After nearly 30 years, the Swedish Academy has returned to international trade awarding the Nobel Prize to Princeton economist Paul Krugman. Earlier, in 1977, the award had gone to two giants, Bertil Ohlin and James Meade, whose brilliant work formed the foundations of trade theory as it was taught when I came to Princeton to do my Ph.D. in 1974. Krugman, no less a giant, revolutionized the field.
Until the end of the 1970s, the Heckscher-Ohlin theory for which Bertil Ohlin won the prize — Eli Heckscher died before the Nobel Prize in economics was instituted — dominated the field. This theory explained well why labor-abundant countries such as South Korea and Taiwan would export labor-intensive products such apparel, toys and footwear and capital-abundant countries such as the United States would export machinery and aircraft.
- High Five With Thomas Schelling: The Nobel Prize-winning economist shares his five favorite composers.
- High Five With Desmond Tutu: The South African cleric who fought apartheid picks his five favorite saints.
- In Pictures: Notable European Inventors
- In Pictures: 12 Stem Cell Revolutionaries
- In Pictures: 10 Ways To Fuel The Future
But it could not satisfactorily explain the two-way trade that was widely known to exist: Many countries exported automobiles and televisions, but they also imported them.
The Heckscher-Ohlin theory also did not adequately explain why rich entities such as Europe and the United States, which had very similar endowments of capital and labor, traded more intensively than those with very dissimilar endowments. While descriptive explanations of these phenomena existed, a tight theory explaining them was lacking.
Starting in 1979, Krugman published a series of papers that successfully tackled these and many other related questions. He postulated that consumers like variety in what they consume. For the same expenditure, their satisfaction is greater if they have a larger variety of products available. This creates the incentive for firms to produce a large variety of products.
But the production of a new variety has setup costs. This leads to declining per-unit costs as a larger quantity of the variety is produced and places a limit on the number of varieties the market can profitably supply. A firm produces a new variety only if it can capture a large enough market to allow profitable sales.
This seemingly simple structure gives rise to a tight theory that leads to rich implications: Countries gain from trade not only because larger market allows them to better exploit scale economies, but also because consumers can access a larger variety of products. And even identical economies can gain from trade through scale economies and a larger variety of products. The theory also brought imperfect competition into a formal trade model.
In subsequent work, Krugman combined this simple model of product differentiation and scale economies with transport costs. Scale economies push toward production in one location to minimize costs and then shipping the product to the locations where consumers are. But transport costs push toward locating production near consumers. These opposing forces give rise to large concentrations of populations such as those along the East Coast corridor of the United States.
A hallmark of Krugman's work is parsimony. His models are among the most elegant: lean and thin and transparent. They have all the required parts but no unnecessary fat.
It is quite remarkable that while other scholars in the field handsomely incorporated the Krugman model into their research, perhaps the most insightful and elegant applications still came from Krugman, as a quick reading of the chapter on economies of scale in my graduate textbook (co-authored with Jagdish Bhagwati and T. N. Srinivasan) would testify.
Trade economists can doubly rejoice in this award. It has not only brought wider recognition to what is perhaps the most important developments in international trade in the last three decades, it has also opened the door of the prize wider to the field where another giant, my colleague Jagdish Bhagwati, awaits recognition of his path-breaking work on trade and welfare that has been the staple of generations of graduate and undergraduate students.
Arvind Panagariya is professor of economics, and the Jagdish Bhagwati Professor of Indian Political Economy, at Columbia University. He is the author, most recently, of India: The Emerging Giant.