Category Archives: International Trade

Krugman’s Alternative Theory of Trade

To many young economics students, Paul Krugman’s legacy is defined, in large part, by his blog. If you have not had a chance to read his academic work, your view of him is going to be based on Krugman the pundit and Krugman the economist who advocates for fiscal stimulus, the minimum wage — an economist who is turning towards Old Keynesian, or Post Keynesianism, whatever the differences may be. But, modern Krugman is probably not what will be remembered within 15–30 years. Rather, what he is known for by economists, and what he will be known for in the future, is his work in trade and international monetary theory (specifically, exchange rates and capital flows). This is what he won the Nobel Memorial Prize for, in 2008. Krugman introduced a formal model of a new trade theory, an alternative to the theory of comparative advantage.

This post is an attempt to communicate the core of Krugman’s theory, for the layman. I will rely mainly on three of Krugman’s original articles on the subject: Krugman (1979), Krugman (1980), and Krugman (1981). There is also Krugman (1985), but the three earlier papers are shorter and go straight to the point, so I recommend interested readers to read those.1 I am also using my favorite textbook, Krugman, Obstfeld, and Melitz, International Economics.

Prior to the 1980s, most trade theorists thought about international trade within the Ricardian framework of comparative advantage. The theory states that, assuming heterogeneous agents and opportunity costs, a person can specialize in producing the good of lowest opportunity cost to them and trade for other products (produced by other people) and be better off than if there were no trade at all, and each person manufactured everything they want on their own. If someone else can make you t-shirts at a lesser opportunity cost than you, you can buy the t-shirt at that cost, and use your own time towards something more productive. You specialize in products others’ demand, which you can sell to them at at least the cost of production — and your relative costs are the lowest, so that is where your competitive advantage is.2

Ricardian trade theory continued to be developed throughout the 19th and 20th centuries, and one of the directions later economists took Ricardian trade theory in is worth mentioning. In the early 20th century, trade theorists began working towards what is now known as the Heckscher–Ohlin theory. Ohlin would go on to win the Nobel Memorial Prize, in 1977. The main insight the model gives is that countries will tend to specialize in goods that are relatively intensive in the inputs (factors of production) that country is relatively abundant in. Thus, the model looks at differences in factor endowments as a cause of international trade. If the U.S. is relatively abundant in capital and Mexico is relatively abundant in labor, it means that the ratio of labor to capital is lower in the U.S. than it is in Mexico. If labor is cheaper in Mexico, Mexican industry is likely to use a greater labor to capital ratio in their production than U.S. industry. Mexico will also tend to produce more of their labor-intensive goods, because labor is relatively inexpensive (to capital). The U.S. will export capital-intensive goods to Mexico, and Mexico labor-intensive goods to the U.S.

But, there are empirical problems to Ricardian trade theory,

  • Against the predictions of the Heckscher–Ohlin theory, Wassily Leontief, in a 1953 article, published data showing that U.S. exports are less capital-intensive than its imports.
  • Other evidence shows that the degree to which countries specialize is exaggerated in the models, and that intra-trade industry makes up a significant chunk of international exchange that is not accounted for by standard, Ricardian, trade theory.
  • After the Second World War, and before the 1990s, it was found that growth in international trade was not leading to the distributional changes that Ricardian theory predicts. In fact, trade was found to be, in large part, neutral to income distribution.

Economists had been toying around with the relationship between economies of scale and trade, but it wasn’t until Krugman that we had a simple formal model. Krugman also took the original insights and developed them further. He did all this by focusing on internal returns to scale, and by adopting a recent modelling innovation in Dixit and Stiglitz (1977), making it easier to model monopolistic competition.

Assuming a situation where are all agents have identical comparative costs, technologies, and tastes, and there is only one factor, there are none of the standard reasons for trade. But, we assume that there are internal economies of scale. Internal economies of scale occur as long as the average cost per unit of output falls as total output increases. The easiest reasons to cite for internal economies are high fixed costs, where more output allows the firm to spread this fixed cost. If there are internal economies of scale, markets are not perfectly competitive. Instead, there will be less firms, and each firm will produce more. Each firm will also have an incentive to differentiate their product from those of their competitors — if they are close/imperfect substitutes —, to compete for profits. The total number of firms can be said to be determined by average cost and price. As long as price is higher than average cost, it might pay for new firms to enter the market to compete; but, when price equals average cost, profits won’t be high enough for new firms to recover their fixed cost investment.

