What is New Trade Theory?

by on October 13, 2008 at 10:33 am in Uncategorized | Permalink

Congratulations to Paul Krugman on his Nobel.  Here is a primer on one of Krugman’s key contributions, New Trade Theory.  Tyler has more links below.

Ricardo showed that every country (and every person) has a comparative advantage, a good or service that they can produce at a lower (opportunity) cost than any other country (or person).  As a result, production is maximized when each country specializes in the good or service that they produce at lowest cost, that is in the good in which they have a comparative advantage.  Since specialization in comparative advantage maximizes production, trade can make every country better off.

But what determines comparative advantage?  In Ricardo it is the natural products of the soil, Portugal is good at producing wine and so England has a comparative advantage in cloth.  Heckscher, Ohlin and Samuelson among others extended the model to show how factor proportions can determine comparative advantage – countries with a lot of labor relative to capital, for example, will tend to have a comparative advantage in labor intensive goods production.

Notice, however, that in the Ricardian model and its extensions the determinants of comparative advantage like geography and factor proportions lie outside of the model.  New Trade Theory of which Paul Krugman can be said to be the founder, brings the determinants of comparative advantage into the model.

Consider the simplest model (based on Krugman 1979).  In this model there are two countries.  In each country, consumers have a preference for variety but there is a tradeoff between variety and cost, consumers want variety but since there are economies of scale – a firm’s unit costs fall as it produces more – more variety means higher prices.  Preferences for variety push in the direction of more variety, economies of scale push in the direction of less.  So suppose that without trade country 1 produces varieties A,B,C and country two produces varieties X,Y,Z.  In every other respect the countries are identical so there are no traditional comparative advantage reasons for trade.

Nevertheless, if trade is possible it is welfare enhancing.  With trade the scale of production can increase which reduces costs and prices.  Notice, however, that something interesting happens.  The number of world varieties will decrease even as the number of varieties available to each consumer increases.  That is, with trade production will concentrate in say A,B,X,Y so each consumer has increased choice even as world variety declines.

Increasing variety for individuals even as world variety declines is a fundamental fact of globalization.  In the context of culture, Tyler explains this very well in his book, Creative Destruction; when people in Beijing can eat at McDonald’s and people in American can eat at great Chinese restaurants the world looks increasingly similar even as each world resident experiences an increase in variety.

Thus, Krugman (1979) can be thought of as providing another reason why trade can be beneficial and a fundamental insight into globalization.

Moreover, Krugman (1979) began the task of bringing the reasons for comparative advantage within the model.  In that paper, Krugman also hypothesizes briefly about what happens when we allow migration within the model.  Recall, that in Heckscher-Ohlin-Samuelson factor proportions explain trade patterns but are themselves determined outside of the model.  When people and capital can move, however, factor proportions are themselves something to be explained.

Krugman (1991) (JSTOR and here) brings increasing returns together with capital and labor migration and transport costs into one model.  Krugman’s (1991) model has become a workhorse of economic geography and international trade.  The model is too complex to explain here but the reasons for that complexity are clear to see – when everything becomes "endogenous" small initial differences can make for big effects.  To minimize transport costs, for example, firms want to locate near consumers but consumers want to locate near work!  Thus, there are multiple equilibria and at a tipping point the location decisions of a single firm or consumer can snowball into big effects.  So Krugman has been a leader in introducing tipping points, network effects and thus the importance of history into international trade as well as into economics more generally. 

jb October 13, 2008 at 10:42 am

I’ve always felt that Ricardo misses the opportunity for growth. Sure, Portugal has a comparative advantage in soil productivity, but that goes nowhere–England can parlay its advantage in cloth into an advantage in weaving machinery, other machinery, and all the products of an expanding industrial economy, while Portugal is stuck growing crops.

Sure, the system improves overall, but it sucks to be Portugal.

cfpete October 13, 2008 at 10:51 am

Put Simply,
Krugman no longer believes in any of his theories.
Let me tell you,
It is fun teaching International Trade when the students bring in NYT editorials conflicting with the theories presented in the text.
Just one of the reasons his text was dropped.

mk October 13, 2008 at 11:37 am

Increasing variety for individuals even as world variety declines is a fundamental fact of globalization.

Would it be accurate to put it this way? Before trade, you have access to only local products, made by both well-run and poorly-run companies. After trade, some of the poorly-run companies tend to die out and you now have access to global products made by (relatively) well-run companies from all over.

The well-run companies get stronger and the less well run ones die out. More consolidation, more economies of scale, more surplus.

