New Trade Theory: Paul Krugman's Contributions

Paul Robin Krugman, born February 28, 1953 is an American economist, Professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times. In 2008, Krugman won the Nobel Memorial Prize in Economics for his contributions to New Trade Theory and New Economic Geography. He was voted sixth in a 2005 global poll of the world’s top 100 intellectuals by Prospect.

According to the Nobel Prize Committee, the prize was given for Krugman’s work explaining the patterns of international trade and the geographic concentration of wealth, by examining the impact of economies of scale and of consumer preferences for diverse goods and services. Krugman is known in academia for his work on international economics (including trade theory, economic geography, and international finance), liquidity traps and currency crises. According to the IDEAS/RePEc rankings, he is among the thirteen most widely cited economists in the world today.

As of 2008, Krugman has written 20 books and has published over 200 scholarly articles in professional journals and edited volumes. He has also written more than 750 columns dealing with current economic and political issues for The New York Times. Krugman’s International Economics: Theory and Policy, co-authored with Maurice Obstfeld, is a standard college textbook on international economics. He also writes on political and economic topics for the general public, as well as on topics ranging from income distribution to international economics.

Krugman considers himself a liberal, calling one of his books and his New York Times blog “The Conscience of a Liberal”.

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INTERNATIONAL TRADE International trade is exchange of capital, goods, and services across international borders or territories. While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system.

Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders. International trade is in principle not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade.

The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or culture. Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. HISTORY OF TRADE THEORIES 1) BARTER: It was the earliest form of trade. When human beings started agriculture it was only to fulfil their needs. However they started creating a surplus of the farm product they were farming.

They were faced with the question: “What to do with the excess products? ” Then they soon realized that other farmers who produced other products were also producing it in excess. To have the best of both sides, the farmers exchanged their farm products and this gave rise to the system of barter. As time passed and with the discovery of money (gold coins) this system of exchange of goods became less prominent. As the imperial society became developed and Kings becoming ruler of the land, it led to another system of trade i. e. – Mercantilism. 2) MERCANTILISM Mercantilism is like a communist type of economy.

The King is responsible for deciding which goods are to be traded and where. The imperial ruler would conquer lands and establish their colony and trade over there. Example- England, France, Portugal, Spain etc. Mercantilism is an economic theory that holds that the prosperity of a nation is dependent upon its supply of capital, and that the global volume of international trade is “unchangeable”. Economic assets (or capital) are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports).

The theory assumes that wealth and monetary assets are identical. Mercantilism suggests that the ruling government should advance these goals by playing a protectionist role in the economy by encouraging exports and discouraging imports, notably through the use of subsidies and tariffs respectively. Mercantilism, which reached its height in the Europe of the seventeenth and eighteenth centuries, was a system which employed economic fallacy to build up a structure of imperial state power, as well as special subsidy and monopolistic privilege to individuals or groups favoured by the state.

Academic belief in mercantilism began to fade in the late 18th century, especially in England, in light of the arguments of Adam Smith and the classical economists which brought   about ideas of free trade as an alternative system. Mercantilism never returned to popularity among economists as the principle Comparative Advantage shows the gains from international trade. 3) ADAM SMITH Adam Smith is known world over as the world’s first free-market capitalist and the father of modern economics. He also popularized what is known today as ‘classical economics’.

Laissez-faire and the idea that an ‘invisible hand’ guides ‘supply’ and ‘demand’ are the key ideas Smith’s writing is responsible for promoting. These ideas reflect the concept that each person, by looking out for him- or herself, inadvertently helps to create the best outcome for all. “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest,” Smith wrote. By selling products that people want to buy, the butcher, brewer and baker hope to make money.

If they are effective in meeting the needs of their customers, they will enjoy the financial rewards. While they are engaging in their enterprises for the purpose of earning money, they are also providing products that people want. Such a system, Smith argued, creates wealth not just for the butcher, brewer and baker, but for the nation as whole when that nation is populated with citizens working productively to better themselves and address their financial needs. Adam Smith is also credited for writing the ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, a massive work of 2 volumes divided into 5 books.