The size of an economy matters for its well-being. All else equal, larger economies — economies with more people — are wealthier. This is because larger economies will have higher demand, will have more inputs, and therefore more output. More output allows firms to exploit greater internal economies of scale, which in turn lowers average cost. Prices fall, real wages increase, the number of firms will increase, and therefore product diversity will increase (the italicized consequences are welfare-enhancing).

International trade creates similar benefits as population growth. If trade between, say, the U.S. and China suddenly emerged, the market each firm faces would grow. There will be less total firms (if the two countries were isolated, the sum of their firms would be greater than the total number of firms in an integrated market), and each surviving firm would produce more, but all consumers in both countries would be able to buy from a greater range of firms. That is, the diversity of the products offer would increase. The price per unit would also fall, because of the exploitation of further internal economies of scale. Thus, even if none of the standard reasons for trade (comparative advantage) existed,  trade would still occur, to exploit the benefits of internal economies of scale.

One implication is that if there are barriers to trade, factors of production will tend to move to countries where there are economies of scale in industries relatively intensive in a given factor (input). For example, if we assume that the only factor is labor, barriers to trade would induce foreign labor to move to the country with the largest market. Remember, larger markets mean more product diversity and higher real wages, both of which are incentives to immigrants. As immigrants arrive, the market grows further, and real wages and product diversity will increase. Sending states, in turn, become poorer, as product diversity and real wages fall.

Countries will, all else equal, export the goods where domestic demand is highest. It will behoove firms to localize production in markets where demand for that type of product is highest. This is because these firms will be able to exploit greater internal economies of scale than anywhere else. Thus, under conditions of internal economies, countries will tend to export the good they produce more of. In a world of no transaction costs, differences in local demand for a product will induce the country with the greatest internal economies to specialize in that product. In a world of transaction costs — where there are added costs to trade —, specialization will be more limited, because these costs reduce the profitability of exporting. Also, the extent of internal economies will also decide the extent of specialization; the less the opportunities for internal economies, the less a country will specialize in a type of good. Thus, with costs to trade and limits to economies of scale, what we expect is intra-industry trade, as each country produces multiple types of good and trade these between each other, even goods of the same type. But, generally speaking, the country with the larger home market for a given good will be a net exporter of that good, because of economies of scale (and out of interest in minimizing transaction costs).

Finally, the type of trade between two nations has much to do with differences in factor endowments (the type of inputs which are relatively abundant). If two countries are similarly endowed, then trade will tend to be of the intra-industry type. As factor endowments become more unique, the type of trade predicted by the Heckscher–Ohlin model will prevail. The implications for changes in the distribution of income as a result of trade is that if endowments are the same, trade is Pareto optimal. If factor endowments differ, how much they differ will decide relative gains from trade and changes in income distribution. Namely, the more unique a country’s factor endowment, the more the relatively scarce factor will lose from trade and the relatively abundant factor will gain. The scarce factor loses, because with international trade, the price of that product in that country falls (as it faces competition from foreign producers, who have lower costs, because they are in countries that have a relative abundance in that factor). Whether trade is Pareto optimal depends on whether the welfare increase from product differentiation is large enough to make up for the relative loss of income for the scarce factor.

The internal economies of scale argument Krugman formalized allows economists to explain aspects of international trade that were previously not explainable by Ricardian comparative advantage. If there are internal economies of scale — firms are monopolistically competitive —, markets will be supplied by a certain quantity of firms (less than the number in perfectly competitive markets), each producing a greater amount of output than its perfectly competitive analogue. In these cases, even if there are no differences in relative costs, tastes, or technology, there will be gains from trade in the form of lower prices and greater product diversity. Whereas standard Ricardian theory applies when there are differences between agents, economies of scale explain trade when agents are similar. It is an alternative approach to the theories of the division of labor and trade.

All economists borrow from their predecessors and their peers, so Krugman’s theory is by no means entirely original to him. In fact, he cites a number of trade theorists who dabbled with economies of scale prior to him: Herbert Grubel, Bertil Ohlin, Irving Kravis, Bela Balassa, et cetera. But, Krugman was able to formalize the theory in a relatively simple model (more simple than alternative approaches to trade with economies of scale). This allowed him to explore the implications of internal economies in greater detail, and with much more precision. This allowed him to persuade the majority of his peers, whereas previously Ricardian theory had continued to dominate alternatives. This is what rightfully earned Krugman his Nobel Memorial Prize.

