The Nobel Prize Awarded on Economies (2008)

Paul Krugman
and
his contribution on New Trade Theory

Shin-Kun Peng (Academia Sinica/ NTU)

To be presented in National Cheng Kung University

December 4, 2008

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I. Biography
„ Birth: February 28,1953

„ Nationality: United States

„ Research fields: International trade theory,

Economic geography,
International finance.

„ Contributions: New trade theory

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 Paul Krugman

„ Author & Professor,

Princeton University

„ Winner of the Nobel Prize for Economics

(2008).

„ NY Times OpEd columnist.

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II. Economics career
„ B.S. in economics: Yale University in 1974
„ Ph.D in economics: MIT in 1977.
„ Staff member of the Council of Economic Advisers:
Reagan White House, 1982-1983
„ The universities he have taught: Yale University, MIT,
UC Berkeley, London School of Economics, Stanford
University, and Princeton University

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„ Paul Krugman joined The New York Times in
1999 as a columnist on the Op-Ed page.

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III. Nobel Prize awarded (2008)
„ In the words of the prize committee

1. “By having integrated economies of scale into

explicit general equilibrium model, Paul
Krugman has deepened our understanding of
the determinants of trade and location of
economic activity”.

2. Main Contribution: Prof. Krugman’s main

contribution is to analyze the impact of
economies of scale in international trade.
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„ In the words of the prize committee
Main Contribution:
Prof. Krugman’s main contribution is to
analyze the impact of economies of scale in
international trade associated with the
consideration of space (city, region, country)

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IV. Introduction on New Trade Theory

Economic activities are unevenly distributed

across city, region and country. The determinants of
spatial differences in the patterns of production have
traditionally been presented in terms of differences in
endowments, technologies, or policy regimes.

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For example:
„ Ricardian: McKenzie (1954), Jones (1961)
„ Heckscher-Ohlin: McKenzie (1955), Jones
(1965,JPE)
„ Specific Factors: Jones (1971), Samuelson
(1971)
„ Technology transfer and adoption: Krugman
(1974).

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„ Such explanations, while relevant, fail to
explain why even a priori similar countries
can develop very different production
structures. They also stand in sharp contrast
with the changing pattern of comparative
advantage of regions and countries
undergoing rapid development.

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¨ Recent contributions (since 1980) to the so-called
“new trade theory” or ‘new economic geography’
have developed a novel approach to the way we
think about location; one in which firms tend to
cluster together, and countries with similar –or even
identical- underlying characteristics can turn out to be
very different.

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¨ These tools, while peculiar, are the best
available for dealing with increasing returns to
scale, trade costs, migration, and input-output
linkages between firms in an analytically tractable
general equilibrium analysis framework.

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¨ The general assumptions in conventional
trade theory:
1. constant returns to scale
perfect competition
2. trade costs: don’t consider trade cost,
3. migration (mobile): doesn’t allow,
4. input-output linkages across country:
haven’t specified.

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¨ Recently, why does the “new trade theory” or “new
economic geography” emerge interesting and popular?
¨ Constant returns to scale: unrealistic,
¨ Under the Globalization:
1. trade costs: both transport cost and tariff decrease,
2. migration (mobile): more easy,
3. input-output linkages between firms across
countries: more integrated.

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€ My research works on New Trade Theory
„ Berliant, Peng, and Wang (JET, 2002)
To investigate impact of R&D on the industrial
agglomeration and household distribution by general
equilibrium analysis approach.

„ Peng, Wang, and Thisse (JET, 2006)

To examine the trade of middle product, agglomeration,
growth, income inequality.

„ Mai, Peng, and Tabuchi (RSUE, 2008)

To discuss the tariff competition in the framework of New
Trade Theory.
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V. Globalization and New Trade Theory
1. Introduction
Major references:
1. Krugman, P.R. (1979), Increasing Return, Monopolistic
Competition, and International Trade, Journal of
International Trade 9, 469-479.

2. Krugman, P.R. (1991), Geography and Trade,

Cambridge, Mass: Massachusetts Institute of Technology
Press.

3. Fujita, M., P. R. Krugman, and A. J. Venables (2000),

The Spatial Economy, Cambridge, Mass: Massachusetts
Institute of Technology Press.
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€ Even though economic activities are, to
some extent, spatially concentrated because
of natural features, our goal is to focus on
economic mechanisms yielding
agglomeration by relying on the trade-off
between various forms of increasing
returns and different types of mobility costs.

