Wednesday, October 15, 2008

Why Krugman Won the Nobel Prize

To be honest, I have been interested in his specialty since I read his popular writing, say, pop internationalism.

In my country Japan, his insight on the monetary policy conducted by the Bank of Japan has been more focused(because it seemed very clear and easy for general people to understand), but to me his research on international trade and geography seems more interesting.

When I read the reason for his winning the Nobel prize, I nodded and wondered what role was played in my favorite area, optimal currency area.

I try to summarize his contribution to new research area*:

From Ricardo-Heckscher-Ohlin to Krugman
The English economist David Ricardo launched the theory of comparative advantage to explain the range and composition of international trade. He focused on the differences of technology. Later the Swedish economists Heckscher and Ohlin implied that foreign trade was based on differences among countries and focused on different accesses to factors of production.

However, intra-industry trade has expanded, in particular between rich countries. Such trade implies that a country both exports and imports more or less the same goods. This would not be compatible with the theory of Ricardo-Heckscher-Ohlin.

Krugman intended to explain the occurrence of intra-industry trade and based an assumption
of economies of scale whereby mass production diminishes the cost per unit produced and an assumption that consumers appreciate diversity in their consumption on his new trade theory.

Economies of Scale and Diversity of Preference
Krugman shows that foreign trade will arise not only between different countries, but also between identical countries in terms of access to technology and factor endowments, and also shows that extensive intra-industry trade will occur.

The approach Krugman used in his foreign trade theory – the assumption of economies of scale in production and a preference for diversity in consumption – was found to be appropriate for analyzing geographical issues.

Krugman asks what would happen if foreign trade became impossible: If two countries are exactly alike, then welfare will be the same in both countries. But if the countries are alike in all respects except that one of them has a slightly larger population than the other, then the real wages of labor will be somewhat higher in the country with more inhabitants.

The firms in the more highly populated country can make better use of economies of scale, which
implies lower prices to consumers and/or greater diversity in the supply of goods. This, in turn, enhances the welfare of consumers.

As a result, labor, i.e., consumers, will tend to move to the country with more inhabitants, thereby increasing its population. Real wages and the supply of goods will then continue to increase even more in that country, thereby giving rise to further migration, and so on.

From Urban to Rural, From Rural to Urban
Later Krugman assumes that although trade is possible, it is obstructed due to transport costs. Otherwise, labor is free to move to the country or region which can offer the highest welfare, in terms of real wages and diversity of goods.

The above considerations evolved into the core-periphery model, which shows that the
relation between economies of scale and transport costs can result in either concentration
or decentralization of communities.

Under certain conditions, the forces which contribute to concentration will dominate. Under different conditions, the forces which give rise to decentralization will dominate. Krugman’s model can be used to account for the mechanisms at work in both directions.

For example, his model indicates that declining transport costs easily generate concentration and urbanization. It seems particularly noteworthy since transport costs have exhibited a declining trend throughout the twentieth century.

* Much of the above is due to here.

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