_______________________________________________

Notes:

  1. You don’t really need to know how to do the math to get the main points in any of those Krugman articles. But, I still recommend reading over them and thinking about them, because sometimes you can get the intuition behind the model without really knowing how to solve it. You will get more out of all those, however, if you can follow the math.
  2. This is an example of a situation in which the whole is greater than the sum of its parts.

Thoughts on Remittances

Felix Salmon writes on remittances, over at Reuters, citing a 2013 World Bank report. He discusses how big banks were eager to enter the remittances markets, but how these are pulling back, even while the markets are becoming more competitive. He also notes that, although the World Bank has pushed to reduce prices, remittances have become more expensive in recent years. Finally, he observes that the volume of remittances have been falling where they’re cheaper, and rising where they’re pricier.

Some scattered thoughts,

(1) Salmon, and the World Bank report, cite anti-laundering regulations and interventions as a reason for the contraction of some of the larger banks’ participation in these markets. An alternative explanation is that external economies dominate internal economies of scale, increasing the number of firms, and decreasing the size of larger, individual firms. Or, maybe large banks simply over-estimated the demand for remittances services to certain countries, originally over-expanding, and now contracting.

(2) I wonder how remittances, especially the involvement of large banks, have affected foreign credit markets. Presumably, by drawing large banks’ investment, and creating a financial industry around remittances, this opens the door for cheaper, easier access to credit.

(3) When the financial industry around remittances was relatively undeveloped, demand for remittances services for most countries was probably low. When this industry grew, there was a growth in demand for its services, targeting other countries. This increase in demand has pushed prices for these specific markets up (even while other in markets, such as remittances to Mexico, the price has fallen).

(4) I’m not convinced by Salmon’s theory as to why the volume of remittances to countries with cheaper rates has fallen. He suggests that maybe, when prices are lower, firms are not as interested in providing their customers the service, so they discourage clients from sending remittances. But,

  • A firm lowers its price to remain competitive, and discouraging people from using that service is essentially a move in the opposite direction, and the firm forgoes an opportunity to profit.
  • Maybe sellers have been pushing clients towards pricier alternatives. But, short of fraud, one would have a hard time explaining why a customer will choose the more expensive option for the same end.
  • Factors which reduce supply should push up the price, not down.

Also, remember the rule of thumb: never reason from a price change. My guess is that the causes of a reduced volume of remittances to Mexico are on the demand-side. But, I wouldn’t be able to provide a theory, only speculation. Pew Research suggests that the U.S. recession, which impacted industries that historically employ large numbers of migrant workers (e.g. construction), is a major reason. But, according to the World Bank, migrant employment, in the U.S., has a faster rate of growth than native employment. I suppose that if remittances to Mexico were to continue falling during the next couple of years, it would be difficult to use the Great Recession as an explanation for the cause in the decline.

When Trade Agreements Aren’t About Free Trade

Dean Baker takes Paul Krugman to task for arguing that the Trans-Pacific Partnership is no big deal,

However it is a misunderstanding to see the TPP as being about trade. This is a deal that focuses on changes in regulatory structures to lock in pro-corporate rules. Using a “trade” agreement provides a mechanism to lock in rules that it would be difficult, if not impossible, to get through the normal political process.

It’s really about allowing firms to pursue monopoly/political rents abroad, and especially in the developing world,

To take a couple of examples, our drug patent policy (that’s patent protection, as in protectionism) is a seething cesspool of corruption. It increases the amount that we pay for drugs by an order of magnitude and leads to endless tales of corruption. Economic theory predicts that when you raise the price of a product 1000 percent or more above the free market price you will get all forms of illegal and unethical activity from companies pursuing patent rents.

Anyhow, the U.S. and European drug companies face a serious threat in the developing world. If these countries don’t enforce patents in the same way as we do, then the drugs that sell for hundreds or thousands of dollars per prescription in the U.S. may sell for $5 or $10 per prescription in the developing world. With drug prices going ever higher, it will be hard to maintain this sort of segmented market. Either people in the U.S. will go to the cheap drugs or the cheap drugs will come here.

