"New" macroeconomics (2)

   In 1979, Paul Krugman, now a Nobel prize-winning economist, was only a very young economist, graduated from MIT with PhD for about two to three years. He also found it hard to publish one of his most influential papers in his life -- a paper entitled "Increasing returns, monopolistic competition, and international trade". Top economists' best papers are mostly published in top five economics journals, which can attract the widest attentions from readers. But this paper is not accepted by the top five. Eventually, it was published in a top field journal Journal of International Economics. Field journals are specialized journals. For example, the journal above is about trade. Since field journals' readership is narrower, it is considered to be less prestigious than top five. [The stories of how influential papers rejected by famous journals are recorded in an interesting book Rejected.]
   Anyway, Krugman's paper, though published in a less influential journal, did kick-start the "new" trade theory, which explains the patterns of trade not by comparative advantage but by increasing returns or scale economies.
   Traditionally, economists consider comparative advantage as a major reason for international trade. The concept is well known even among high-school economics students: Suppose England can produce 1 unit of cloth by sacrificing 1/2 unit of wine while Portugal can produce 1/2 unit of cloth by sacrificing 1 unit of wine. Then, England has a comparative advantage in producing cloth while Portugal in wine. As such, England should specialize in producing cloth while Portugal in wine. Doing so maximize the total output of both goods. Meanwhile, England can buy wines from Portugal, which can buy cloth from England. Both countries can then get both goods at a higher quantity. Specialization and trade thus are mutually beneficial to both countries.
   This traditional theory predicts that international trades should be most frequently made between rich and poor countries because each side has an opposite comparative advantage: rich countries possess more capital and master better technologies while poor countries possess plentiful low-skill workers. Hence, it is ideal for rich countries to specialize in capital-intensive and skill-intensive products while poor countries in labour-intensive products.
   Is this prediction correct? In the decades before Krugman's paper, this prediction was particularly at odd with facts. With the rise of European Common Market and European Union, trades were particularly intensive between rich countries, such as between European countries. Furthermore, the pattern of trade was also not based on comparative advantage. For example, France exported Renault to, while at the same time imported BMW from, Germany. As both products are cars, there is no question about which country has comparative advantage of a product (car) over another product (car).
   These examples about intra-industry trades are important in the real world but the traditional theory cannot explain them. Krugman's paper offers a convincing answer: scale economy and monopolistic competition.
   Take car again as an example for illustration. Its production involves scale economy: more is produced, the lower the average cost of producing it. Hence, if the Renault producer can sell more products, its cost is low and the price is also lower. Suppose that originally there is a large number of competitors in France which also produce cars similar to Renault but it cannot sell many cars as France's domestic demand for cars are limited. Failing to tap the benefit of scale economy, the firms competing with Renault face a high unit cost and has to charge a high price. French consumers will tend to buy Renault and avoid its substitutes. Eventually some firms will bankrupt and only few survive. There is thus a trade-off involved: scale economy and product variety. Scale is obtained at the expense of little variety (as Renault's substitutes will be driven out from markets).
   Nevertheless, international trade resolves this conflict, increasing both scale and variety. The point is that if the market demand is not large enough, the total sale of car is limited and the scale economy enjoyed by each firm in a country is limited. Trade essentially enlarge the market demand. Each firm in each country can sell its products not only to domestic customers but also to foreign ones. Renault can sell more cars as some goes to Germany, exploiting scale economy at a higher degree. Meanwhile, France consumers can also buy BMW, not only Renault, enjoying more varieties of cars. The rise of European Common Market reduced trade barriers between countries, facilitating more trades, and increasing both scale and variety as described above.
   Krugman's contribution is to create a suitable economics model that captures effects outlined above. The model is a simple one but tells a big story. It is not exaggerating to say that, since then, all new trade theory is simply an extension of this idea: monopolistic competition, scale economy, and trade.