Trading Places

Economic geography is all location, location, location 

Listener: 29 November, 2008 

Keywords: Globalisation & Trade; 

When I was awarded a Marsden Grant to study globalisation in 2004, I was pretty clear about the -subject’s economics. As the costs of distance (such as transport costs) fell, the opportunities and benefits from trade rose, and that would transform society. 

You will find this elegant and revealing analysis in the first non-introductory chapter of my book Globalisation and the Wealth of Nations, applied to the arrival of refrigeration in New Zealand. 

While studying, I was awarded a Distinguished Fulbright Fellowship to visit the US. As so often happens, spending time away from home provides major insights (thank you, Fulbright New Zealand), which transformed my thinking. The next chapter uses the US to illustrate that when there are economies of scale – average costs fall as the scale of production increases – the effects of falling costs of distance are even stronger. Economies of scale are integral to the theory of the firm, but they introduce such nasty complications into “general equilibrium theory” (which includes the theory of international trade) that even non-ideologues tend to underplay their significance. 

\Paul Krugman had studied such effects in a seminal paper in 1980. One of the “curiosities” of postwar globalisation is intra-industry trade, in which the same product is exported between two countries – eg, Volkswagens to France and Renaults to Germany. (There is a chapter in the book discussing the principle.) Depending on definitions, up to a quarter of the world’s merchandise exports involve intra-industry trade, and the proportion is growing. It is a phenomenon that changes the way we think about economic development and trade. Sadly, much of New Zealand’s thinking is trapped in David Ricardo’s 19th-century paradigm of “comparative advantage” in which unlikes are traded, with little recognition of the importance of “competitive advantage” that is based on, and extends, Krugman’s thesis. 

In 1991 Krugman went on to consider the economies of agglomeration, which are economies of scale for the production costs of a region rather than just a firm. Densely populated areas have lower production costs (which need not be outweighed by the diseconomies of congestion). The “new economic geography” revolutionised the way we think about location. Certain sorts of activities cluster in cities. My book applies the notion to New York, but you may have noticed that, in a number of columns, I have applied the same analysis for Auckland as a global city. 
Economies of scale effects are difficult to analyse. Too often superficial economics ignores them, putting them in the too-hard basket. Some of the findings are almost counter-intuitive – eg, as the costs of distance fall, a point is reached when the price of food rises relative to the price of manufactures. Yet the empirical evidence is that, coupled with the falling costs of distance, they shape the world in which we live. 

Krugman’s innovations simplified the complexity of the analysis, but still there are puzzles. (My book aimed to make the key ideas available to the general public, while avoiding getting bogged down in the mathematics; there is none in the book, except hidden in the verbal analysis.) 

So it was absolutely right that the committee in charge of the economics prize in honour of Alfred Nobel gave this year’s award to Paul Krugman “for his analysis of trade patterns and location of economic activity”. In a way, it was a brave decision for a usually timid committee. Krugman has a second profession as a columnist for the New York Times, where he has been perhaps the world’s most outspoken and cogent liberal critic of the Bush Administration. (When his -columns are not political they are very fine expositions of economics ideas – perhaps he should get a Nobel Prize for literature, too.) 

Krugman has not stopped at revolutionising international trade theory. Even in the 1970s he was presciently studying international financial crises. In the 1990s he was a major expositor of Japan’s economic stagnation, and the difficulties Asian economies were in. He is a shrewd critic of the US health system. Whatever his political views, his analytic ones still have much to tell us.