The Nobel series: Krugman's 'new economic geography'

The Nobel Prize in Economic Sciences in 2008 was awarded to Paul Krugman who was then at Princeton University, "for his analysis of trade patterns and location of economic activity".

Krugman did his BA in economics from Yale University in 1974, and his PhD in economics within three years in 1977 from MIT where his advisor was the well-known trade economist — Rudi Dornbusch. Krugman's thesis was titled 'Essays on flexible exchange rates.'

He joined as faculty at Yale University in September 1977 after completing his PhD. He then joined the faculty of MIT in 1979. Krugman also taught at Stanford, Yale, and the London School of Economics, but settled down in Princeton University in 2000, from where he retired in 2015. After retirement, he joined the City University of New York.

Krugman's book, 'International Economics: Theory and Policy' — co-authored with Maurice Obstfeld — is a standard undergraduate textbook on international economics. Krugman also writes on trade policy and other areas of public policy in newspapers and magazines.

He is mainly known for marrying theories of international trade with those of economic geography. In other words, he introduced location and transport costs as important determinants of trade in addition to what traditional trade theory tells us.

In this article, we will review the main works of Krugman, and discuss how they continue to guide us in various aspects of trade and public policy.

Main works

Krugman is an international trade specialist, but what is unique about his work is that he looked closely at the link between patterns of international trade and locations of economic activity. As we know, international trade and economic geography have been separate areas of study. Krugman's work not only created a link between the two, but also contributed to the convergence in the two areas.

Trade theory has evolved greatly from the time of Adam Smith who had proposed the theory of absolute advantage — meaning that the country which was more efficient in the production of a good, would specialise in its production and exchange it for other goods from other countries that specialised in their production. This was followed by Ricardo's theory of comparative advantage — which was propounded in early 19th century and held sway for more than 100 years. As we know, the theory of comparative advantage states that a country would produce the good in which it was relatively efficient. In other words, if two countries produce two goods and if one of them is more efficient in both of them, it would still specialise only in that good, in which it was relatively more efficient. In the 1920s, the Heckscher-Ohlin theory was proposed, which explained international trade as a function of differences in factor endowments of different countries, and different factor-proportions needed for producing different commodities that account for difference in comparative costs. Ohlin was awarded the Nobel Prize in 1977, as we saw in these columns, for the said work. While the Heckscher-Ohlin theory provided explanation for most trade patterns, in the 1970s, it was noticed that a large part of trade was taking place within the same industry — intra-industry trade was growing. For example, there was growing trade in different makes of cars. This was explained by economies of scale and consumers' preference for diversity, apart from the fact that countries could specialise in different makes or brands. This was the beginning of inclusion of location or economic geography as an important factor affecting trade. Krugman led this effort. His theory came to be known as the new trade theory.

Krugman's first work was his paper in 1979, where he suggested that even if there was no comparative advantage, trade could be triggered by economies of scale (a firm can reduce its cost of production by increasing production) and imperfect competition. The paper — 'Increasing Returns, Monopolistic Competition and International Trade' — was published in the 'Journal of International Economics'. The paper explained why intra-industry trade occurred, and also introduced the idea that economic geography was an important factor in explaining trade patterns. In an extension of this work, Krugman included transport costs in his 1980 paper. It was however his 1991 paper which explicitly introduced economic geography into the model. Krugman's core-periphery model distributed the population between the core (a few highly urbanized and developed regions) and the periphery (the agricultural hinterland). The majority of the population in the model lives in the core. Mobility of workers between the two regions is allowed. The model is driven by the location choices of firms and individuals. To quote from the Nobel website:

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.

Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities.

Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. Lower transport costs can trigger a self-reinforcing process whereby a growing metropolitan population gives rise to increased large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. Krugman's theories have shown that the outcome of these processes can well be that regions become divided into a high-technology urbanized core and a less developed "periphery".