For this reason, trade deals like the TPP, in which they hope to eventually incorporate India and other major suppliers of low cost generics, can be very important. The drug companies would like to bring these producers into line and impose high prices everywhere. (Yes, we need to pay for research. And yes, there are far more efficient mechanisms for financing research than government granted patent monopolies.)

Comparative Advantage’s Fate

Chris Dillow writes,

Now, in saying this I don’t mean that the theory of comparative advantage is correct. It isn’t. There’s less (pdf) trade in some ways than the theory predicts, and more trade within industries and between neighbouring countries. Some guy got a Nobel in 2008 for analyzing these issues.

In case you didn’t follow the links he provides us, Dillow is referring to Krugman. Krugman is known for his work in trade theory, specifically the application of the concepts of monopolistic competition and returns to scale. This was motivated by the fact that empirical evidence did not support a straightforward Ricardian story, and early marginalist developments (viz. Heckscher-Ohlin) of that theory were not empirically successful either.

But, my interpretation of Krugman’s work is different from Dillow’s. While it’s easy to say that the former’s research seems to disprove the empirical significance of comparative advantage, I interpret Krugman’s research as making the theory of comparative advantage more complete. Ricardian theory tells us that the agent with the lowest cost associated with some line of production will specialize there. Krugman told us that there’s more to the determination of these costs than innate characteristics and factor endowments, and that we need to consider return to scale and economies of scale. These latter factors also influence costs, and trade patterns can reflect the role economies of scale play in determining where firms locate themselves and which firms will have competitive advantages.

I’ve been meaning to write a post on this subject for some time and, while I haven’t found the time yet, I should mention that I interpret Krugman’s work in trade theory as a dynamic model within the general framework of Ricardian trade. The phenomena he’s trying to explain is clearly dynamic, in that the effects of economies of scale take time to reveal themselves — current trade patterns reflect economic geographies that took time to come into place. In fact, the post I have in mind is meant to be somewhat controversial, because I think there is an affinity between Krugman’s trade theory and the Austrian concept of the market process.

Unlike Dillow, I don’t think that Ricardian trade theory has been proven false. I think that basic Ricardian theory has been proven to be incomplete — it does not consider costs that we now know are relevant. Far from being a substitute to Ricardian theory, Krugman’s research should be seen as complementary.

The Grocery Store Analogy

In the previous post, I used the grocery store analogy to illustrate why it doesn’t make a lot of sense to depict international trade as zero-sum by looking only at trade deficits and surpluses. I, however, have seen the analogy used to illustrate why it’s not unsustainable for a country — such as, in the United States — to run a persistent trade deficit. I don’t think the analogy is apt for this scenario.

Suppose you and the grocery store are the only “agents” involved in a hypothetical market, and you work at this store and spend all your income on goods sold by the store. A zero trade balance on net implies that you spend just as much as you make: you “export” your labor to the grocery store owner for, say, a total of $100, and you “import” goods from the store owner for a total of $100. A trade deficit means that you export $100 of your labor, but you import (or buy) goods at a total value greater than $100. To afford these goods, you either have to dip into savings (if you have them) or you have to buy them on credit. If we assume that savings are not the main financing method, running a persistent trade deficit implies running up debt.

In a more complicated world, where you don’t necessarily work for the grocery store owner, you may run a persistent deficit with the grocery store. But, if you don’t finance this out of savings or credit, it means you’re running a persistent trade surplus elsewhere. Most of us run trade surpluses with our employer, because we rarely spend all of our income on goods provided by the firm we work for. There are many people who run persistent trade deficits overall, but these people run up their debts or they dip into their savings, and some of them come to find that their current account deficits are unsustainable, and they declare personal bankruptcy (or they’re bailed out). Sans bankruptcy, large trade deficits have to be paid off by sacrificing future consumption, which is not necessarily bad, but when the deficit is persistent there’s reason to believe that there’s some degree of discoordination somewhere.

In the macro world, all of this applies. Of course, that the U.S. has a persistent current account deficit with, for example, China isn’t necessarily a bad thing. What matters more is what our current and capital accounts look like on aggregate, and over time. But, even here, U.S. trade and capital flows over at least the past 20 years do not seem “healthy.” Given the bubble economies that also correlate over these dates, there’s most likely a connection between the two. One thing persistent trade imbalances seem to imply, though, is that there are significant global structural problems, which seems to give currency to the supply-side interpretation of the current international economic malaise.

