Paul Krugman is a Nobel Prize winning economist whose name is among those reaching the peaks of macroeconomics and beyond through his work on international trade among other topics. He is a professor of economics at City University of New York and a columnist for The New York Times. The Prize he received was due to his work in explaining the patterns of international trade and the geographic distribution of economies scale and of consumer preferences for diverse goods and services. Krugman’s influence on international trade has helped garner a better understanding of free trade, urbanization and how worldwide trade is dominated by countries of similar conditions and products.
The trade theory was based on, as of the mid-1970s, on the notion of comparative advantage. Up until then, David Ricardo’s theory from the 19th century and Heckscher-Ohlin theory from the 1920s held more weight due to the assumption of trade being conducted either in terms of technology or factor endowments. Comparative advantage is the ability to produce a good at a lower opportunity cost than a competitor can. Ricardo’s theory stated that countries can specialize on the production of goods it produces efficiently and buy the goods it produces less efficiently from other countries, even if this means buying goods from other countries it could efficiently produce itself. The Heckscher-Ohlin theory summed down to a capital abundant country exporting relatively capital-intensive goods and importing labor-intensive goods while assuming that both countries hold identical technology.
The left side shows that the best place for coconuts is the trading with the best place for wool. Both of their items has to do a lot with the climate due to their geographic location. On the other hand, the right side shows that countries can be similar in abilities but they tend to pick a good that requires large scale production and focus on it so that different countries can come to them for that particular good. For example, Germany luxury cars trading with America for their aircrafts.
The new trade began to emerge in the 1970s and was developed by Paul Krugman. This theory focuses on increasing returns to scale and network effects. Before this theory, the only reason trade was seen as a benefit was due to comparative advantage which means countries traded only what they were good at. These theories provided good explanations of the trade patterns in the first half of the 20th century. But as many researchers began to observe, comparative advantage seemed less relevant in the modern world. Today, most trade takes place between countries with similar technologies and similar factor proportions; quite similar goods are often both exported and imported by the same country.
Paul Krugman developed that trade is due to increasing returns to scale, not the differences between the countries. He established a technology that indicates that it is cheaper to operate at large scale when extra units of a good are produced. When countries focus on the production of large quantities of specific products, it reduces production costs allowing for them to reap greater economies of scale. As a result, even if there are not differences in endowments, including culture and institutions, international trade is still beneficial. This is a form specialization which also helps to gain other network benefits while attaining a gain in economies of scale.
The rate of scale is an increase in production which is related to the increase in factors of production. This is a relationship between input and output. There is a certain amount of input where the output remains constant so the best place for companies plugging in these inputs is to do it with the least amount of input generating the most output which in this case is at the number 3 for the scale of inputs.
The new trade theory could also be said to show a role of government through their support in the growth of vital industries and in the promotion of new industries.
There are many Asian economies who had protection and support from their governments which provides sustenance to this element of the new trade theory. For example, the support of the Japan’s government in the car industry. This evidence backs up the belief that a few years of support through tariff protection and domestic subsidies could be the encouragement needed in capital-intensive industries. There is also a downfall to government support because it could create a tendency for powerful businesses to rely on state support which could encourage inefficiency.
The infant industry is another argument that justifies tariffs on imports to aid in the development of diverse industries. If a country could establish economies of scale through infrastructure then they can develop a comparative advantage and to do so they would place tariffs on countries where their industries have a dormant comparative advantage.
While many developing countries have comparative advantage in minerals and agriculture, the long term production could be disadvantageous due to low-income elasticity of demand and unstable prices. The up and downs of supply and demand could be overcome if a developing country were to diversify the economy which could be done through a provision of a domestic market in lieu of a lack of capital markets through tariffs that will be reduced once the industries become more efficient.
Urbanization, which has played a big part through specialization in the new trade theory, can be seen as a consequence of economic growth. It can also be seen as an extension of a process driven by technological and institutional changes in different countries. For example, specialization in the Silicon Valley surrounding the industry of IT expanded when Hewlett and Packard began the computer business. This is an outcome of network benefit which resulted in new firms popping up around older IT firms. The network effects can also be called the bandwagon effect where there is no intention to create value for others but it occurs anyway.
The new trade theory also becomes an explanatory factor in the growth of globalization meaning that poor, underdeveloped countries that lag behind the economies of scale cannot hope to ever cultivate certain industries in their countries. There is not because of comparative advantage but due to the large economies of scale already owned by established firms.
The increase in variety is a result of globalization. For example, there is heavy branding in the British and Italian labels so they hold a position in monopolistic competition even when they do not have a particular comparative advantage in producing clothes.
The firms who have been a part of a certain industry for a long time have a certain advantage as opposed to new firms who cannot compete against these mature firms. The limited competition that global industries with great economies of scale face lead to a form of monopolistic competition. The element is very important in the new trade theory and it proposes that firms in their specialized industry are not just competing on simple price but also on branding and quality to out qualify the other and increase their demand.
The number of firms in a competitive monopolistic industry and prices charged by them are affected by the size of market. The increase of the market size is credited to the opening up of a country to free trade. CC: AC= F/Q + c = n x F/S + c & PP: P = c + 1/ (b x n).
A type of imperfect rivalry, meaning monopolistic competition, is where many producers sell different products that are different from each another. There will be no single firm that controls the market and some firms will be larger than others. Aside from the automotive, pharmaceuticals and aerospace industries, another example is the fast food industry. On every corner of America, where there is a McDonalds, there will be a Burger King or Wendy’s or literally any other place that can serve food just as fast.
The fast food restaurants will have something in their items that distinguishes them and that is a part of the new trade theory. The U.S. is big on imports more than exports which means there is a trade deficit. However, the investment of other countries is done in dollar so that makes America’s currency strong. The benefits of international trade outweigh the disadvantages that come with it.
Paul Krugman influenced international trade through his analysis on trade patterns and location of economic activity. He revolutionized international trade by allowing other countries to take a step forward in strengthening their own economies through the commerce and trade. It has allowed underdeveloped countries to flourish and grow.
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