Empirical evidence has supported Krugman's convergence theory where the new trade theory converged with economic geography and has come to be known as the 'new economic geography'. For example, positive relationships between market size and wages, and between market size and migration, have been found — validating the core-periphery model.

Krugman has also worked on other aspects of trade policy such as the use of tariffs as a strategy to change the terms of trade in its favour when there is imperfect competition and economies of scale. He also co-authored a paper — 'Trade Policy and Market Structure' — with Helpman in 1989, which looked at the implications of using tariffs as a strategy for regulation of industry. The paper found that tariffs actually reduced domestic output, and that import subsidies improved the terms of trade.

Another important contribution of Krugman has been in the area of international monetary economics in the form of analysis of the impact of exchange rate management on growth. More specifically, in a paper in 1979, he proposed a framework to analyse exchange rate management. He suggested that a country could hold a fixed exchange rate by buying and selling foreign currency only in the short run. This is because rational investors anticipate a future depletion (or accretion) of the currency reserve in the long run, thereby leading to speculation and trading in the currency. Krugman also proposed a 'canonical' model in 1991, wherein he analysed how exchange rates will behave in a specified band or zone.

Krugman was also instrumental in reviving the discussion on liquidity trap in the context of Japan's stagnant growth in the 1990s — also known as Japan's lost decade. Krugman argued in his book, 'The Return of Depression Economics', that Japan was suffering from a Keynesian liquidity trap on account of high interest rates, and the way out was inflation targeting: The Central Bank should commit to raise the expected inflation rate so that people are forced to save less and spend more. Krugman also argued that most developed countries were also caught in a liquidity trap after the 2008 meltdown.

Finally, Krugman was at the forefront of the Keynesian resurgence in the immediate aftermath of the 2008 global financial crisis. Having observed the US government rescuing the big banks that virtually ruled the Wall Street and were the high priests of free markets, Krugman concluded that a fiscal stimulus would be a key policy intervention across the world for some time to come. He also launched 'A Manifesto for Economic Sense' with Richard Layard in 2012, wherein Keynesian policies such as an expansionary fiscal policy to reduce unemployment and generate growth have been prescribed.

Krugman has authored / edited a number of books (including textbooks) and journal articles. Krugman has also been writing newspaper articles on various trade and public policies. One of his recent books is 'The Conscience of a Liberal' (which was a compilation of his blogs in New York Times) — published in 2007, where he laments the rising inequality of income since the 1980s and asserts that government policy has been responsible for this, just as it was responsible for falling inequality from 1930s to 1970s. His other work is 'The Great Unravelling', published in 2004, which was a compilation of his columns. His most recent book, published in 2021, is titled 'Arguing with Zombies: Economics, Politics, and the Fight for a Better Future', wherein Krugman strongly criticises the Republicans for sticking to their economic policies even though there is no evidence to support those. The 'zombies' in the book are the beliefs held by Republicans such as: budget deficits are always bad and the notion that tax cuts are beneficial for growth.

Conclusion

Krugman is one of the most versatile economists of this century, having contributed in areas of trade theory, macroeconomics and finance. He has also been instrumental through his books, blogs and newspaper / magazine columns in simplifying important economic terms so that they are understandable to non-economists. We have seen above that his most fundamental contribution was in marrying his new trade theory (in which he introduced economies of scale and preference for diversity) with economic geography (by introducing location of economic activity and transport costs). Krugman was also not afraid of speaking his mind and had criticised George W Bush in his abovementioned book, 'Arguing with Zombies'. Defending Barack Obama's stimulus plans, Krugman also joined the issue with Robert Lucas of University of Chicago, who had called Obama's policies 'schlock economics'. Krugman criticised macroeconomists for not having foreseen the 2008 crisis. He also called out Kenneth Rogoff and Reinhart of Harvard University over their suggestion that high debt leads to low growth. Krugman is a liberal. While he has written in favour of free trade, he has also emphasized the problems of rising inequality and poverty.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal