Not every day do we get a new Nobel Prize winner in Economics, not to mention one whose name, Paul Krugman, might actually be familiar to more Americans than the few of us who are poor closet economists. Krugman is of course not only a Princeton professor (we pause to take pride here in the home team), but a regular op-ed columnist in The New York Times where he is known for wielding a hatchet against all things touching or concerning the Bush Administration.
As for his Times op-ed columns, we are, as you know, resolutely apolitical here at "Adam Smith, Esq." Perhaps the best that can be said of those is that we come not to praise but to bury them in the context of his winning the Prize. Or, as was said more pungently in Australia’s National Post, "You don’t get the Nobel Prize in Economics for writing newspaper columns (as I’ve been trying to explain to my mother the last couple of days). So the prize awarded Monday to Paul Krugman should not be read as an endorsement of Krugman’s uber-Democratic newspapering."
Actually, I’ll give the last word on his Times op-eds to his fellow columnist Maureen Dowd:
"I’m not sending Paul Krugman Champagne.
He won the Nobel prize in economics this week, and while I’m sure that’s delightful for him, it has raised the bar to an impossible height for his fellow columnists at The Times. We used to strive for Pulitzers, or simply regional awards, or even just try to top each other on the paper’s most e-mailed list.
Now we’re supposed to compete for Nobels?"
We’re here to take a brief interlude, a detour, if you will, into economic theory and into what Krugman’s Nobel is all about.
Classic models of trade between countries, stemming from David
Ricardo‘s shockingly brilliant concept of "comparative advantage," predicted, in theory, that trade flows would depend on such things as ratios of capital to labor, with capital-rich countries exporting capital-intensive goods and importing labor-intensive goods from labor-rich countries.
But that’s not what the data showed. In reality, most international trade takes place between countries with very similar capital:labor ratios.
Krugman sought to, and succeeded in, explaining this. His explanation was based on economies of scale and on transaction costs across distances. What does this mean?
Economies of scale mean that producer incentives are to concentrate production in a limited number of locations. Too abstract? Let’s make it concrete: There’s a reason Silicon Valley is a self-reinforcing hub of high technology and innovation in general. An engineering and entrepreneurial culture combined with venture capitalists combined with a world-class research university (Stanford) combined with a very start-up friendly business ecosystem has made it a hotbed for new companies.
Similarly, New York and London are likely to remain global financial centers as far as the eye can see. They both have the infrastructure that sophisticated financial professionals depend on. Permit me to state the obvious ones:
- English
- Entrepreneurial cultures
- The Anglo-Saxon common law tradition, and the rule of law
- An indigenous infrastructure of banks, law firms, marketing professionals, and all the multifarious support professions.
And the less obvious:
- Workable, if not Asian-clean-slate, physical infrastructures
- Terrific international air connections
- Fabulous stores, restaurants, museums, parks, and schools
- Great, and highly diverse, residential and commercial real estate
But back to Krugman.
He described his basic findings in the 1992 "Geography & Trade:"
"Because of economies of scale, producers have an incentive to concentrate production of each good or service in a limited number of locations. Because of the cost of transacting across distance, the preferred locations for each individual producer are those where demand is large or supply of inputs is particularly convenient — which in general are the locations chosen by other producers. Thus [geographical] concentrations of industry, once established, tend to be self-sustaining."
An example he used was that the auto industry in capital-intensive Sweden
exports cars to capital-intensive America while also importing cars from America. The
logic is that both Volvo and GM can reduce costs by producing a relatively
large output (sufficient to satisfy worldwide demand) in particular geographic
niches where the requisite inputs are concentrated.
Krugman, of course, was building on the theory of comparative advantage, which he explained perhaps most famously in "Ricardo’s Difficult Idea." Comparative advantage is a theory at once powerful and notoriously elusive, which–although beloved by economists, including yours truly–seems to inspire incomprehension even by those who loudly retort that while they subscribe to it, they only happen to see certain exceptions applying, which are only visible to those with a particularly subtle intellect.
At that point you know you’re in the company of someone whose fellow intellectual travelers include those who proclaim their belief in evolution while demanding equal time in the schools for "intelligent design." They say they believe, but they don’t believe.
Here’s where Krugman’s brilliant "Ricardo’s Difficult Idea" comes into play. Permit me to quote at some length (my own Cliff’s Notes version is here at the bottom):
My objective in this essay is to try to explain why intellectuals who are interested in economic issues so consistently balk at the concept of comparative advantage. Why do journalists who have a reputation as deep thinkers about world affairs begin squirming in their seats if you try to explain how trade can lead to mutually beneficial specialization? Why is it virtually impossible to get a discussion of comparative advantage, not only onto newspaper op-ed pages, but even into magazines that cheerfully publish long discussions of the work of Jacques Derrida? Why do policy wonks who will happily watch hundreds of hours of talking heads droning on about the global economy refuse to sit still for the ten minutes or so it takes to explain Ricardo?
[…]At a deeper level, comparative advantage is a harder concept than it seems, because like any scientific concept it is actually part of a dense web of linked ideas. A trained economist looks at the simple Ricardian model and sees a story that can be told in a few minutes; but in fact to tell that story so quickly one must presume that one’s audience understands a number of other stories involving how competitive markets work, what determines wages, how the balance of payments adds up, and so on.
