"New" macroeconomics (3)

   In my last post for this series, I have introduced Paul Krugman's 1979 paper on international trade. This is perhaps the first paper that re-ignited economists' interest in increasing returns at the macroeconomic level. As scale economy can explain the prevalent trade pattern -- intra-industry trade -- better than traditional theory, one may start to wonder the world is more suitably described by models featuring increasing returns.
   The explanatory power of scale economy for macroeconomic phenomenon was soon confirmed by another theory innovation -- Paul Romer's endogenous growth theory or "new" growth theory.
   Why do we need a "new" growth theory? What is "endogenous" in this theory? This is related to what traditional growth theory says. Put it simply. Growth is either fueled by employing more inputs or by technology improvement, which means the same quantities of inputs can produce more. Broadly speaking, labour and capital are two major inputs for production. Empirically, most advanced countries' population growth, thus labour input growth, is stable at a low rate. Then, can growth be sustained by employing more capital (more investments)? If capital actually grows faster than labour, the law of diminishing marginal returns applies. As extra output is smaller and smaller, output growth will then be declining over time. Thus, investing too much is not a way to obtain a sustainable stable growth rate. In fact, capital growth and investment normally simply keeps the pace of labour.
   Now, if production exhibits constant returns to scale, and if both labour and capital grow at the same rate, output can only grow at the same rate. As output and labour move at the same pace, GDP per capita (or per worker) will stagnate. But that's also not realistic -- in the real world, almost all advanced countries record stable (though low) growth in GDP per capita. Living standard per person is indeed improving over time.
   Now, it is clear that, to explain the real-world growth pattern, one must resort to technology (or productivity) improvement. This is the major conclusion of traditional growth theory, or what may be called the Solow model as the theory is due to economist Robert Solow, who won the Nobel prize in 1987.
   While the theory is insightful, what Solow left unanswered is why technology may keep growing? Solow simply sets this question aside. As such, technology is an unexplained factor in his model, and thus an "exogenous" variable (in economics terminology). The task of "new" and "endogenous" growth theory is exactly to explain technology or productivity improvement.
   Why does technology improve over time? The answer is more or less the same as why capital grows: people invest in innovations that fuel technology improvements. Investors' behaviours are again explainable by cost and benefit involved in it. So, the "new" theory is simply applying these old theory to the new area -- the invention sector. But is it? If this is so, the above problem cannot be solved indeed. Normally diminishing marginal returns applies to any input-output relation. If innovation is a normal product, eventually its marginal returns will be declining, other things being equal. We cannot rescue the traditional growth theory simply by introducing a new investment activity subject also to the same pattern of diminishing marginal returns and constant returns to scale.
   At this point, we can see why increasing return is an important factor for growth. If investment in technology exhibits increasing returns, it can sustain a stable GDP per capita growth. But is there increasing return? In fact, there is a good reason why increasing return exists. Technology improvement is due to new ideas, which are knowledge and which are, in economics terminology, public goods. To obtain a new idea, we need investments. But once a new good idea is found, it can let as many people as possible make use of the idea without extra resource incurred. Increasing returns are then possible. But the situation is also not that simple because we need to explain why there are private investments in public goods. For a public good like an idea, if you cannot prevent others from enjoying the idea for free, there is no reason why you will devote efforts and resource to inventing it. Hence, the whole point is not public good but excludable public good: you can prevent others from enjoying it if they don't pay you; you can get the reward of invention although the good can be shared by many people without extra resource incurred. Patents and intellectual properties are a key element involved for making the invention business profitable. The idea can be shared but you have to pay for it first.
   Either we need a policy that can properly protect private property (invention) rights or we need an environment that can encourage (private or public) innovations. These are the key to sustainable economic growth in this "new" theory. Paul Romer's contribution is to re-discover these (perhaps old) concepts about public goods and increasing returns, relate them to growth, and construct appropriate mathematical models for the mechanism. For this contribution, he got the Nobel prize in economics in 2018.

"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.
 

"New" macroeconomics (1)

   In "hi, economics", I have written articles using various economics concepts. But regular readers may have noticed -- I use or analyze much more microeconomic concepts than macroeconomic (yet due to the pandemic, I have written several pieces on macro). Other readers may also get this from other occasions: I had ever taught microeconomics and now I mainly teach macroeconomics although I like microeconomics more than macroeconomics.
   Having said that, I don't dislike macro but my interest in macro, especially the basic level of macro, is lower than micro. However, I in fact like the more advanced level of macro -- the "new" macroeconomics developed since late 1970s. Sadly, "new" macro is not taught at the basic course even though it is extremely influential in macroeconomists' mind. All new economics PhDs simply learn "new" macro in graduate school, almost no any "old" macro as what readers of "hi, economics" are normally familiar with.  Due to this reason, I would like to briefly introduce some concepts of "new" macro to the readers of "hi, economics".
   Roughly speaking, "new" macro started from late 1970s and includes three major developments: "new" trade theory, "new" growth theory and "new" economic geography. All the three major developments are due to the realization of scale economy at the macroeconomic level. So, you can see: scale economy is a microeconomic concept but its application in macro is profound. That's also the reason why I like "new" macro: I like micro and "new" macro is an exploration of a micro concept in macro.
   Let us revisit the concept of scale economy or increasing returns to scale. If we produce more but the per unit cost of the producing the good is declining, there is scale economy. Why there is a scale economy? Increasing return is an important reason. If we increase the employment of all inputs by the same proportion but output will increase by more than this proportion, there is an increasing return to scale.
   At the micro level, we can have scale economies for some goods. For example, suppose the average cost curve is U-shaped. For those goods where production is at the downward sloping side of the curve, there exist scale economy for these goods. At the macro level, however, we may not think that scale economy is a relevant concept. If the concept is relevant for macro, this means that most goods in the economy exhibit scale economy. Nevertheless, if so many goods involve scale economies, the whole economy's output can be greatly improved simply by employing more resource. Why don't we, then, do this (employing more resource) exactly? Failing to exploit this gain, the economy is indeed at a state of massive waste of resource. Traditional economists do not believe that this is a realistic situation as market competition in the real world is intensive. With keen competition, economists believe that there should be no massive waste of resource (although some wastes are possible). Meanwhile, we also do not see aggregate output can be so easily greatly increased by increasing some more resource employed. Taken together, scale economy must not be relevant at the macro level (though may exist at micro level).
   This traditional belief started to change since late 1970s. What happened in late 1970s? There might be many things happening that changed economists' belief. But now it is not controversial to agree that Paul Krguman's (Nobel prize for economics in 2008) paper in 1979 on international trade is a truly influential one that helps reverse economists' belief. What this paper is about? I will touch on this in the next post.