Economics focus - Paul Krugman

Illustration by Jac Depczyk

WHEN Paul Krugman won the Nobel prize in economics on October 13th, the news was greeted with nostalgia as well as congratulation by some of his fellow economists. Since 1999 Mr Krugman has written a twice-weekly column for the New York Times, in which he has devoted himself to attacking the Bush administration and all of its works. The nostalgists feel these jeremiads have distracted him from the cutting-edge research that secured his reputation. The polemicist, they feel, has buried the theorist.

And yet the old Krugman is still recognisable in the new. Indeed, the arts of the columnist are not so far removed from Mr Krugman's style as an economist. In his most celebrated academic papers, Mr Krugman paints with bold strokes, striving to render his insights as starkly as possible. Like a good columnist, he cuts to the quick of a problem, stripping it of clutter and encumbering nuance. The result is a revealing caricature: what economists call "models".

Mr Krugman won the prize for his models of international trade and economic geography. Both belong to the same grand project he confidently launched just a year after earning his doctorate: "Before my 25th birthday," he has written, "I basically knew what I was going to do with my professional life." In 1978 he realised that a model of "monopolistic competition", published a year earlier by Avinash Dixit and Joseph Stiglitz, could help him introduce economies of scale into trade theory and beyond.

Economies of scale had long posed awkward problems for theorists. If bigger firms face lower costs, then in principle one firm should supply the entire market, thereby enjoying the lowest costs of all. But in the Dixit-Stiglitz model, this monopolising logic is offset by a countervailing force: consumers' taste for variety. People prefer to spread their custom over different versions of the same good. The market is therefore carved up among competing firms, each offering a product bearing its own distinctive stamp. The model is highly stylised. Nonetheless it gave Mr Krugman, as he put it, "a tool to open cleanly what had previously been regarded as a can of worms".

Mr Krugman used this tool to save economics from an abiding empirical embarrassment. According to one of the discipline's founding doctrines, countries gain from specialisation and exchange, concentrating on what they do best and importing the rest. The theory explains why the Portuguese might sell wine in exchange for English cloth. But it cannot explain why similar countries, blessed with similar ratios of capital, labour and land, should so vigorously trade similar goods back and forth. This is not a small blind spot. According to the World Trade Organisation, 52% of Germany's exports to France are things France also produces and exports to Germany. But the Dixit-Stiglitz model, with its subtly differentiated firms competing for variety-loving consumers, lent itself to explaining why Germans might import Renaults, even as the French imported Volkswagens.

Mr Krugman's model showed that when trade barriers fall, firms gain access to bigger markets, allowing them to expand production and reap economies of scale. But openness also exposes them to competition from rival foreign firms, paring their margins. Some firms may go out of business. But between the domestic survivors and the foreign entrants, consumers still have more goods to choose from. Thus the gains from trade arise not from specialisation, but from scale economies, fiercer competition and the cornucopia of choice that globalisation provides.

Scale economies also allowed Mr Krugman to give economics for the first time a sense of space. In a 1991 article, he notes that night-time satellite photos of Europe reveal the distinctive contours of economic activity: bright lights cluster around metropolitan centres, shining particularly brightly around the triangle of Brussels, Amsterdam and Dortmund.

Before Mr Krugman, economists found these images difficult to square with the rest of their body of theory. They were accustomed to assuming that firms face constant returns to scale. But if that were true, then every peasant could build a small smelter or assembly line in his backyard. There would be no need for an economy to divide into a farm belt and an industrial belt.

In Mr Krugman's model, by contrast, big factories benefit from lower costs of production. Manufacturing firms might therefore cluster near to a large market, leaving behind a sparsely populated hinterland, in order to make the most of scale economies and minimise the cost of transporting goods to their customers.

Earlier theorists had instead assumed that firms herd together to benefit from some kind of "spillover". Perhaps firms pick up tricks of the trade and other know-how from their neighbours. However plausible, these explanations were nonetheless unsatisfying. Because economists could not measure spillovers or delimit their scope ("How far does a technological spillover spill?" Mr Krugman wondered), they could invoke them to explain just about anything.

Mr Krugman's models instead identified a less elusive benefit of proximity. He pointed out that a firm's decision to locate in a district is a gift to other firms in the area, because in attracting new workers it also brings new customers. Unlike a technological spillover, this gift would in principle leave a paper trail, showing up in local firms' sales figures.

In neither contribution did Mr Krugman claim great originality for his ideas or great realism. His achievement was to formalise insights that many people had previously had informally. Ideas that had fluttered in and out of people's grasp for decades, he pinned down like a butterfly on display. Sometimes a good economist, like a good columnist, succeeds not by making a point before everyone else, but by making it better than anyone else.