The Bad Economist?

R. A. Hettinga rah at
Wed Dec 3 09:40:53 PST 2003


Man Without Qualities

Tuesday, December 02, 2003

 Posted 11:25 PM by Robert Musil
The Bad Economist?

A version of one fairly common - if not exactly standard - refrain
concerning Herr Doktorprofessor Paul Von Krugman is found in the recent,
curious Economist article that suggested that he is a gifted writer and
economist, but ... these days his relentless partisanship is getting in the
way of his argument.

It's a curious dichotomy. Herr Doktorprofessor qua journalist is widely
admitted routinely to distort and even misrepresent the sources on which he
relies for his columns. It is also almost universally acknowledged that a
sensible reader of Herr Doktorprofessor's columns will not assume that
representations of statistics, facts, figures or economic arguments one
sees there are as Herr Doktorprofessor presents them to be without
independent checking - and that the more difficult the checking and
confident the assertion, the more a sensible reader with politely reserve
belief until the fact checkers have had their say. The New York Times, of
course, has no fact checkers for its columns. [UPDATE: Just by way of
amusing example, in light of the recent uproar on the left over President
Bush's successful drive to obtain adequate funding for reconstructing Iraq
and Afghanistan, this column by Herr Doktorprofessor is worth re-reading to
see just how justified his claims to understanding the "real" minds and
hearts of the current Administration really are.]

Herr Doktorprofessor's most questionable columns often include what he says
he considers to be harmless assumptions - or omit a complex, technical
analysis that he asks the reader to trust him he has performed (it's his
job and his expertise, isn't it?). The assumption or omission is just to
render the column straightforward, you understand. "For simplicity." In
these columns he is, after all, engaged in the controversial and difficult
art of popularizing economics. Today's near-paranoid rant (pinned wriggling
to the wall by Don Luskin) accusing someone of fixing the new voting
machines, for example, includes a typical "trust me, I have done the hard,
scientific work" line: "The details are technical, but they add up to a
picture of ..." In other columns, he assures us, he is making the kinds of
simplifying assumption that theorists make all the time, abstracting
somewhat from the real world in order to increase explanatory
power-sacrificing some realism to gain tractability, he might say. Such
assumptions, he comforts the reader, if slightly less than realistic, are
basically innocuous: he has done the hard work, nothing vital hinges on it,
anyway - and to relax the assumption would make for a messier argument that
leads to the same place.

Of course, all of that isn't true in Herr Doktorprofessor's important
academic writing - right?

Well, maybe that's not so clear. Herr Doktorprofessor's most shining
credential is his John Bates Clark Medal, which he was awarded in 1991. The
official American Economic Association summary of the work for which he was
given that award makes clear that the so-called "new trade theory" was what
caught the AEA's attention and admiration, beginning with his paper
"Increasing Returns, Monopolistic Competition, and International Trade."
Journal of International Economics, 1979 9(4): 469-479.

What is the "new trade theory?" A Federal Reserve Bank paper on the topic
dated late last year explains it this way:

Since the early 19th century, economists have used the theory of
comparative advantage ... According to this classic theory, nations are
made better off through trade by capitalizing on their inherent differences
in natural resource or capital endowments. ...

But over the last 20 years, international trade economics has undergone
what some have termed a "revolution" because of a new theory that gives
very different answers to the same kinds of questions.This new trade theory
is often summed up in the simple words "increasing returns"-shorthand for
"increasing returns to scale," a term synonymous with "economies of scale."

The new theory, then, is the idea that trade arises to take advantage of
economies of scale: Industries in each country can achieve lower unit costs
by producing in large volume and spreading the high start-up expenses (for
example, research and development, machinery purchases) over many, many
units. If confined to the domestic market, an industry might not be able to
achieve the highest level of scale economies, but by producing for both
domestic and foreign markets, sufficient volumes can be produced to reap
greater economies of scale.

According to this theory, two countries could both get cheaper cars and
lamps, for instance, if one specialized in automobile manufacturing and the
other devoted its resources to making lighting equipment, regardless of the
inherent resource endowments of those countries. By taking advantage of
increasing returns to scale, each country could produce its specialty at
low unit costs and then trade with the other-both countries will gain
through trade, but not because of comparative advantage.

