Economics Nobel to Paul Krugman

January 10, 2009

“For his analysis of trade patterns and location of economic activity,” Paul Krugman (left), a professor in the Department of Economics and the Woodrow Wilson School of Public and International Affairs at Princeton University, received the 2008 Nobel memorial prize in economics. Widely known as an op-ed columnist for The New York Times and as a media commentator on economic policy issues, Krugman is shown here with his Princeton colleague John Nash, who received the prize in 1994. Photograph by Brian Wilson, courtesy of Princeton University Office of Communications.

James Case

On October 13, 2008, the Royal Swedish Academy of Sciences announced its decision to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2008 to Paul Krugman, a professor of economics at Princeton, "for his analysis of trade patterns and location of economic activity." Best known to the general public as a contentiously liberal op-ed columnist at The New York Times---where he has been among the earliest and least remitting critics of the Bush administration---Krugman is known in the profession mainly for his contributions to the mathematical theories of international trade and economic geography.

Readers of SIAM News might be interested in the autobiographical essay Krugman posted on his Princeton Web site shortly after winning the prize. Titled "How I Work," it summarizes his opinions on mathematical modeling. Although Krugman did not enter economics from engineering or the physical sciences---as many now do, in the expectation that their quantitative skills will prove advantageous---he soon discovered that he "was facile with small mathematical models, with a knack for finding simplifying assumptions that made them tractable." Soon after leaving graduate school, he realized, in what he calls his "formative moment," that a "lovely little model" of something called "monopolistic competition" could be adapted to the analysis of international trade. He spent the better part of the next six years---first by himself and later in collaboration with Elhannan Helpman---milking that model for a string of papers that substantially altered the field. The book Krugman calls their magnum opus, Market Structure and Foreign Trade, was published in 1985.

Among the distinguishing characteristics of the monopolistic competition model Krugman chose is the ease with which it accommodates "increasing returns to scale." Orthodox economic models emphasize "decreasing returns," whereby each increase in output necessitates a decrease in (productive) efficiency, so that revenue per unit decreases as production increases. More accurate models reflect the fact that efficiency typically increases before beginning to decrease, so that a plot of revenue against volume resembles the graph of x^2/(1 + x^2) in having an inflection point to the left of which the revenue curve is convex rather than concave. Only in the last few decades has it become fashionable for economists to concede that the realm of increasing returns is typically so large that few firms are able to escape it. In its "Information for the Public," the Royal Academy specifically cited Krugman's appeal to "economies of scale" to explain previously unexplained patterns of trade.

Although he didn't consider his early discoveries particularly startling, and soon learned that they were far from new, they had yet to be incorporated into the conventional wisdom of mainstream international economics. The reason---or so it seemed to him---was that they had never been deduced from concise mathematical models. So addicted had the profession become to model building that its members had grown blind to other sources of learning. Important in-sights were ignored because they could not be deduced from the "hallowed assumptions of the standard competitive model." That model, he now writes, is rife with "silly assumptions" that "continue to be made only because they have been made so often that they [have] come to seem natural." His monopolistic competition model offered escape from the confines of an inadequate paradigm.

Krugman's first paper on monopolistic competition in international trade met the fate that (in his opinion) seems to await every innovation in economics: dismissive rejection from a prestigious journal. Nonetheless, he persevered, and the 10-page article appeared in the Journal of International Economics in 1979. In part because others were thinking similar thoughts, his work found quick acceptance within the field. By 1985, when Market Structure and Foreign Trade was published, his thoughts had be-come "not only respectable but almost standard: from iconoclasm to orthodoxy in [a mere] seven years."

Over the course of his career, Krugman has developed four (rather cryptic) rules for conducting research: "(1) listen to the Gentiles, (2) question the question, (3) dare to be silly, and (4) simplify, simplify." By the first rule he means only that aspiring model builders should listen to knowledgeable individuals, even if they speak a strange language or approach the matter from an unexpected point of view. The second is a reminder that a well-constructed model, even if it fails to answer the questions it was designed to answer, can still shed light on other questions. The third cautions that the test of an assumption lies not in its immediate plausibility, but in the richness and verifiability of the theory it underlies. The fourth, which seems self-explanatory, is but a variation on Einstein's dictum that a theory (aka model) should be as simple as it can be---though no simpler.

Later in his career, Krugman noticed that the methods he and (subsequently) others had been using in international trade theory also applied to economic geography, long a backwater of economic research. Some-times called "location theory," this once-prominent branch of the subject seeks to explain why fast-food franchises occur in clusters along major thoroughfares, why steel mills tend to be built along low-cost transportation routes connecting coal fields with ore fields, and why other sorts of economic activities take place where they do. "Here," he writes, "perhaps even more than in trade, was a field full of empirical insights, good stories, and obvious practical importance, lying neglected right under our noses because nobody had seen a good way to formalize [aka model] it."

Monopolistic competition is a particular form of the "imperfect competition" in which oligopolists perforce engage. Oligopolists are the operators of firms that enjoy the "pricing power" obtained by controlling large shares of an established market, like that for beer, for autos, or for breakfast food. Imperfect competition is a catchall descriptor of everything save the "perfect competition" to which the founding fathers of mathematical economics almost exclusively limited their attention. As a simplifying assumption, perfect competition knows no peer! It simplifies everything. But in so doing it runs the risk, inherent in any simplifying assumption, of throwing out babies with bath water. The question is, how much is lost? For generations, economists dodged that question by insisting---through such elder statesmen as Sir John Hicks (Nobel, 1972) and Milton Friedman (Nobel, 1976)---that the difference between market competition and perfect competition is negligible.

Though by no means the first to challenge that established orthodoxy, Krugman has certainly been among the most effective. Due in large part to his efforts, the economics profession now possesses more nuanced theories of both international trade and economic geography than ever before. Only time and empirical testing will tell how much more valuable the new theories are than the old.

James Case writes from Baltimore, Maryland.

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