8. Paul Krugman, New Trade Theory and New Economic Geography

In Krugman’s (1990, p. 3) opinion: “Since economics as practiced in the English-speaking world is strongly oriented toward mathematical models, any economic argument that has not been expressed in that form tends to remain invisible”.

It should be noted that the new trade theory equates increasing returns with economies of scale at the firm or industry level.

The standard formula for calculating intra-industry trade (I) within an industry is: I = 1 – (|exports – imports|)/(exports + imports). See Krugman and Obstfeld (2003, p. 139, f.n. 5).

Krugman et al. (2018, p. 212) point out that the proportion of intra-industry trade in world trade has grown over the last half century. Depending on the coarseness of the industrial classification (whether into hundreds or thousands), intra-industry trade ranges from one fourth to one half of world trade.

Krugman gives three reasons for this. First, even though Ohlin recognized that there were “arbitrary elements in location” and that the “historical influence can lead to an uneconomical location of industry” his main emphasis is that location decisions are likely to be mistaken. The main point, however, is that an industry may be in the wrong place even if nobody is making a mistake. Second, Ohlin downplays the endogeneity of factor location attributing regional differences in natural resources as the cause rather than the effect of location of industry. This may be true of Europe but not in America where the manufacturing belts owed their existence to early starts rather than to resource advantages. The location of activity in America in the 1920s was driven by the logic of self-reinforcing concentration. Third, unlike the integration of increasing returns with comparative advantage which reinforced his basic vision, the integration of increasing returns with factor mobility went counter to this vision. While in the former case the integration leads to convergence of factor prices, in the latter case it leads to their divergence.

Krugman and Obstfeld (2003, p. 131) note that there are few industries in practice which are well described by monopolistic competition. The most common market structure is likely to be “small-group oligopoly” where only a few firms actively compete. Thus the key assumption of monopolistic competition model that each firm behaves like a true monopolist is likely to be violated. Interdependence of firms will come into play. There are two kinds of behaviour in oligopoly which are excluded by assumption in the monopolistic competition model. First is collusive behaviour to charge high prices or a tacit understanding to allow one firm to act as a price leader for the industry. Second is strategic behaviour where, for example, a firm may build extra capacity to deter potential rivals from entering the industry.

In the US in 2009, intra-industry trade indices were high for goods such as metalwork machinery (0.97), inorganic chemicals (0.97), power generating machines (0.86) and medical and pharmaceutical products (0.85), and low for furniture (0.30), clothing and apparel (0.11), and footwear (0.10). See Krugman et al. (2018, p. 213).

Price discrimination can also be of reverse type where the domestic consumer pays a lower price, but price discrimination in favour of exports is more common. Since international markets are imperfectly integrated with the domestic market because of transportation costs and protectionist barriers, domestic firms are more likely to have a larger share of the home market. This implies that foreign sales are likely to be more price sensitive than domestic sales.

In many countries including the US, dumping is regarded as unfair trade practice, and firms which are injured by foreign firms can appeal through a quasi-judicial procedure. If the appeal is successful, an anti-dumping duty is imposed. In the US, the appeal is made to the Commerce Department (which accepts most complaints about unfair pricing), but the actual injury is determined by the International Trade Commission (which rejects about half the cases). Economists regard dumping as a form of price discrimination and have reservations on singling out dumping as a prohibited practice. They regard charging lower price or selling at a loss in the foreign market as a normal business practice of gaining experience or breaking into a new market.

Brander and Krugman (1983) present a model of reciprocal dumping where lower price abroad is not related to a higher price elasticity of demand (and therefore to accidental differences in country demands) but to systematic reasons associated with oligopolistic behavour.

These temptations for governmental intervention from new economic geography literature may include: (1) the market may not get it right, (2) small policy interventions have large effects, and (3) cumulative processes of concentration produce winners and losers, so government authorities have an incentive to ensure that their country emerges as a winner.

Other early contributions to strategic trade policy include Brander and Spencer (1981, 1983), Krugman (1984), Dixit (1984) and Eaton and Grossman (1986). See also Spencer and Brander (2008) entry on strategic trade policy in The New Palgrave Dictionary of Economics.

Krugman and Obstfeld (2003, p. 221) point out that in practice there is a political argument for free trade though there may be better policies in principle. Trade policy in practice is often dominated by special-interest politics rather than national costs and benefits. Though selective tariffs and subsidies can sometimes be shown to increase national welfare, but in practice a sophisticated programme of trade intervention is subject to capture by interest groups and there may be redistribution of income in favour politically influential sectors.

Krugman et al. (2018, pp. 47–48) point out that till the 1970s, developing countries mainly exported primary products, but since then are moving rapidly into manufactured exports. During 1960–2001 there has been a complete reversal of relative importance of agricultural goods and manufactures in developing countries exports. While agricultural exports as a percentage of developing countries’ exports declined from about 60% to about 10%, manufactured exports increased from about 10% to over 65%. China’s manufactured exports now constitute more than 90% of its total exports.