Paul Krugman: New Trade Theory and New Economic Geography Theory
- Nottingham Economics Society
- Aug 11, 2022
- 4 min read
Updated: Aug 24, 2023
Introduction
Paul Robin Krugman (1953-) is a Neo-Keynesian, American economist (Brock, 2020) that became a Nobel laureate in 2008 for his New Trade Theory and New Economic Geography Theory, in which he helped revolutionize our modern understandings of international trade along with explaining the rationale behind economic disparities between different regions (The Nobel Prize, n.d.). Paul Krugman is also known for his op-ed column in The New York Times and is sometimes referred to as the most important political columnist in America (The Editors at Encyclopedia Britannica, n.d.).
New Trade Theory
Under the old trade theory, economists assumed that countries only export goods and services that they have a comparative advantage in its production, while they would import goods and services products that they did not have a comparative advantage in.
However, The New Trade Theory proposes the idea that economies of scale and imperfect competition are two critical factors that impact modern international trade and were neglected in the old trade theory (Pettinger, 2017). Krugman mentions that countries with substantial economies of scale in the production of a certain good or service are more likely to export that good instead of importing it from another country. This is because a country that has economies of scale can significantly reduce its average cost of production, allowing it to become more competitive than other countries (Brock, 2020). Another note worth mentioning is that if a country is an early entrant into an industry, the country would have an advantage over other entrants since it would achieve economies of scale earlier than the rest, ultimately crowding out current and future entrants and creating an imperfectly competitive international market (Pettinger, 2017).
The New Trade Theory also suggests that the reason as to why intra-industry trade exists regardless of which trading country has the comparative advantage in production is due to imperfect competition. Contrary to the assumptions made in the old trade theory, most industries in reality have an imperfectly competitive market in which some industries are monopolistically competitive while other industries could experience oligopolistic competition. This means that different countries could have drastically different opportunity costs to produce the same good, but both countries would still trade the good between each other due to the differences in the product such as branding, quality, and other non-price differences (Pettinger, 2017). A real-world example of this would be the trade of automobiles between Germany and Japan, both of which are major automobile manufacturers. Although Germany and Japan produce their own automobiles, consumers in either country favor diversity, hence both countries still trade automobiles with each other.
New Economic Geography Theory
Krugman’s New Economic Geography Theory attempts to explain the rationale behind regional economic disparities by utilizing the Core-Periphery Model to explain the importance of geography and how network effects play a huge role in creating and dissolving such regional imbalances (Baldwin and Wyplosz, 2020).
NEG has four main assumptions (Baldwin and Wyplosz, 2020):
1- There are two countries that are similar in all aspects except population size
2- Firms are monopolistically competitive (product differentiation)
3- Firms can experience economies of scale (decreased average costs as output increases)
4- Consumers prefer diversity of consumption
Krugman further adds by explaining that there are two kinds of forces that create a centralization and a decentralization effect between the two regions, pro-agglomeration forces and pro-dispersion forces. Pro-agglomeration forces lead to increased concentration within one region, thus creating a regional imbalance. For example, if more firms begin to allocate their operations into one region more than the other, this decreases the costs of trade and transportation for those firms since they are all concentrated in one area instead of being spread apart, hence it becomes more expensive to produce in the less concentrated region. Firms in the concentrated region are now able to decrease the prices of their outputs, denoting that the costs of intermediate goods have also decreased, encouraging firms outside of the region to enter, ultimately creating large disparities between both regions.
On the other hand, pro-dispersion forces lead to decentralization, decreased regional disparities, and a balanced rate of development between both regions. For instance, if one region has become too concentrated to such a degree that it increases the costs of trade through increased traffic jams, rent prices, and competition, this results in firms losing their economies of scale and causing them to withdraw from the concentrated region to the less concentrated one. Eventually, enough firms will move back to the previously less concentrated region, thus balancing the rate of development between both regions and reducing economic disparities between them.
Conclusion
Paul Krugman has gone to win the Alfred Noble memorial prize in Economic Sciences in 2008 for both his New Trade Theory, and his New Economic Geography Theory for providing new and successful insights into modern understandings of international trade. The New Trade Theory helped economists understand the reasons behind intra-industry trade and the importance of economies of scale for international trade. While his New Economic Geography Theory was used to explain industries tend to cluster into specific regions instead of being spread evenly across different regions.
About The Author
Yazan Al Bishtawi
Yazan is an undergraduate student majoring in Economics and International Economics at the University of Nottingham Malaysia Campus. By becoming a research contributor in NES 2021-2022, he aims to enhance his skills in the analysis, interpretation, and synthesis of research articles in economics and politics. Yazan hopes to pursue further academic education by undertaking postgraduate studies relating to one of the sub-disciplines of economics.
References
1- Baldwin, R.E. and Wyplosz, C. (2020). The Economics of European integration. London Mcgraw Hill.
2- Brock, T. (2020). Paul Krugman Definition. [online] Investopedia. Available at: https://www.investopedia.com/terms/p/paul-krugman.asp.
3- Pettinger, T. (2017). New Trade Theory - Economics Help. [online] Economics Help. Available at: https://www.economicshelp.org/blog/6957/trade/new-trade-theory/.
4- Pinkus, E. (2020). Axios|SurveyMonkey poll: urban/rural Impressions. [online] SurveyMonkey. Available at: https://www.surveymonkey.com/curiosity/axios-surveymonkey-poll-urban-rural-impressions/.
5- The Editors at Encyclopedia Britannica (n.d.). Paul Krugman | Biography, Nobel Prize, & Facts. [online] Encyclopedia Britannica. Available at: https://www.britannica.com/biography/Paul-Krugman.
6- The Nobel Prize (n.d.). The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008. [online] NobelPrize.org. Available at: https://www.nobelprize.org/prizes/economic-sciences/2008/krugman/biographical/.
7- Tires and Automotive Parts (2018). Toyota And Mercedes-Benz Top Auto Brands in 2018 Best Global Brands List. [online] Tires & Parts News. Available at: https://tiresandparts.net/news/automotive/toyota-and-mercedes-benz-top-auto-brands-in-2018-best-global-brands-list/ [Accessed 7 Aug. 2022].
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