Is that the gist?

improbable October 13, 2008 at 12:11 pm

That was an interesting description. I had never thought about it before, but the effect you describe here is a version of what in physics is called spontaneous symmetry breaking: even if the countries have no natural advantages in what they produce, there are advantages to them specialising in something, so they pick something and do that, breaking the symmetry they started with before trade.

Does anyone know whether the links are more explicit? Spontaneous symmetry breaking was a big topic in physics in the 70s (and the 60s too), I wonder if these ideas seeped through, or were independently discovered?

Sam Wilson October 13, 2008 at 12:17 pm

It is fun teaching International Trade when the students bring in NYT editorials conflicting with the theories presented in the text.

Isn’t the case of a student bringing in conflicting statements by the same author (in this case, a newly minted Nobel laureate) a great opportunity for encouraging the student towards deeper insight?

Are the conflicts real? What caused the change of opinion in this clearly learned individual? He’s moved on, why haven’t you?

Understanding the conflicts in a particular field (and often times, within a particular individual) is a critical part of truly becoming part of that field. Frankly, it’s what makes any field of study interesting.

No wonder students find econ boring. Their profs are hiding all the good conflicts!

Alex Tabarrok October 13, 2008 at 12:42 pm

mk,

think about it this way. Without trade consumers in each country choose 3 varieties. With trade, it’s possible to have a larger market and thus to lower costs and prices. Consumers could take all the gains in lower prices by choosing 3 varieties (eliminating 3) but consumers care about variety as well as low prices – thus in the new equilibrium they take a little bit more of both – 4 varieties with each variety being sold to more consumers and thus supplied at lower price.

Alex

lee A. Arnold October 13, 2008 at 12:55 pm

Alex Tabarrok, wouldn’t the same thing be happening WITHIN countries, too? Specialization and the division of labor in each industry will tend to give increasing returns, and by causing lower real prices, this would slowly crowd-out the nearly-equivalent goods and services. It this a partial explanation for both brand dominance and, at a higher level, path dependence?

mk October 13, 2008 at 1:12 pm

Thanks to alex and DRDR for the helpful explanations!

diz October 13, 2008 at 2:44 pm

Put Simply, Krugman no longer believes in any of his theories.

This is what I was wondering about.

How accurate is a claim that Krugman has since repudiated the work for which he won the Nobel prize?

srp October 13, 2008 at 4:00 pm

I’m a little surprised that no in mentioning the pioneering work of Kelvin Lancaster, who first wrote about models of this type in 1979. This work was in turn based on his early (1971 or so) book about how consumers consume the attributes of goods rather than the goods themselves. I’ve always felt that his spatial models are more realistic at a micro-level than the Dixit-Stiglitz taste-for-variety stuff.

Alan Brown October 13, 2008 at 4:27 pm

Variety will not decrease as we continue to globalize and everyone gains access to information technology.

With increased automation, variety will actually increase.

When anyone can create a new product and have it manufactured anywhere when even a single customer orders it, product variety will explode into the billions.

At this point, people will be crying out for sameness. Fortunately, they’ll be able to order that online too.

Eric October 13, 2008 at 5:36 pm

I’m a bit surprised that Jeffrey Sachs was overlooked for his work in economic development and now poverty…what is everyone elses thought on this?

Crank October 13, 2008 at 6:21 pm

“Ricardo showed that every country (and every person) has a comparative advantage, a good or service that they can produce at a lower (opportunity) cost than any other country (or person).”

Really? I must have gotten something wrong in my undergrad micro class. I thought what you just described is absolute advantage. Furthermore, I thought that what Ricardo showed was that absolute advantage wasn’t required to benefit from trade. That mere comparative advantage was sufficient to ensure gains from trade. In other words, that I can benefit from trade even if I lack an absolute advantage in anything.

leg October 14, 2008 at 12:28 am

Krugman continues to write about the benefits of trade. But one huge thing he’s added is that if the benefits of trade flow to a small number of people, it may not be in the interest of a country to promote it. I think that his political views have been evolving around trying to understand how the winners of trade can compensate the losers (say, through progressive taxation) which would continue the flow of free trade.

One thing he’s been very explicit about is the size of trade relative to the US economy: 20 years ago, not so much. Now, much bigger, and thus the effects (both positive and negative) of trade can be that much more important.

Alex October 14, 2008 at 2:38 am

Krugman has remained true to his theories.

Extremists who don’t like his politics, be they on the right or left, look for ways to attack him.

They usually are clumsy both in thought and application, incapable of hiding their hatred.

