Why Krugman got the Nobel Prize: Economics, not polemics

Avinash Dixit 17 October 2008

a

A

I concluded my appreciation of Paul Krugman’s research on the occasion of his winning the Clark Medal by saying: “I am sure the Clark Medal is but one milestone of many to come in his career.” Now I can write this short article of continued appreciation on the occasion of his winning the Nobel Prize with the confidence and delight of a man whose forecast has come true.

The main new theme in Paul Krugman’s scientific contributions since the Clark Medal is of course the fulfilment of what was then a promising start of research on economic geography. This work has now transformed that subject from a somewhat arcane sideline into a flourishing research field.

In the last 10 years, Krugman has achieved fame in a much larger arena with his columns in the New York Times. These offer strong views on economics and politics, and they have been harshly critical of the Bush administration on most issues. It is no wonder that they attract adulation from readers who share his views on these matters and hatred from the other side. The former delight in his Nobel Prize, and the latter are shocked and dismayed by it, but both these reactions are mistaken. The prize has nothing to do with the Op Ed columns and would have come to Krugman just the same if he had never written a single one of them. The prize celebrates his achievements in science, not in the policy arena. It is therefore important to summarise and clarify exactly what those achievements are.

The traditional theory of international trade was cast in the traditional framework of microeconomic theory, namely perfect competition. Differences among countries in their endowments of factors of production and in their technologies explained trade. A relatively labour-abundant country would have a comparative advantage in producing goods that required relatively more labour in their production, and would export these goods so long as the country did not have an even greater bias toward consuming exactly the same goods. The outcome, as so often with perfectly competitive markets, was efficient resource allocation; each nation stood to gain from trade.

By the early 1970s, this picture was increasingly thought to be anachronistic. Trade in perfectly competitive markets, where thousands of producers of cloth in England and wine in Portugal traded their goods, seemed a poor model of trade with two or three giant firms making aircraft or computers. Voices for protectionism are always looking for arguments they can voice; they could now claim that traditional theorems on gains from trade did not apply to this modern reality. A new theory for this new world was needed.

Krugman was the undisputed leader of the group that took on this task. To quote and paraphrase Stephen Jay Gould (The Flamingo’s Smile, pp. 335, 345), Krugman has won his just reputation because he grasped the full implication of the ideas that predecessors had expressed with little appreciation of their revolutionary power. He had the vision to make the idea work in two ways, using it to make new discoveries and by recognising its implications as a far-reaching instrument for transforming general attitudes.

Too much has been transformed to allow a full explanation in this short article. I will merely touch upon three highlights, leaving interested readers to explore the details in my earlier appreciation (Journal of Economic Perspectives vol. 7, no. 2, Spring 1993, pp. 173-188), and the Nobel award committee’s scientific background statement.

The main new feature of all these models is the existence of economies of scale in production. The importance of this was recognised going back at least two centuries to Adam Smith, but economists lacked the technical apparatus to include this feature, and the imperfection of competition it brings, into their models so they could quantify and formalise the idea and derive all its implications. In the last three decades we have seen the rich results of modeling scale economies and imperfect competition, not only from Krugman’s work in international trade and economic geography, but also from work in macroeconomics by Blanchard, Kiyotaki and others, and on economic growth by Romer, Grossman, Helpman, and others.

Monopolistically competitive trade: This model is relevant to situations with moderate scale economies and consumer preference for product variety, thereby allowing several firms, each with some market power, to coexist in the market. The world auto industry is the prime example. This model provides a ready explanation for the seemingly puzzling rise in intra-industry trade. If as in the traditional theory countries use their advantages of technology or factor endowments to produce some goods at lower cost and export them, how can it be that France and Germany simultaneously export cars to each other? The answer is that the two types of cars are not identical in consumers’ evaluation, and the economies of scale make it less costly to produce each type in only one of the countries. In this situation the old presumption of gains from trade is generally strengthened by the new theory. Each country benefits because of the better exploitation of economies of scale, and both gain further by having access to a larger variety of types of cars.

Oligopoly and strategic trade policy: If economies of scale are so large relative to the market that only a very small number of firms can coexist, they have substantial market power and can make super-normal profits. The large commercial aircraft industry, with Boeing and Airbus, is often cited as the paradigmatic example (but depending on the market conditions the profit may be eroded by fierce competition between the two). Now each country might benefit by strategically promoting its firm so it can seize this profit as a part of its own national income. Krugman, along with Brander and Spencer, developed models where such policy could in principle work, although later empirical work by Baldwin and Krugman, Dixit, and others found that the size of the gain was usually small even in the absence of retaliation by other countries. Thus this line of research gave some logical comfort, but not realistic support, to those who advocated protectionism in the new world of imperfectly competitive trade.

Economic geography: Others had argued that scale economies bring an element of historical accident to firms’ location choices. Krugman went further and explored some important new mechanisms of economic interaction. A more populous region can enjoy lower costs and therefore higher real wages by carrying economies of scale farther. It can then attract more migration from other regions. The higher wages also create demand for the products of other firms; this is a positive externality supplementing the economies of scale within each firm. This tendency for concentration of production in a region is checked by transport costs across regions. The balance of all these forces determines the overall pattern of location of production. These ideas have led to a revolution in the field of economic geography, transforming it from a primarily descriptive endeavor into an analytic discipline.

I have not said anything about Krugman’s popular writings, most importantly because they are not the reason for his “ennobelment,” but also to a small extent because I sometimes dislike his polemical and combative style of writing at the same time as I agree with the substance of his criticisms. But my delight at the recognition of the scientific achievements of this friend and colleague of over three decades is great. In fact it is doubled by the joy of my having played a part in creating the tools that are proving their worth – models of monopolistic competition and product diversity, and of entry deterrence. With that in mind, here is my nomination for next year’s prize: Romer, Grossman, and Helpman for endogenous growth theory.

a

A

Topics:  International trade

Tags:  Nobel Prize, Krugman