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€ As noted by many historians and
development theorists, economic growth
tends to be localized. This is especially
well illustrated by the rapid growth of East
Asia during the last few decades, or the
rapid growth of East Area of China during
the last 20 years.

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2. Cities, countries, and regions: past and future

Casual observation reveals the extreme variation

in the intensity of human settlements and land use--
a fact that has culminated in the existence of cities
in which population densities are very high.

From a historical perspective, cities emerged

in several parts of the world about 7,000 years ago
as the consequence of the rise in agricultural surplus.

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 The mere existence of cities may be viewed as a
universal phenomenon whose importance slowly but
steadily increased during the centuries preceding the
sudden urban growth that appeared during the nineteenth
century in a small corner of Europe.

Technological development was necessary to

generate the agricultural surplus without which cities
would have been inconceivable at the time, as they
would be today.

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 In addition to technological innovations, a
fundamental change in social structure was also
necessary: the division of labor into specialized
activities. In this respect, there seems to be a large
agreement among economists, geographers, and
historians to consider “increasing returns” as the
most critical factor in the emergence of cities.

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 Economists and geographers must explain
why firms and households concentrate in large
metropolitan areas (or regions) even though
empirical evidence suggests that the cost of living
in such areas is typically higher than in smaller
urban areas (Richardson 1987).

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 As Lucas (1988, p.39) neatly put it, “What
can people be paying Manhattan or downtown
Chicago rents for, if not for being near other
people?” But Lucas did not explain why people
want, or need, to be near other people. Likewise,
economists and geographers must explain the
formation of small and specialized clusters of
firms and workers not necessarily located within
major cities.

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 The increasing availability of high-speed
transportation infrastructure and the fast-growing
development of new informational technologies
might suggest that our economies are entering an age
that will culminate in the “death of distance”. If so,
locational difference would gradually fade because
agglomeration forces would be vanishing. In other
words, cities would become a thing of the past.

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 Indeed, one of the general principles to be
derived from our analysis is that the relationship
between the decrease in trade costs and the
degree of agglomeration of economic activities is
not that expected by many analysts.

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 In addition, technological progress brings
about new types of innovative activities that benefit
most from being agglomerated and, therefore, tend to
arise in developed areas.

Consequently, the wealth or poverty of

nations seems to be more and more related to the
development of prosperous and competitive clusters
of specific industries as well as to the existence of
large and diversified metropolitan areas.

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The Economist (1995,18)
The liberalization of world trade and the
influence of regional trading groups such as
NAFTA (North American Free Trade Agreement)
and the EU (European Union) will not only reduce
the powers of national governments, but also
increase those of cities.

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 This is because an open trading system
will have the effect of making national
economies converge, thus evening out the
competitive advantage of countries, while
leaving those of cities largely untouched. So
in the future, the areas in which companies
will compete may be cities rather than
countries.

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3 Why do we observe agglomerations?
Intuitively, it should be clear that the spatial
configuration of economic activities is the outcome
of a process involving two opposing types of forces,
that is, agglomeration (or centripetal) forces and
dispersion (or centrifugal) forces.

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 The observed spatial configuration of
economic activities is then the result of a
complicated balance of forces that push
and pull consumers and firms. This view
agrees with very early work in economic
geography.

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 Individuals must get together to benefit
from the advantages of the division of labor,
but various difficulties restrict the
gathering of many individuals.

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4. Agglomeration and Increasing Returns
Ohlin (1933;1968, 97) has challenged
the common wisdom that considers
international trade theory as separate from
location theory.

International trade theory cannot be

understood except in relation to and as part of the
general location theory, to which the lack of
mobility of goods and factors has equal relevance.

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 Natural resources, and more generally
production factors, are not uniformly distributed
across locations, and it is on this unevenness that
most of trade theory has been built.

The standard model of trade considers a

setting formed by two countries producing two goods
by means of two factors (labor and capital) (2 x 2 x 2)
under identical technologies subject to constant
returns to scale and strictly diminishing marginal
products.

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 When production factors are spatially
immobile and goods can be costlessly moved from
one country to the other, this model predicts the
equalization of factor prices when the ratios of
factor endowments are not too different.