The ideas it promoted generated international attention and helped to drive the move from land-based wealth to wealth created by assembly-line production methods driven by division of labour. The reason for the successful acceptance of Adam Smith’s Theory of free trade without government interference was that the traders were tired of working with the sovereign. They made a lot of losses and found it much better to trade without any interference. As a result they earned a lot of profits and this trade model became well established. Still till today Adam Smith’s trade theory is being used.

It is the fundamental basis of many trade theories. Poverty which was not being removed by this theory was the main drawback of it. 4) DAVID RICARDO’S THEORY OF COMPARATIVE EDGE: David Ricardo’s theory was very simple. If there are two countries trading then the two of them will trade in such a way: If country A specializes in industrial sector and country B specializes in agricultural sector then country A will concentrate more on its industrial sector rather than its agricultural sector. Similarly country B will concentrate on its agricultural sector rather than its industrial sector.

Thus country A will export its industrial products to country B and country B will export its agricultural products to country A. Example-Japan being a small island and having a good infrastructure concentrates on it automobile industry while it depends on neighbouring South East Asian countries for most of the agricultural goods. 5) HECKSHER-OHLIN MODEL The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin. The theory expands David Ricardo’s theory of comparative advantage.

The model essentially says that countries will export products that utilize their abundant and cheap factor(s) of production and import products that utilize the countries’ scarce factor(s). The model instead of using the words of “specialization of country” uses the “concept of labour and capital of a country” to expand the simple model of David Ricardo. Assumptions of Heckscher-Ohlin Model The Heckscher-Ohlin model is based on the following assumptions:
• Countries involved in international trade differ in terms of factor abundance.

One country needs to be labor-abundant and the other country being capital-abundant.
• Commodities can be categorized in terms of factor intensity. One commodity is labor-intensive and the other commodity is capital-intensive. This in turn implies that there is no possibility of factor intensity reversal.
• Both the countries involved in trade use same production technology and identical ranking of factor intensity of commodities.
• Both countries are assumed to have identical demand conditions.
• Production is carried out as per the CRS production function.
• Perfect competition persists in both countries. Open trade or free trade policy is followed in both the countries. In simple words Hecksher-Ohlin say that the capital-abundant country will export capital-intensive commodity and import labour-intensive commodity and the labour-abundant country will export labour-intensive commodity and import capital-intensive commodity. Hecksher-Ohlin till Paul Krugman’s NTT was the most accepted trade theory. But it had taken many assumptions and hence was also criticized. The Hecksher-Ohlin model also won a Nobel Prize. Example- Bangladesh has a lot of labour and hence produces garments which require more labour.

India with respect to Bangladesh has more capital in the ‘small car’ industry and hence exports cars to Bangladesh which in turn exports garments to India. SHORT COMINGS OF HECKSHER-OHLIN MODEL Even though the model was one of the widely accepted trade model, it still failed to explain many phenomena: 1. China did not follow a free trade policy, yet it was developing and growing very fast. 2. Even though Bangladesh exported garments to India, India itself was able to export its garments made to other countries. 3. Germany although had BMW, Volkswagen, Mercedes Benz to make cars, yet it imported cars from Renault in France. 4.

America even though it had Ford still imported cars of Toyota and Honda from Japan. 5. England even though it did not grow cotton was one of the biggest producers of cloth. These were some of the questions that Hecksher-Ohlin and any other trade models could not answer. HISTORICAL DEVELOPMENT NEW TRADE THEORY To explain these phenomena and to remove the assumptions, the economists of the world tried to make a new theory. This theory was called New Trade Theory. All Paul Krugman did not play a part in the initial forming of the theory, but in 1979 his paper made the most significant and valuable contribution with respect to the NTT.