What is the "new trade theory" good for? A key result of the theory is
supposed to be the so-called "home market effect:" Countries will
specialize in products for which there is large domestic demand. For
example, the Introduction to Krugman's (1990, p. 5) selected papers says:
"The main additional insight from [my article "Scale Economies, Product
Differentiation, and the Pattern of Trade," American Economic Review, 70,
950-959] is the 'home market effect,' the tendency of countries to export
goods for which they have a relatively large domestic market." Krugman
first considered questions asked by Staffan Burenstam Linder in 1961 in An
Essay on Trade and Transformation. Krugman showed that in a world with
increasing returns to scale and costs of trade, high demand for a locally
produced product would result in a more than one-to-one response from local
production, leading exports of the demanded product to rise. Such "home
market effects" from demand to production structure, in the presence of
trade costs and scale economies, are seen by some as defining
characteristics of the "economic geography" later pursued by Krugman as one
of his major interests.

But along the way something rather curious happened to the "new trade
theory." As the Fed Bank article rather diplomatically puts it:

Harvard economist Donald Davis dealt this flourishing movement what seemed
a damaging blow. Krugman had developed his increasing-returns trade theory
by looking at a model with two sectors, one, alpha, with increasing returns
to scale and the other, beta, with constant returns. To render the
mathematics straightforward, he adopted what he considered a harmless
assumption. "For simplicity," Krugman wrote in his seminal 1980 paper,
"also assume that beta goods can be transported costlessly."

It was the kind of simplifying assumption that theorists make all the time,
abstracting somewhat from the real world in order to increase explanatory
power-"sacrificing some realism to gain tractability," Krugman wrote. And
he believed this assumption, if slightly less than realistic, was basically
innocuous-nothing vital seemed to hinge on it. ...

Davis, now chair of Columbia University's economics department, examined
the assumption more carefully. Reviewing data on trade costs (including
costs of transportation, nontariff barriers, "border effects" and other
costs inherent to trade), Davis concluded that Krugman's simplification was
unrealistic:"There is little suggestion that total trade costs are higher"
for increasing-returns goods, he wrote. If anything, the cost of trading
constant-returns goods is likely to be higher than that for
increasing-returns goods.

Even more crucially, Davis found that the simplification was far from
innocuous; something crucial does hinge on it. In fact, if Krugman's model
is duplicated with just one small change: Assume that both sectors-not just
the increasing-returns sector-have positive transportation costs, then
Krugman's striking finding about trade and industry location evaporates.
When "the industries have identical trade costs, the home market effect
disappears," Davis concluded. "Industrial structure then does not depend on
market size."

Professor Davis has not had the last word, as the Fed Bank points out. A
still more recent paper by other authors may salvage some of the "home
market effect" under some assumptions - although not so much in the area of
international trade as the rather curious zone of inter-regional trade.

A brief review of Professor Davis's paper reveals that it is not really all
that much more complex than Herr Doktorprofessor's original effort. It does
require that one do the work - but it's hard to imagine that someone of
Paul Krugman's intensity of involvement in this field would not have at
least seriously suspected that what he said he considered a basically
innocuous assumption might completely undermine his most eye-catching
results in many circumstances.

Of course, if Herr Doktorprofessor had explained all that, it would have
made his work seem a lot more like a technical advance, quite possibly a
mere curiosity, and less like the breathtaking, revolutionary revision of
classical thinking he and his admirers have held it out to be. But would
the John Bates Clark committee that evaluated the "new trade theory" in
1991 have the same high opinion of it after reading Professor Davis'

Somehow, in certain ways the more one looks at the trajectory of Herr
Doktorprofessor's breathtaking, revolutionary academic accomplishments the
more that trajectory resembles the trajectory of his breathtaking,
revolutionary assessments of the Bush administration and its economic
program - assessments that started out pretty hi-falutin, but so far have
turned out to be just ludicrous.

No doubt all will be revealed and settled in the fullness of time.

POSTSCRIPT: Don Luskin and others have wondered why Herr Doktorprofessor
doesn't really go after President Bush on trade restrictions. After all, he
was on the right side with Bill Clinton aginst the rest of the Democratic
Party, and otherwise Herr Doktorprofessor seems to get at least some trade
matters right.

But maybe Herr Doktorprofessor doesn't think trade restrictions for a
country like the US are any big deal, after all:

Yet there is a dirty little secret in international trade analysis. The
measurable costs of protectionist policies--the reductions in real income
that can be attributed to tariffs and import quotas--are not all that
large. The costs of protection, according to the textbook models, come from
the misallocation of resources: protectionist economies deploy their
capital and labor in industries in which they are relatively inefficient,
instead of concentrating on those industries in which they are relatively
efficient, exporting those products in exchange for the rest. These costs
are very real, but when you try to add them up, they are usually smaller
than the rhetoric of free trade would suggest.

R. A. Hettinga <mailto: rah at>
The Internet Bearer Underwriting Corporation <>
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'

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