Sunday, November 8, 2009

Comparative advantage and increasing returns in global trade

Paul Krugman has a working draft that argues and models how increasing returns, in the form of localized external economies, plays a major role in explaining trade patterns even in a world of comparative advantage.

He traces the history of international trade to three parts - pre-War (export of different goods - manufactures and primary products - based on comparative advantage), post-War (trade between similar countries and similar products, driven by increasing returns due to specialization and explained using models of monopolistic competition), and post-trade liberalization of the eighties (comparative advanatage driven trade between developing and developed countries in manufactured goods based on their labor and skill intensities).

Standard trade theories have sought to explain international trade in terms of comparative advantage and increasing returns from specialization. In the past two decades, increasing returns have taken the form of localized external economies (or the concentration of specialized industries in particular localities) which has been sustained by Alfred Marshall's trinity of agglomeration effects - information spillovers (network effects in the knowledge economy), specialized suppliers, and thick labor markets.

Krugman illustrates this with the example of China's comparative advantage with abundant labor and relatively high manufacturing competence, and its high degree of industrial localization - 60% of the world’s buttons are manufactured in the small town of Qiaotou, Wenzhou produces 95% of the world’s cigarette lighters, and Yanbu is the underwear capital of the world! While comparative advantage explains the overall pattern of trade, external economies explains the national origins of industrialization based on local differentiation and specialization. He writes about the double gain from trade

"There are gains from trade due to the specialization of China in labor-intensive industries like button manufacture, but there are further gains from trade – gains that accrue to the world as a whole – from the concentration of world button production in the single small town of Qiaotou... eras in which comparative advantage seems to have ruled international trade are also the eras in which increasing returns has seemed to exert its strongest influence on intra-national economic geography... gains from localization arguably are a significant source of gains from trade, even if they don’t seem to affect the pattern of specialization."

Krugman invokes the role of external economies of local industrialization to argue that the depressing effect (arising from the Samuelson-Stolper effect) of labor intensive imports from developing countries on the real wages of less-skilled workers (who are relatively less abundant there) in developed economies may not be as large as claimed. Further, there is always the possibility that the Stolper-Samuelson reduction in wages of American workers has been covered by the TFP increases due to import competition.

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