Hence it is now a days called Paul Krugman’s New Trade Theory. Concept: New Trade Theory (NTT) is a collection of economic models in international trade which focuses on the role of increasing returns to scale and network effects, which were developed in the late 1970s and early 1980s. New Trade Theory is the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Some economists have asked whether it might be effective for a nation to shelter infant industries until they had grown to sufficient size to compete internationally.

New Trade theorists challenge the assumption of diminishing returns to scale, and some argue that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market (via a Network effect). They wondered whether free trade would have prevented the development of the Japanese auto industries in the 1950s, when quotas and regulations prevented import competition. Japanese companies were encouraged to import foreign production technology but were required to produce 90 percent of parts domestically within five years.

It is said that the short-term hardship of Japanese consumers (who were unable to buy the superior vehicles produced by the world market) was more than compensated for by the long-term benefits to producers, who gained time to out-compete their international rivals. New Trade theorists relaxed the assumption of constant returns to scale. It used protectionist measures to build up a huge industrial base in certain industries and then allowed those sectors to dominate the world market. CONTRIBUTION OF PAUL KRUGMAN IN NTT(BRIEF) In brief : In the Krugman model, every firm is the same, though they each produce different products.

Models with heterogeneous firms really didn’t take off in the field until recently. Essentially the theory contends that there are increasing, rather than decreasing returns to scale. We observe this all the time with technology products where the so-called network effect creates larger returns as the network gets larger. It is sometimes used as a justification for protecting developing industries from competition on grounds that once those industries have reached a “takeover” mass, the returns will be larger than if they had to develop in a competitive environment.

Now, moving on to explain the Old trade theory, we can say that it is what we probably learned when we took to introduce economics. Countries are different – they have different levels of productivity in particular industries, they have different resources, and those differences drive trade. Tropical countries grow and export bananas, temperate countries grow and export wheat. Countries with highly educated workers export high-tech goods, countries with less educated workers export shirts and pyjamas. The new trade theory starts with the observation that while this explains a lot of world trade, it also misses a lot.

France and Germany sell lots of stuff to each other, even though they have similar climates and resources; so do the United States and Canada. The answer is that there are many goods that aren’t like wheat or bananas, but are instead likewide-bodied jet aircraft. There are, enormous economies of scale – you only want a couple of factories worldwide. Those factories have to be somewhere,and those countries that get the factories export jets, while everyone else imports them. But who gets the aircraft factories, or the factory producing a specialized kind of machine tool?

This is explained by new trade theory –There are many economies-of-scale goods; everyone gets some of them; and the details, which may be largely a story of historical accident, aren’t important. What matters, instead, is the overall pattern of trade: the broad pattern of what countries produce is determined by things like resources and climate, but there’s a lot of additional specialization due to economies of scale, and there’s much more trade, especially between similar countries, than from a purely resource-based theory.

All this seems obvious, and it is still obvious, but it was totally not obvious before 1980 or so, except for some prescient quotes from Paul Samuelson. The two main things that Paul Krugman pointed out in his paper were: a. Consumers want diverse choice of products. b. Production favours economies of scale. These two were the main basis on which the problems of the Hecksher-Ohlin model were explained. In the next two chapters we will see the role of these two points in detail. CONSUMERS WANT DIVERSE CHOICE

The first question that the old theories failed to answer was that why countries who specialize in one product export it as well as import it. To explain this Paul Krugman gave the reason of consumer choice. He tells us that the consumer wants choice. the taste and preference of different consumers is different. To fulfil this choice the countries had to import certain goods even though it was well efficient in producing the same product. Let us understand this theory of Paul Krugman using examples: 1. America has Ford which is well efficient in making good cars.

However Japan also exports cars to the US. The reason is that not all people of the US want the cars made by Ford. Even though the pricing and technology of both cars of Ford and that of Japan are same, people still buy both cars of Japan as well as US, 2. The same is the case in Japan and Germany. Inspite of having the best automobile industry both Japan and Germany also import cars. 3. France is a wine loving nation and hence it produces wine only. However some people also like beer, so to cater to them, France has to import Beer from Germany.

