Where Fun Comes to Die

Paul Krugman won the Nobel Prize in Economics today, and it is well-deserved. Krugman’s most important work, called new trade theory, solved the puzzle of why most trade is between very similar countries, like the U.S. and Canada.

Why is this a puzzle? Well, the historical justification for trade followed Ricardo and comparative advantage. If the U.S. is good at producing cars and China is good at producing clothing, then there are gains from trade to be had if the U.S. specializes in making cars and trades them to China, where production is being focused on clothes. This basic idea was refined in the 1920′s, so that what’s actually important is the proportion of inputs each country has. If the U.S. has a bunch of capital (relative to people to work) and China has a bunch of people, then, again, there are gains from the U.S. specializing in producing goods that require capital and China producing goods requiring labor.

OK, so good so far. The only problem is, that most real world trade doesn’t work like this! The U.S. trades primarily with Canada and Europe, while China did most of it’s trading with poor, undeveloped countries. This pattern, dubbed “North-North trade” doesn’t fit the traditional trade story at all.

This is where Krugman comes in. He pulls two ideas together to solve this apparent puzzle. First, people like variety. We enjoy having several different types of cars to choose from, and having 30 differents restaraunts instead of 5. Second, firms have what we call returns to scale, which implies that, the smaller a market of consumers is, the fewer firms will exist to produce goods.

Therefore, when the U.S. opens its doors to Europe, the market base for firms drastically increases (because of scale returns) which allows us to get way more variety than we had before. Voila! Trade happens and it is good for everyone.

Along with new trade theory, Krugman also made several seminal contributions in understanding currency crises and in the resurgence of economic geography. Although he has spent the past 10 years or so as a public intellectual with all the political baggage that entails, this Nobel is justly deserved for his economic contributions.

If there’s one good reason to not fret too much about the (potentially) looming financial crisis, it’s the following graph (from here). The little blips down in recent years are recent recessions. The one big one is the Great Depression followed by the WWII build-up. Do these affect the overall growth path? Sure doesn’t look like it.

Why is this line so straight? The standard economic answer is that the growth trend reflects producitivity increases, or, in more lay terms, the rate at which we get new ideas. As long as we keep getting good ideas about building better cars, or new iPhones, or shipping steel, or just about anything, we should expect this growth to keep on trucking.