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 Similarly, regional economics has long been
dominated by the dual version of the neoclassical
trade model. It is assumed that a single good is
produced and that (at least) on production factor can
freely move between regions.

According to this model, capital flows from

regions where it is abundant to regions where it is
scarce until capital rents are the same across
regions, or regional wage differences push and
pull workers until the equalization of wages
between regions is reached.

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 Because the production function is linear
homogeneous and has strictly diminishing
marginal product in each factor, the marginal
productivity of the mobile factor depends only on
the capital- labor ratio.

This implies that the mobile factor moves

from regions with low returns toward regions
with high returns up to the point at which the
capital- labor ratio is equalized across all regions.

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 In other words, the perfect mobility of
one factor would be sufficient to guarantee the
equalization of wages and capital rents in the
interregional marketplace.

Thus, it would seem that either costless

trade or the perfect mobility of one factor
would be sufficient to guarantee the
convergence of labor income across various
places.

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 Increasing returns in production activities are
needed if we want to explain economic agglomerations
without appealing to the attributes of physical
geography.

In particular, the trade-off between increasing

returns in production and trade costs is central to
the understanding of the agglomeration economies,
globalization, or the distribution of economic activities
(for example, production, market, labor and the other
inputs).
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5. Globalization, Agglomeration, and Externalities
A. Marshall ([1890], 1920, chap.10):
Externalities are crucial in the formation of
economic agglomeration and generate something
like a lock-in effect.

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 When an industry has thus chosen a
location (country, region, or city) for itself, it is
likely to stay there long: so great are the
advantages which people following the same
skilled trade get from near neighborhood to one
another.

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 Good work is rightly appreciated;
inventions and improvements in machinery, in
processes and the general organization of the
business have their merits promptly discussed:
if one man starts a new idea, it is taken up
by others and combined with suggestions of their
own; and thus it becomes the source of further
new ideas (p.225).

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iii. formation of a highly specialized labor force and
the production of new ideas, both based on the
accumulation of human capital and face-to-face
communications; and
iv. the existence of modern infrastructure.

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 The concept of Marshallian externalities
has been much used in the economics and regional
science literature devoted to the location of
economic activities because it captures the idea that
and agglomeration is the outcome of a “snowball
effect” in which a growing number of agents want
to congregate to benefit from a larger diversity of
activities and a higher specialization.

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 Following Scitovsky (1954, JPE), it is now
customary to consider two categories:
“technological externalities” (also called spillovers)
and “pecuniary externalities”.

The former deals with the effects of

nonmarket interactions that are realized through
processes directly affecting the utility of an
individual or the production function of a firm.

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 Pecuniary externalities are by-products of
market interactions:

They affect firms or consumers and

workers only in so far as they are involved in
exchanges mediated by the price mechanism.
Pecuniary externalities are relevant when
markets are imperfectly competitive, for when an
agent’s decision affects prices, it also affects the
well-being of others.

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 Technological externalities are often
black boxes that aim at capturing the crucial role
of complex nonmarket institutions whose role and
importance are strongly stressed by economists,
geographers and spatial analysts.

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 Pecuniary externalities focus on
economic interactions mediated by the market,
their origin is clearer. In particular, their impact
can be traced back to the values of fundamental
microeconomic parameters such as the intensity
of returns to scale, the strength of firms’ market
power, the level of barriers to goods, and factor
mobility.

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 Whatever externalities are at work, prices do
not fully reflect the social values of goods and
services, and thus market outcomes are likely to be
inefficient.

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6. On the relationship between space and economics

Krugman (1995, Development, Geography, and

Economic Theory, MIT Press)

It is rare to find an economics text in

which space is studied as an important subject-if
it is even mentioned.

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 6.1 Space and the competition Paradigm

Isard (1949) critically discussed general

equilibrium analysis, and concluded that Hicks (1939)
that Hicks confined himself to “ a wonderful land of
no dimension.”

Production theory…….cannot justifiably treat

the particular effects of transport (or trade) and spatial
costs in separating producers from each other must be
considered.

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 Arrow and Debreu (Econometrica
22,265-290, 1954):
In general equilibrium analysis, the
problem of space can be handled by defining each
commodity by its physical characteristics as well
as by the place (period) in which it is made
available, and hence, once we have this index
commodities, we can essentially forget space (and
time) in economic theory.