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Pete Murphy October 14, 2008 at 8:12 am

Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today’s recession may be just a preview of what’s to come.

Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?

At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. In fact, our largest per capita trade deficit in manufactured goods is with Ireland, a nation twice as densely populated as the U.S. Our per capita deficit with Ireland is twenty-five times worse than China’s. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.

Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at OpenWindowPublishingCo.com where you can read the preface for free, join in the blog discussion and, of course, buy the book if you like. (It’s also available at Amazon.com.)

Please forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

Pete Murphy
Author, “Five Short Blasts”

Anonymous October 14, 2008 at 2:52 pm

Pete Murphy,

you state that “The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow.”

The statement contains two major flaws, and several minor. I will briefly comment on the major.

The first flaw is the implicit suggestion that the trade deficit is the result of imports relacing domestic production (hence American jobs are lost to foreign). While this may be true for specific industries only, it is not true for the economy as a whole. American exports have been growing steadily. We export today way more than we ever used to, and that has contributed to new jobs in many of these exporting sectors. The deficit is due to the fact that our imports have grown even faster, in large part because of our increased spending on oil imports from abroad. As proof let me remind you that the trade deficit as a percentage of GDP grew in the 1990s at the same time that the unemployment rate was falling to unprecedented levels (below 4%).

The second flaw, and perhaps the most important one, is the claim that if workers in an industry are more productive then we shouldn’t be importing the product this industry produces from another country. You are refering of course to the concept of absolute advantage. It is amazing that in the 21st century people still don’t get what David Ricardo showed back in the 19th century: What matters for trade is comparative advantage, not absolute advantage (absolute productivity). Simply put, a country may be SOMEWHAT more productive in making some products, and yet still be able to buy it cheaper from abroad if it is MUCH more productive in making other products. In other words, a country will gain by importing things it is a bit more productive in making, and exporting things it is a lot more productive in making. What matters is comparative productivity. In this sense, it doesn’t matter that textile workers or steel workers are somewhat more productive than their Chinese counterparts, because American aircraft workers, software engineers, film makers, etc. are much more productive, thus giving us a comparative advantage in these goods.

Now, you would think that someone who has written a book on trade should know these things, and many other (like that per capita consumption is rising, not falling like you state) but alas, in the words of Dirty Harry (Callahan): “An opinion is like an asshole-everybody has one.”

dg lesvic October 15, 2008 at 3:47 am

My posting somehow got lost.

I’ll try again.

As well as I can understand this discussion, and I can’t understand it very well, Krugman’s point and your point is that international trade is mutually beneficial.

But the question is: to whom?

Obviously it’s beneficial to its participants, otherwise they wouldn’t enter into it.

The objection to it is supposedly on behalf of those unemployed and left behind by it.

That is the issue you must address.

RedZone October 18, 2008 at 12:34 am

Willy’s comment is interesting in at least one point:

What happens when one country adopts a “beggar thy neighbor” policy and another adopts a “mutually beneficial” “free trade” policy?

There are political implications in this. If our MNCs were to benefit from this specific combination, they would attempt to induce this result. They would, to use Willie’s example, attempt to steer China to a “Beggar thy Neighbor” policy towards the U.S. and steer the U.S. into a “Free Trade” policy with the Chinese. The advantages–or disadvantages–to either or both the U.S.A. and the Chinese would be of no relevance to the MNCs, who, as a third party, benefit regardless of the suffering of the two countries. If the policy makers of both countries are sensitive to the MNCs, they will each pursue policies without giving a second thought to the welfare of their respective countries.

And this would be the case regardless of whatever results “Free Trade” or “Protectionism” in and of themselves would produce if practiced mutually or if each country were taking into consideration the interest of its people. Whether the Nationalists or the Globalists are right would be of no importance if it can be demonstrated that an asymetrical policy situation would hurt one or both countries.

tn chaussures April 3, 2009 at 11:52 pm

I must have gotten something wrong in my undergrad micro class. I thought what you just described is absolute advantage.

Frank December 13, 2009 at 5:36 pm

I cannot believe what I am reading. A person who earns 35 cents an hour, working for a company in some part of the world where environmental costs, worker benefits and safety issues are not considered, certainly has a comparative advantage over the old time American worker, meaning pre-Clinton. In retrospect, it is apparent that this theory has been put into effect, American tariffs lifted, trade agreements changed to the extent that America is now dead broke on its ass. Tax revenue to support a strong nation, as we were when we sent man to the moon is gone. This theory is part of the globalization process, which equates, here in America, to killing the American worker and taking down America. We are becoming a Chinese puppet show.

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