Published on Let's Talk Development

Rediscovering Krugman

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As you may know from my previous blog, I recently returned from a fascinating trip to Vietnam. While there, I suggested regional integration of South East Asia as a promising development strategy for Vietnam, as well as other countries in the region. The reaction was strong and immediate: We are too similar to integrate. We all produce and export the same products. We compete with each other, how can we integrate?

These responses made me realize that it is perhaps time to go back to the 1970s, and read Krugman’s seminal work on precisely this question — work for which he received the 2008 Nobel Prize in Economics, but is apparently overlooked by some policy makers today.

Krugman’s work was inspired by the observation that a lot of post-World War II trade was between similar countries (for example, France and Germany) that traded similar products (for example, cars). This was hard to reconcile with traditional trade theory. In traditional theory, countries trade because they are different — for example, a country rich in capital and high-skilled labor such as the United States will produce and export industrial goods and import products that use a lot of cheap, low-skill labor, while a country like Bangladesh will do exactly the opposite. This is the so-called theory of “comparative advantage.” Krugman showed that there is another reason that countries trade: to exploit economies of scale. Many goods and services are produced more cheaply if they are produced in large quantities. International trade allows countries to replace small-scale production for the local market by large-scale production for the world market. For example, rather than producing Peugeot’s exclusively for the French market, France can produce them more cheaply in larger quantities for the integrated European market. Germany does the same with Volkswagen’s. Consumers value both low prices and variety. International trade delivers on both margins: economies of scale lead to lower prices, and trade — even between similar countries and in similar products — leads to more product variety (e.g., different car models).

This so-called “new trade theory” became the dominant paradigm in academic economics. But then, the “old” theory of comparative advantage made an impressive come-back in the real world. Massive trade liberalization in many developing countries in the 1980s and 1990s in combination with lower transport and communication costs led to the integration of the developing world into the world trading system. What followed was an unprecedented explosion of world trade, and an increasing share of this trade was trade between dissimilar countries, i.e., between developed and developing countries, that traded dissimilar products. This new pattern was consistent with the traditional theory of comparative advantage: advanced economies specialized in and exported capital- and high-skill-intensive products (e.g., machinery, precision instruments), while developing countries exported low-skill-intensive products (e.g., apparel or footwear).

The reactions in Vietnam reflect this revival of comparative-advantage-based thinking, thinking that views differences between countries as an important condition for trade. However, this model of trade may come under increasing pressure in the near future. The integration of developing countries into the world trading system was to a large extent the result of open trade policies that included unilateral liberalizations in many countries, international trade agreements, and membership in the World Trade Organization (WTO).  Increasing trade tensions and heightened uncertainty about the future of multilaterism make the future of globally open policies questionable. And with that, comes increased uncertainty about the future of trade between dissimilar countries.

In such an environment, it is time for a come-back of Krugman’s theory. The argument in favor of regional integration is an argument in favor of trade based on economies of scale and consumers’ appreciation of variety. Countries do not need to be different in order to benefit from it. Rather than thinking of themselves as competitors, Vietnam et al need to rediscover Krugman.



Pinelopi Goldberg

Former Chief Economist, World Bank Group

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