Evolution of Trade Theory

Though most must have read this Krugman paper, those who have not should make it a priority. It is amazing the way Krugman writes on economics. It is just so many things in such a simple fashion.

This paper has been written for celebrating Alan Deardoff’s career. Alan Deardoff is an international trade professor at Univ of Michigan.

In this paper, Krugman tells you about the development of  Trade Theory.

I like to begin classes on international trade by telling students that there are two basic explanations of international trade. The first is comparative advantage, which says that countries trade to take advantage of their differences – a concept that lay at the heart of Alan Deardorff’s beautiful, classic paper “The general validity of the law of comparative advantage” (1980). The second is increasing returns, which says that countries trade to take advantage of the inherent advantages of specialization, which allows large-scale production – which is what the “new trade theory” was all about.

I also like to illustrate these concepts from everyday experience. Everyday illustrations of comparative advantage are, of course, a staple of introductory textbooks – why sports stars shouldn’t mow their own lawns, etc. But it’s equally easy to illustrate the role of increasing returns. Even if two people are equally suited for the roles of rocket scientist and brain surgeon, it makes sense for one to specialize on surgery and the other on rockets, because mastering either skill takes years of study, and it would be wasteful for both people to master both disciplines.

The new trade theory is what Krugman helped develop.

He then says there are three eras of international trade. Era I before World War I was where you saw comparative adv work. Era II was after WWII where we saw increasing returns work. In Era III now, we again see a comeback for comparative adv. 

But he now thinks both comparative adv and increasing returns are important

Over the past century world trade has gone through a great arc. At the beginning of the century trade was primarily between countries with very different resources exporting very different goods, so that it seemed to be a comparative advantage world. By the 1980s trade was largely between countries with similar resources exporting similar goods, so that economists turned to increasing-returns models to make sense of what they say. But today, with the rise of China and other low-wage economies, we seem once again to be in a comparative advantage world, in which countries with very different resources export very different goods.

What I’ve argued in this paper, however, is that even during comparative-advantage eras increasing returns in the form of localized external economies plays a significant role. In fact, the same eras in which comparative advantage seems to have ruled international trade are also the eras in which increasing returns has seemed to exert its strongest influence on intra-national economic geography. And this observation isn’t irrelevant even in the trade context: gains from localization arguably are a significant source of gains from trade, even if they don’t seem to affect the pattern of specialization.

Excellent stuff. Great insights into how trade theory ahs evolved and very interesting examples as well.

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2 Responses to “Evolution of Trade Theory”

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