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 Losch (1940), Isard (1954), Koopmans ( 1957),
Greenhut (1963), and several others: The problem is
not that simple.

Koopmans (1957) claimed in his Three Essays

on the State of Economic Science that the vital
effects of space become evident when our concern is
the location of several economic activities and, hence,
when the spatial distribution of activities itself
becomes a variable.

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„ Koopmans (1957,154): Without recognizing
indivisibilities-in human, in residences, plants,
equipment, and in production-urban location
problem, down to those of the smallest villages,
cannot be understood.

„ This is probably because economists

lacked a model embracing both increasing
returns and imperfect competition, the two
basic ingredients of the formation of economic
landscape, as shown by pioneering work of
Hotelling (1929), Losch (1940), Isard (1954),
Koopmans( 1957), and Greenhut (1963).

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 Because conventional general equilibrium
analysis abstains from the consideration of
indivisibilities or increasing returns to scale, it
will fail to capture the essential impact of
transport and land when one comes to study the
spatial distribution of economic activities.

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 In the long debate concerning the
comprehensiveness of general equilibrium
theory for the spatial. Starrett (1978, Journal of
Economic Theory 17, 21-37) has made a
fundamental contribution.

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 The essential question is whether the
competitive price mechanism is able to explain
the endogenous formation of economic
agglomerations.

To check the ability of a spatial model to

do so, the best approach is to consider the case
of a homogeneous space in which economic
agents are free to choose their locations.

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 For, if any concentration of economic
activities is to occur, it must be due to endogenous
economic forces.
Starrett has shown that if space is homogeneous
and trade costly, then any competitive equilibrium is
such that no trade occurs.

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 In other words, the economy degenerates
into separated single-location groups of agents
with all trades taking places within, rather
between groups.

Consequently, the perfectly competitive

price mechanism alone is unable to deal
simultaneously with countries (or cities) and trade.

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„ Spatial Impossibility Theorem (Starrett 1978, JET)
i, Space is heterogenous,
ii, Externalities is production and consumptions,
iii, Markets are imperfectly competitive.

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7. Spatial competition

Combining space and economies of scale

has a profound implication for economic theory.
If production involves increasing returns, a
finite economy accommodates only a finite
number of firms, which are imperfect
competitors.

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 Treading in Hotelling (1929) footsteps,
Kaldor (1935) argued that space gives this
competition a particular form. Because
consumers buy from the firm with lowest price
augmented by transport cost, each firm competes
directly with only a few neighboring firms
regardless of the total number of firms in the
industry.

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 The very nature of spatial competition is,
therefore, oligopolistic and should be studied
within a framework of interactive decision
making. This was one of the central messages
conveyed by Hotelling (1929) but was ignored
until economists become fully aware of the power
of game theory for studying competition in
modern economies.

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 Following the application of game theory to
industrial organization in the late 1970s, it
become natural to study the implications of space
for competition. New tools and concepts are now
available to revisit and formalize the questions
raised by the early location theorists.

Most of the contributions to location theory

by industrial organization deal with partial
equilibrium models.

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 Although a comprehensive general
equilibrium model with imperfect competition
has so far been out of reach and is likely to
remain so for a long time (Bonanno 1990),
specific models have been developed that, taken
together, have significantly improved our
understanding of how the spatial economy works..

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 In particular, since 1990s, a growing
number of economists have become interested in
the study of space (or location) problems, and it
is fair to say that some real progress has been
made.

This increased interest has been partially

triggered by the globalization, such as the
integration of national economies within trading
blocks, such as the European Union or NAFTA,
that leads to the fading of national borders.

66
 In the same vein, the study of the
microeconomic underpinnings of economic
development has led several economists to
investigate the connection between growth and
regions (or cities).

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VI. Concluding remarks

(i), Paul Krugman has developed a frontier model with the

microeconomics foundations to deal both spatial economic
agglomeration and regional imbalances at national and
international levels.

(ii), Paul Krugman has achieved this goal with a series of

remarkably original papers and books that succeed in
combing imperfect competition, increasing returns, and
trade costs in new and power ways (i.e., general
equilibrium analysis approach).

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Thank you

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