Worstall and Coppola on Comparative Advantage

Tim Worstall corrects Frances Coppola on the theory of comparative advantage. Writes Worstall,

Comparative advantage is not about what you are better at compared to other people. That is absolute advantage. Comparative advantage is what you are better at doing relative to the other things that you could be doing. And as such it greatly strengthens the case for trade.

Worstall is pretty much correct, but I’m not sure that the first sentence is right. There is an interpersonal comparison of productivity. We should specialize where our opportunity cost is lowest. This, as described above, means we have to compare the costs of the alternative actions of one individual, but then we compare these opportunity costs to those of other individuals who could specialize in the same profession. If the theory of comparative advantage didn’t include an interpersonal element, then it wouldn’t make sense to make a connection between that theory and the theory of the division of labor.

But, the theory of comparative advantage is the least of our worries with respect to Coppola’s piece,

  1. Trade is not zero-sum. It could be zero-sum from an ex post analysis, if we consider malignant cases of asymmetric information. But, my guess is that the vast majority of exchanges are positive sum: we enter into exchanges to mutually improve our welfare. There are problems with things like persistent trade deficits, but again these are unique cases that are exceptions to the general benefits to trade. We don’t consider it a bad thing when we run a trade deficit against the local grocery store;
  2. While I agree that running a large, persistent trade deficit or surplus is a sign of a problem, I don’t know why this immediately leads us to the conclusion that the country in surplus needs to conduct structural reforms. Take the case of Germany and the Eurozone. Maybe we ought to blame bad monetary policy, or bad public policy in the countries running a deficit — maybe they’re the ones that should push structural reform;
  3. Coppola continues with the zero-sum theme throughout the piece, arguing that “[c]ountries compete with each other for market share and profits.” But, she neglects to mention that international trade allows us to increase the size of the pie, without necessarily increasing our productivity. Trade allows us to consume on a consumption possibility frontier that is beyond our production possibilities frontier. Further, she paints exporting capital in the same light as colonialism. There are no similarities between the two; one involves forced political acquisition, the other involves voluntary exchange. If we treated the export of capital to third world nations as the same as colonialism, and put an end to it, the third world would be worse off because of it — this is capital that isn’t accessible without trade, and capital that increases the wages of third world workers over the long-run. So, a firm in Uganda is owned by an American…so what?

I agree with Coppola that whoever advocates “exporting towards prosperity” is wrong. I think that anybody who currently makes that case is mistaking the purpose of countercyclical monetary policy. They think that monetary policy will make that country’s exports internationally cheaper, because traditionally that’s what we associate easy money with. When there’s a shortage of money, however, the role monetary policy plays is to increase demand, without necessarily decreasing the relative prices of our exports. But, Coppola takes her argument beyond that and ends up writing a generally anti-trade diatribe that is, in my opinion, dangerously misleading.

Am I the Only One…

…that finds it shocking that the following was written in the “leading trade theory textbook,”

International Economics (Krugman)When they were first proposed, market failure arguments for protection seemed to undermine much of the case for free trade. After all, who would want to argue that the real economies we live in are free from market failures? In poorer nations, in particular, market imperfections seem to be legion. For example, unemployment and massive differences between rural and urban wage rates are present in may less-developed countries.

— p. 227.

To be clear, this is part of a single paragraph, and by no means represents the entire book. The book is very good, and if you’re looking for a textbook introduction to trade theory and international monetary policy, I definitely recommend it. And, no, it’s not anti-free trade, although not everything would be found in a hypothetical analogous textbook by Mises or Rothbard (e.g. optimal tariff theory, market failure arguments for tariffs, et cetera — and my intention isn’t to disparage the latter two authors, especially since I’d mostly agree with them).

However, in my opinion, that’s a shocking statement. There are market failures. The market often fails to coordinate. But, to blame poverty and mass unemployment in the developing world on market failure seems disingenuous, and I mean that word with all of its implications. Many of these problems are caused by failures of those countries’ political institutions, and this shouldn’t be controversial. Economists have blamed bad policy on poor economic performance since the birth of the discipline. More formal and more recent research on institutions has expanded on our intuitions.  Market failure probably explains very little of poverty in the developing world. What those economies need are freer markets.