However France also imports Beer from England. This is done because people want choice. 4. In, India we have Colgate which is one of the world’s biggest brands, yet there is scope for small companies like Amar and Babool. This is because people have different tastes and they want choices to choose from. 5. India is self sufficient in clothes making, yet we still import clothes. A person wearing an expensive Nike shoe also wears a cheap Bata shoe because of his liking. 6. India imports apples from New Zealand inspite us having the apples of Kashmir an Himachal.

These Indian apples are themselves exported to other country which proves that consumer’s choice is an important factor in trade. 7. Hitachi and Onida air-conditioners use a same compressor built by Hitachi but the consumers of Hitachi and Onida are very different. Thus looking at these examples we can say that Germany imports cars from France only because the people of Germany want a diverse choice. This looks simple but it took a lot of time for Paul Krugman to develop. Thus the question why do countries who export one product also import the same is answered. The diverse choice of consumers is very helpful for everyone.

Due to this choice the domestic consumer always has competition not only of other domestic companies but also of international companies. As a result the consumers as benefited greatly. The resources are used efficiently and new technology helps in making better products. PRODUCTION FAVOURS ECONOMIES OF SCALE Before we go further and explain this, we must 1st understand the concept of economies of scale. Economies of scale: The ‘economies of scale’ investing high capital to make a big production factory. The main objective is to make such a production centre that it behaves like a monopoly.

The production capacity of such a place is very high. Production favours economies of scale: Paul Krugman says that production will be highest where input i. e. capital, technology and labour is high. To understand what he says we must 1st look at some examples: The question what he answered was that why when England had no cotton, it still was the capital for cloth. It also answers the question that why China and Japan grow so fast. Paul Krugman tells us that building an economies of scale is the reason why Japan and China grew so fast. He explains that when a place is made as a centre of production, the company benefits a lot.

This is because the capital invested for higher production is much less that the total capital that would have been used to invest in factories at different locations for producing the same amount of product. This means that instead of having many factories one should just invest in one factory and thus save a lot on capital. The cost of freight is less than cost of land. Also making multiple factories of small scale would take a lot of time. Governments take initiative in some major industries and set up resources to build an economy of scale. Boeing and Airbus were created as a result of this.

The English invested a lot of capital at Manchester in the textile industry. Thus even thought they did not grow any cotton, they still using their machines and technology make more cloth than any other country. Embraer the small jet company of Brazil whose jets are in so much demand was as a result of the support of the Brazilian government who set up an economy of scale for them. Jamnagar is still today the World’s Largest Refinery because Dhirubhai Ambani created a monopoly by investing huge capitals at one place and thus it was one of India’s 1st economy of scale.

Maruti the Indian Car company was set up to cater the needs of Indians. A lot of investment was made for this. Today this small car manufacturer not only caters the Indian consumers but also exports to other countries. Coimbatore and Ludhiana are today the garment manufacturers of India because an economy of scale has been created at these two centers. Bangalore is the IT capital because an economy of scale (labour i. e. IT engineers) is available there. Anand is the milk capital of India because it is another form of economy of scale. Thus Paul Krugman said that production favours economies of scale.

He further adds that government should take measure to reduce freight costs by building roads. He also tells that government should subsidize exports which will in turn increase production exports and there after growth. This theorem was the basis for growth in China and Japan. Japan: Japan from 1950s started investing high capitals in infrastructure and establishment of industries. Being a small group of islands, they were forced to make small centres of production with high capabilities. Thus this resulted in tremendous production and thus they exported goods to register high growth and become an economic super power.

The freight rate was reduced as the government had built millions of kilometres of roads and tracks. The ports of Japan are also well developed. Thus by making economies of scale Japan became a super power. China: To become a super power economically, China started to open it s markets for trade. They invested a lot along the costal line and at Shanghai and Beijing. Thus centres of productions were created at scattered places. Thus even though development was not uniform economies of scale of different industries were created. Each village creates different products in China.

