Krugman (1980) - Scale Economies, Product Differentiation, and the Pattern of Trade

Summary

This paper introduces a novel theory of trade that departs from the comparative advantage theory, and provides a new explanation about why does trade happens. Traditional Ricardian models concludes that a country’s comparative advantage would determines the trade patterns, with an assumption of constant return to scale. In this paper, Krugman introduced the the idea of increasing return to scale (larger-scale production reduces the average cost of production), which in the model becomes a key driver of trade. Combined with the assumption of additive CES utility function for households, and the monopolistic competition market, Krugman shows that specializing in different goods and trade can actually benefit for both countries.

To be more specific, Krugman assumes an additive CES utility function for households, which is convex to the consumption set. This feature actually brings a nice property of household would benefit if there are more varieties of good to consume. As for the production side, Krugman assumes a market of monopolistic competition, where firms produce differentiated products and have some degree of monopoly power. However, the assumption of free entry ensures that profits are driven to zero, which pins down the number of varieties of production. Trade, which brings two countries’ goods to each other can benefit households in both countries. And this conclusion is not restricted to a two country case as well, it could be generated to a multiple-country case.

In Krugman’s model, when transportation costs are introduced, countries with larger labor markets (larger countries) tend to have higher wages. This is because larger countries attract more firms due to economies of scale and reduced transportation costs, leading to higher labor demand and thus higher wages. The smaller country faces lower demand for labor and has lower wages. This makes sure that trade are balanced in the case of non-zero transportation cost.

The model also has a proposition that export patterns can be driven by domestic demand. Countries with larger domestic markets for a particular class of good will specialize in the production of that class and becomes a net exporter due to the economics of scale. This is called the home market effect.

Critiques

Krugman’s model made a bunch of strong assumptions to obtain those good predictions that I mentioned in the previous section. First, this model assumes labor as the only factor of production, ignoring capital. In other words, the fixed cost of firm could be transformed into labor input as well. This setting oversimplifies the production inputs, because capital could also play an important role in production. In some sectors that require high capital input, it may not be realistic to ignore the importance of capital. Second, some of the key propositions rely heavily on the setting of the CES utility function. Krugman assumes elasticity of substitution to be constant over all products to simplify the math, which also oversimplifies the reality because consumers may find it easier to substitute between certain goods than others. For example, consumers may find easier to substitute a Toyota sedan with a Honda SUV rather than with a Giant bicycle.