[…]I believe that much of the ineffectiveness of economists in public debate comes from their false supposition that intelligent people who read and even write about world trade must grasp the idea of comparative advantage. With very few exceptions, they don’t — and they don’t even want to hear about it. Why?
[…} [I]f one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn’t that simple after all.There are, I believe, at least three implicit assumptions that underlie the most basic Ricardian model, assumptions that are justified by the whole fabric of economic understanding but are not at all obvious to non-economists. Here they are:
– Wages are determined in a national labor market: The basic Ricardian model envisages a single factor, labor, which can move freely between industries. When one tries to talk about trade with laymen, however, one at least sometimes realizes that they do not think about things that way at all. They think about steelworkers, textile workers, and so on; there is no such thing as a national labor market. It does not occur to them that the wages earned in one industry are largely determined by the wages similar workers are earning in other industries. This has several consequences. First, unless it is carefully explained, the standard demonstration of the gains from trade in a Ricardian model — workers can earn more by moving into the industries in which you have a comparative advantage — simply fails to register with lay intellectuals. Their picture is of aircraft workers gaining and textile workers losing, and the idea that it is useful even for the sake of argument to imagine that workers can move from one industry to the other is foreign to them.
Not is it obvious to non-economists that wages are endogenous. Someone looks at Vietnam and asks, "what would happen if people who work for such low wages manage to achieve Western productivity?" The economist’s answer is, "if they achieve Western productivity, they will be paid Western wages" — as has in fact happened in Japan. But to the non-economist this conclusion is neither natural nor plausible.
– Constant employment is a reasonable approximation: The standard textbook version of the Ricardian model assumes full employment in both countries. But in reality unemployment is constantly a concern of economic policy — so why is this the usual assumption? There are two answers. One — the answer that Ricardo would have given — is that international trade is a long-run issue, and that in the long run the economy has a natural self-correcting tendency to return to full employment. The other, more modern answer is that countries have central banks, which try to stabilize employment around the NAIRU ["Non-Accelerating Inflation Rate of Unemployment"–Bruce]; so that it makes sense to think of the Federal Reserve and its counterparts acting in the background to hold employment constant. This is not at all the way that non-economists think about the issue.
– The balance of payments is not a problem: The standard textbook presentation of the Ricardian model assumes balanced trade — indeed, it is usually a one-period model in which trade must be balanced. Yet the news is full of stories about the balance of payments, of complaints about trade surpluses and deficits. Why are these absent from the story?
Again, economists have good reasons for thinking that it is a good approximation to separate balance of payments from real international trade issues. In Ricardo’s case, the essential ingredient was the argument by David Hume that trade imbalances are self-correcting: a surplus country will acquire specie, leading to rising prices that price its goods out of world markets, while a deficit country will correspondingly find its goods increasingly competitively priced. In the modern world, again, the channels involve less Invisible Hand and more government intervention: when monetary policies target the unemployment rate, exchange rates do the adjusting. Economists are also aware that even persistent trade imbalances are not necessarily a problem, and certainly that surpluses are not a sure sign of health or deficits one of weakness.
Permit me to try to summarize the virtues of comparative advantage.
The benefits of trade do not depend on countries’ having absolute advantages over other countries, but only on having comparative advantages. This means that a country that is absolutely disadvantaged in producing all relevant goods and services can still benefit from trade. The secret is opportunity costs, not absolute costs.
Consider two hypothetical countries, North and South, which produce only two goods, food and clothes. If each country devoted its entire economy to producing food, North would produce 100 tons and South 200 tons. Similarly, if each devoted everything to clothes production, each would produce 100 tons of clothes. South appears absolutely advantaged, so where’s the benefit from trade?
First, let’s pretend that each country is equally predisposed to consumption of food and of clothes, so that each devotes 50% of their productive capacity to each. This produces:
| Food | Clothes | |
|---|---|---|
| North | 50 | 50 |
| South | 100 | 50 |
| Total | 150 | 100 |
Now let’s assume trade barriers are lifted and each concentrates entirely on its preferred output in anticipation of being able to trade. This yields:
| Food | Clothes | |
|---|---|---|
| North | 0 | 100 |
| South | 200 | 0 |
| Total | 200 | 100 |
Of course, this "production" leaves North starving and South naked.
So if we introduce actual trade and imagine some arbitrary preference "price" of one ton of Food for 2/3 ton of Clothes, we get:
| Food | Clothes | |
|---|---|---|
| North | 75 | 50 |
| South | 125 | 50 |
| Total | 200 | 100 |
Everyone is better off.
Now, if you still don’t believe me, consider the famous "attorney/typist" example.
Suppose you’re the best lawyer in town and also the fastest typist in town; you have an absolute advantage in both.
Q1: Are you going to go to work as a secretary? Obviously not. You put your absolute advantage as a lawyer to its highest use.
Q2: Are you going to type your own documents? Obviously not. You put your comparative advantage as a lawyer to its highest use.
You are now a subscriber to the doctrine of free trade.