The speciality of this is that each village produces only one unique product. One village produces socks only while another produces pants only. Haer which is the world leader in switch boards was 1st established to cater the Chinese domestic market. However the capacity of production at that one factory was so high that today Haer does not only cater the domestic market but also exports world over. This is the reason why China grew so much. This is also the reason why China is the world’s biggest exporter. They invested a lot of money at one single place which could produce a lot and thus they became a superpower.

Thus Paul Krugman has rightly explained by giving the theorem “Production favours economies of scales” the reason why China and Japan are today economic super powers and why England is the largest producer of cloth. APPLICABILITY IN INDIA The framers of the economic and industrial policies of China and Japan have used NTT trade model to establish economies of scale to become the world’s biggest exporters and become economical super powers. Automobile companies of Japan, US, Germany are constantly researching and trying to bring innovative features to their cars.

Right now these companies are in competition to make more fuel efficient and eco friendly occurs. Thus importing even when you are a major exporter of that product is now a good thing which is helping the environment. Toyota Prius will be soon imported in India. This will make companies like Honda to bring their own versions of hybrid cars. The competition will result in drop in price of Prius from an expensive 27 lakhs. NTT has also affected policies of other countries. Just as Japan and China have become economic super powers, similarly India can become superpower using policies that are derived from NTT.

In the textile industry we have already established two economies of scale. However we need to create more economies of scale. TATA motors today has more than3 factories India, but its production capacity is much less than that of any of Maruti’s factory. More incentive and subsidies need to be given in India to establish more economies of scale. These economies of scale will in turn reduce capital wastage and increase production to increase economic growth. Our export capacity will also increase. To facilitate this growth the Indian Government will have to reduce freight cost by investing in transportation(roads, ports, railways).

Also to increase exports the government will have to subsidise exports. The Chinese government have subsidised exports by 30%. The same products available in China are more expensive than that abroad. This was the sacrifice the Chinese people had to make for economic growth. Also imports on certain goods should be subsidised. Example- Hybrid cars This will in turn result in healthy competition and as the above example shows will result in benefit not only for country but also the worlds. There are only two drawbacks of having a NTT centred policy: 1) Growth and development will be scattered. Thus the benefits of this will not be got by all.

In a country with India where the gap between village and city is already large such a policy will have to be implemented very carefully. Also investment of high capitals can get wasted in a corrupt country like ours. 2) Many companies will not be able to compete with the imported goods. This will result in loss and unemployment. Thus the government has to be careful and should also import technology when importing goods. The India government should use a NTT based policy to fulfil the goal of becoming a superpower in 2020 but will have to also make new schemes to achieve the goal of eradicating poverty by 2014. CONCLUSION

The contributions of Paul Krugman are immense to developing this new trade theory. It can be said that Paul Krugman gave the heart and soul to the New Trade Theory. The New Trade Theory of Paul Krugman explains most of the problems of old theories and using it would amount to tremendous economic growth as observed in Japan and China. Paul Krugman’s theory is very good and its criticism is very less because it has very less drawbacks. The NTT is like Adam Smith’s Wealth of Nations and it has already brought a revolution. However one must remember the two drawbacks of having such a policy and proceed with caution.

The positives of NTT are great but it has two big negatives which become even bigger in our country and so we must proceed with caution. BIBLIOGRAPHY Books Referred:
• Samuelson Paul & Nordhaus William, Economics, 19th Edition, McGraw-Hill/Irwin
• Krugman Paul, Strategic Trade Policy and The New International Economics, MIT Press
• Mankiw N. Gregory, Principles of Economics, South Western College
• Krugman Paul & Obstfeld Maurice, International Economics: Theory & Policy, 6th Edition, Addison Wesley
• Krugman Paul, Rethinking International Trade, 6th Edition, The MIT Press