Dual General Equilibrium Approach, Cambridge, Cambridge University Press.

Fujita, M., P. Krugman and A. Venables, (1999), The Spatial Economy: Cities, Regions and International Trade, Cambridge, MA: MIT Press.

Helpman, E. and P. Krugman (1985), Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy, Cambridge, MA: MIT Press.

Helpman, E. and P. Krugman (1989), Trade Policy and Market Structure, Cambridge, MA: MIT Press.

Krugman, P. (1979), “Increasing Returns, Monopolistic Competition and International Trade”, Journal of International Economics 9, 469-479.

Krugman, P. (1980), “Scale Economies, Product Differentiation, and Patterns of Trade”, American Economic Review 70, 950-959.

Krugman, P. (1991), “Increasing Returns and Economic Geography”, Journal of Political Economy 99, 483-499.

Lancaster, K. (1980), “Intra-Industry Trade under Perfect Monopolistic Competition”, Journal of International Economics 10, 151-171.

a

A

Topics:  International trade

Tags:  Nobel Prize, economic geography, Paul Krugman, new trade theory