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Sunday, 30 March 2014 03:45

Paul Krugman (1987). "Is Free Trade Passé?" Featured

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Paul Krugman (1987). "Is Free Trade Passé?"

     According to Paul Krugman, comparative theory can be simplified to mean countries trade to maximize their differences.  Economies are believed to be characterized by constant returns to scale and perfect competition.  This means that is triggered by differences in technology, tastes, and factors/resources endowment.  Ricardian theory holds that technological differences are the main cause of trade while the Heckscher-Ohnlin-Samuelson model holds that different in resources endowment is what triggers international trade. These traditional trade theories are unable to explain the existence of different production structure in a similar region.  They also implied that trade should lead to conflict between factors of production and countries with complimentary endowments are best candidates to the formation of trading blocs.    However, these theories failed to address some trade phenomenon experience post war such as trade among similarly endow countries, intra-industry trade, and the formation of trading blocs.  

Krugman outlines the existence of other nature advantages such as to the traditional forces (factor, and technology.  He argues that increasing returns could be a reason for trade between seemingly similar countries is not well understood.  According to Krugman theory, countries can achieve competitive advantage through economies of scale, where each firm produces fewer varieties of goods, but at much larger scale, driving down the cost of production.  Therefore, firms in each country can produce similar products but with different characteristics (differentiation) at much larger scale (with lower cost).  These products are similar but not direct substitutes.  Variety tastes among consumers drive intra-industry trade.  Krugman argues that trade driven by economies of scales is fundamental in the world economy, and imperfect competition is also important.  His theory of increased returns and imperfection completion did not undermine the competitive advantage held by traditional theories, but rather complimented the position.  In order to explain the phenomenon of intra-industry trade, the theory removes the two main orthodox assumptions of perfect competition and constant returns to scale and has emphasized imperfect competition and increasing returns to scale.  With increasing returns, a firm’s marginal cost is lower than the average cost. If the firm faces perfectly competitive market, it must set its product prices to marginal cost, and it will incur losses.  Thus increasing returns to scale are incompatible with perfect competition and are likely to produce natural monopoly. In a world with free trade, a product is, therefore, likely to be monopolized by a single producer in one country, and trade will occur as a result of specialization caused by increasing returns to scale.

Krugman views of international trade holds that trade is to a certain degree driven by economies of scale. This new perspective outlines two main objections/ideas to free trade.   The first idea is the strategic trade policy and the second idea is that government policies should favor industries that yield externalities.    In a state where there are increasing returns and imperfect competition, some firms may be able earn higher returns than the opportunity costs of the resources.   Such a firm would discourage the entry of another firm into the same market.  Therefore, countries ca n boosts their income at the expense of others by promoting firms that are able to earn excess return sin local market.   Governs can use interventions such as subsidies and import restrictions, under the right circumstances to protect local firms from the competition from foreign firms.  However, trade policy argument has disadvantages in that it can be used by governments to increase or raise the welfare of its citizens at the expense of another country.

The argument for free trade is usually based on comparative advantage theory.  Krugman argues that is desirable to deviate from free trade to encourage activities that yield positive external economies.  This conception that protection can be beneficial when an industry generates external economies is part of convectional theory of trade policy.   The theory holds that governments can intervene to promote external benefits by exploiting external economies.    In free trade, positive internalities originate from the inability of innovative firms to appropriate the knowledge they create.  This problem is common among industries that are adopting technologies at a faster rate.   Traditional trade theories rely on perfect completion, which does not recognize externalities from incomplete appropriability.   This is because it is not possible to identify the source of externalities spillovers.   Firms can take advantage of these spillovers and appropriability to adopt new technologies and consequently improve their efficiency and reduce their cost of production. Therefore, traditional theories view external economies in abstract.   Firms can use research and design to gain external economies thereby destabilizing the theory of a perfect market.  Governs can introduce interventions or policy that target specific sectors.  Such a move would trigger the production in the sector, which may affect other countries adversely.  However, externalities are boundless countries can utilize externalities to disadvantages other especially so when the externalities are restricted at a national level.  

           However, govern interventions or policies as a force in the new trade theory faces objection and criticism.  First, there are questions on whether governments can be able to formulate useful policies or interventions given the existence of imperfect markets.  Secondly, there is room for exploitation of government interventions by rent-seeking firms. Third, it is believed that general equilibrium considerations will increase the difficulty of formulating intervention policies.   Most economic policies face uncertainty. It is not possible to predict how firms will respond to government interventions.  The success of these interventions greatly depends on collaboration and cooperation from the targeted firms.  Therefore, the use of externalities faces several empirical difficulties.   Benefits of government interventions may be eroded by the entry of other firms.  For example, in strategic trade policy, which aims at securing excess returns within local firms, it is possible that target market can support more than one firm.  Therefore, entry of other firms will ultimately be unavoidable thereby creating an oligopoly.  Therefore, subsidies may ultimately achieve the desired results.  Similarly, policies aimed at promoting external economies may fail.  This is mainly due to the fact that it is not possible to control all factors.   Entry of new factors will ultimately reduce the extent to which competition for external economies represents a source of international conflict.  In addition, there is the need to balance between sourcing revenue and protecting local firms.  Therefore, government works within restrictive intervention policies, which do more harm than good. Therefore, a government should clearly understand any intervention policy and also have a thorough knowledge of the industry before formulating any intervention policies.

The challenges of formulating interventions that work perfectly in imperfect markets are a challenge.   Therefore, the potential gain of interventions may be outweighed by uncertainty of these policies, entry that dissipate gains, and by general equilibrium.  Therefore, interventionist policies are complicated to apply.


Paul Krugman (1987). "Is Free Trade Passé?" retrieved from

Last modified on Sunday, 30 March 2014 03:50
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