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Trade Theory Status Quo Despite Krugman

Paul Krugman's contribution in the development of "new" trade theory pushed the profession beyond the overly simplistic assumption of perfect competition. Since then, new trade theory has tended to be integrated and reconciled with traditional trade theory, undermining its deployment in support of successful strategic trade policy intervention.

ECONOMICS OF PAUL KRUGMANEconomic & Political Weekly EPW December 6, 200829Trade Theory Status Quo Despite Krugman Jomo K S, Rudiger von ArnimPaul Krugman’s contribution in the development of “new” trade theory pushed the profession beyond the overly simplistic assumption of perfect competition. Since then, new trade theory has tended to be integrated and reconciled with traditional trade theory, undermining its deployment in support of successful strategic trade policy intervention.What is new in trade theory? What does the new trade theory (NTT) imply for the theory of economic development, and how, in turn, does it fit into the public debate over trade, trade liberalisation and development in developing countries? Paul Krugman receiving the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2008 gives good reason to review the relevant currents in research, and how they influence policymaking. All too often, pundits and the economics profession have attempted to read political meaning into the Nobel. This time around, Krugman’s outspoken criticism of the Bush administ-ration and the end of the Bush era amplify the temptation to see “a shift to the left”. In this brief essay, we review major devel-opments in trade theory, including Krug-man’s contribution,1 but conclude that there is a long way to go to make new trade theory relevant for developing countries. The case for trade liberalisation rests on David Ricardo’s theory of comparative advantage. Put forward in the early 19th cen-tury, he argued that England and Portugal could engage in the mutually beneficial ex-change of cloth and wine – whatever the res-pective industries’ prices and productivities. However, for this to hold true, exchange rates have to be flexibly responsive to changes in goods markets, full employment has to be maintained instantaneously, and factors have to be immobile, meaning neither labour nor capital crosses borders. Quite obviously, especially in developing countries with chronic underemployment and volatile capi-tal flows, the latter two assumptions are generally not satisfied. Exchange rates, on the other hand, are now often flexible, but determined primarily in asset markets, where they respond to changes in expectations about future growth and interest rates. Traditional TheoryAccording to the modern day version of the theory of comparative advantage, trade follows “factor endowments”, a term referring to resources relatively abundantly available in a given country. The problem with this theory, called “Heckscher-Ohlin-Samuelson” (HOS) after its original propo-nents, is that it explains only a minor por-tion of world trade. In fact, an overwhelm-ing share of trade flows involves “two-way trade”, i e, the international exchange of goods and services between countries (and industries) with broadly similar endowments, productivity and real wages. In order to explain such realities, Paul Krugman made use of the idea of consum-er’s love for variety. Dixit and Stiglitz (1977) wrote the seminal article on demand for variety. Usually, “utility” de-rives from consuming a particular pro-duct, such as a TV. Utility increases if you have aTV not only in the living room, but in the bedroom as well. With Dixit-Stiglitz preferences, however, consumers value having a choice of brands, models and ac-cessories. For example, high-end consum-ers in Germany appreciate having a choice between the GermanBMW and the im-ported Lexus, and vice versa in Japan. The resulting trade flows represent intra- industry exchange between economies with similar endowments and hence con-form with observed patterns. Krugman (1979, 1980) formulated a series of simple models that explained trade flows be-tween similarly endowed countries, based on these Dixit-Stiglitz preferences.Space for Policy Krugman’s papers were soon famous, and the quickly burgeoning literature soon became known as the NTT. InNTT, trade policy can be justified as tariffs and subsi-dies for strategically important, but still uncompetitive industries can increase welfare. Helpman and Krugman (1989) investigate the complex possible outcomes of strategic trade policy. Clearly, the stand-ard conclusions of traditional theory were irrelevant. Krugman (1990) discusses cases where trade policy has diverse and often positive effects. Similarly, Markusen (2002) employs a new trade model that is clearly inconsistent with the one-size-fits-all, free-trade-is-always-better, traditional policy prescription. Where does this trade policy space come from? The new trade literature Jomo K S (jomoks@yahoo.com) is with the United Nations Department for Economic and Social Affairs (UN/DESA) and Rudiger von Arnim (rudiarnim@gmail.com) is at the Department of Economics, University of Denver, Colorado, United States.

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