What is New Trade Theory?

Congratulations to Paul Krugman on his Nobel.  Here is a primer on one of Krugman's key contributions, New Trade Theory.  Tyler has more links below.

Ricardo showed that every country (and every person) has a comparative advantage, a good or service that they can produce at a lower (opportunity) cost than any other country (or person).  As a result, production is maximized when each country specializes in the good or service that they produce at lowest cost, that is in the good in which they have a comparative advantage.  Since specialization in comparative advantage maximizes production, trade can make every country better off.

But what determines comparative advantage?  In Ricardo it is the natural products of the soil, Portugal is good at producing wine and so England has a comparative advantage in cloth.  Heckscher, Ohlin and Samuelson among others extended the model to show how factor proportions can determine comparative advantage - countries with a lot of labor relative to capital, for example, will tend to have a comparative advantage in labor intensive goods production.

Notice, however, that in the Ricardian model and its extensions the determinants of comparative advantage like geography and factor proportions lie outside of the model.  New Trade Theory of which Paul Krugman can be said to be the founder, brings the determinants of comparative advantage into the model.

Consider the simplest model (based on Krugman 1979).  In this model there are two countries.  In each country, consumers have a preference for variety but there is a tradeoff between variety and cost, consumers want variety but since there are economies of scale - a firm's unit costs fall as it produces more - more variety means higher prices.  Preferences for variety push in the direction of more variety, economies of scale push in the direction of less.  So suppose that without trade country 1 produces varieties A,B,C and country two produces varieties X,Y,Z.  In every other respect the countries are identical so there are no traditional comparative advantage reasons for trade.

Nevertheless, if trade is possible it is welfare enhancing.  With trade the scale of production can increase which reduces costs and prices.  Notice, however, that something interesting happens.  The number of world varieties will decrease even as the number of varieties available to each consumer increases.  That is, with trade production will concentrate in say A,B,X,Y so each consumer has increased choice even as world variety declines.

Increasing variety for individuals even as world variety declines is a fundamental fact of globalization.  In the context of culture, Tyler explains this very well in his book, Creative Destruction; when people in Beijing can eat at McDonald's and people in American can eat at great Chinese restaurants the world looks increasingly similar even as each world resident experiences an increase in variety.

Thus, Krugman (1979) can be thought of as providing another reason why trade can be beneficial and a fundamental insight into globalization.

Moreover, Krugman (1979) began the task of bringing the reasons for comparative advantage within the model.  In that paper, Krugman also hypothesizes briefly about what happens when we allow migration within the model.  Recall, that in Heckscher-Ohlin-Samuelson factor proportions explain trade patterns but are themselves determined outside of the model.  When people and capital can move, however, factor proportions are themselves something to be explained.

Krugman (1991) (JSTOR and here) brings increasing returns together with capital and labor migration and transport costs into one model.  Krugman's (1991) model has become a workhorse of economic geography and international trade.  The model is too complex to explain here but the reasons for that complexity are clear to see - when everything becomes "endogenous" small initial differences can make for big effects.  To minimize transport costs, for example, firms want to locate near consumers but consumers want to locate near work!  Thus, there are multiple equilibria and at a tipping point the location decisions of a single firm or consumer can snowball into big effects.  So Krugman has been a leader in introducing tipping points, network effects and thus the importance of history into international trade as well as into economics more generally.