The Competitiveness of Nations
in a Global Knowledge-Based Economy
H.H. Chartrand
April 2002
Ron Martin
* and
Peter Sunley **
Paul Krugman’s Geographical
Economics and Its Implications for Regional Development Theory:
A Critical Assessment
***
Economic Geography
Volume 72, Issue 3
July 1996, pp. 259-292
Index
Abstract
Trade, Externalities, and Industrial Localization: The
Bases of Krugman’s “Geographical Economics”
The New Trade Theory and Location
Increasing Returns and Imperfect
Competition
The Role and Implications of
Externalities
Krugman’s Geographical Economics and Economic Geography:
A Critical Comparison
The Resurgence of Regional
Economies
The New Political Economy of Trade
Krugman’s Model of Economic Integration and Regional
Development: The Lessons of the
Economic Integration and Regional
Specialization
Economic Integration and Divergent Regional
Growth
Trade and the Regional Policy Issue
Strategic Trade Policy
Geographical Clustering and Strategic Industrial
Policy
Conclusions
References
Abstract:
Economists, it seems, are discovering geography. Over the past decade, a “new trade
theory” and “new economics of competitive advantage” have emerged which, among
other things, assign a key importance to the role that the internal geography of
a nation may play in determining the trading performance of that nation’s
industries. Paul Krugman’s work, in
particular, has been very influential in promoting this view. According to Krugman, in a world of
imperfect competition, international trade is driven as much by increasing
returns and external economies as by comparative advantage. Furthermore, these external economies are
more likely to be realized at the local and regional scale than at the national
or international level. To
understand trade, therefore, Krugman argues that it is necessary to understand
the processes leading to the local and regional concentration of production.
To this end he draws on a range of
geographical ideas, from Marshallian agglomeration economies, through
traditional location theory, to notions of cumulative causation and regional
specialization. Our purpose in this
paper is to provide a critical assessment of Krugman’s “geographical economics”
and its implications for contemporary economic geography. His work raises some significant issues
for regional development theory in general and the new industrial geography in
particular. But at the same time
his theory also has significant limitations. We argue that while an exchange of ideas
between his theory and recent work in industrial geography would be mutually
beneficial, both approaches are limited by their treatment of technological
externalities and the legacy of orthodox neoclassical
economics.
The relationship between economic geography and
economics has long been an asymmetric one. In constructing their theories and
explanations of regional development, economic geographers have drawn freely on
the concepts and perspectives of different schools of economics; but, for their
part, economists have tended to accord little if any attention to the role of
geography in the economic process. The case of trade theory admirably
illustrates this point. Regional devel
* Ron Martin, Department of Geography,
** Peter Sunley, Department of Geography,
*** This is a revised version of a paper presented at
the Special Session on Economic Geography held at the Annual Conference of the
259
opment
theory has always been concerned with the question of interregional trade,
because a region’s ability to export goods and services is one of the
foundations of local economic growth and employment (Erickson 1989). The typical approach to the study of
interregional trade has been to borrow and adapt the ideas and models of
comparative advantage (factor endowment) trade theory from economics. Trade economists, however, have
invariably regarded the national economy as spaceless, and even international
trade typically has been seen as an exchange system devoid of any geography, a
world where goods and services move between dimensionless points at zero or
uniform transport costs. This lack
of a sensitivity to geography by trade theorists partly explains why there is no
overall theoretical framework guiding geographical research on international
trade (Grant 1994). The absence of
such a framework is particularly evident at a time when the “globalization” of
economic relations and the continental regionalization of trade are challenging
the territorial and regulatory significance of national economic spaces and
giving greater prominence to the nature and performance of individual regional
and local economies within nations (Dunford and Kafkalas 1992; Anderson and
Blackhurst 1993; Gibb and Michalak 1994).
Recently, however, there have been developments within
economics which may mark the beginning of a closer relationship with economic
geography in general and regional development theory more particularly. Over the past decade, a “new” trade
theory and a new economics of competitive advantage have emerged which, among
other important features, assign a key significance to the role that the
internal geography of a nation may play in determining the trading performance
of that nation’s industries. 1
Economists, it seems, are discovering
geography. In particular, Paul
Krugman, the leading and extraordinarily prolific exponent of the “new” trade
theory, 2 has sought to show how trade is both influenced by and
in turn influences the process of geographical industrial specialization within
nations (for example, Krugman 1991a). In his view, the importance of regional
industrial specialization and concentration is such that economic geography
should be accepted as a major subdiscipline within economics, “on a par with or
even in some senses encompassing the field of international trade” (Krugrnan
1991a, 33). Likewise, from a
different, but ultimately related perspective, Michael Porter, the eminent
business economist, has argued that the degree of geographical clustering of
industries within a national economy plays an important role in determining
which of its sectors command a competitive advantage within the international
economy (Porter 1990). In a similar
vein to Krugman, Porter also argues that there are strong grounds for making
economic geography a “core discipline in economics” (Porter 1990,
790).
Paul Krugman’s work, especially, is worthy of closer
interest by geographers. Krugrnan
has written on a wide range of issues that impinge on the regional development
question: trade, externalities, the localization of industry, strategic
industrial policy, globalization, the role of history and “path dependence,” and
the implications of economic and monetary integration for regional growth. One of the key thrusts of his work is
that in order to understand trade we need to understand the process of regional
development within nations. A
number of his writings have thus sought to explain why industrial development is
likely to be geographically
1.
The set of ideas referred to as the
“new trade theory” was originally expounded in a series of papers by Dixit and
Norman (1980),
2. Such has
been Krugman’s influence within the economics profession that Paul Samuelson
(1994, vii) refers to him as “the rising star of this century and the
next.”
260
uneven. To
this end, he draws on a range of economic and geographical ideas, from Alfred
Marshall’s account of localization economies, through traditional location
theories, to notions of cumulative causation. For Krugman, economic geography - by
which he means uneven regional development - is a central part of the process by
which national economic prosperity and trade are created and
maintained.
Our aim in this paper is to provide a critical
assessment of Krugman’s “geographical economics” and its implications for
contemporary economic geography. An
exchange of ideas between his theory and recent work in economic geography would
be mutually beneficial. Such an
exchange is not easy to engineer, however, as there are several significant
obstacles, on both sides. First,
Krugman’s ideas are far from static. Indeed, his views seem to change
continuously over time - sometimes in a self-criticizing way - so it is
important to base any evaluation on a range of his works. Second, throughout Krugman’s writings
there is a strong distinction between what is theoretically possible and what is
empirically and practically important, so that his conclusions have to be read
carefully and closely. Most
important, however, Krugman’s geographical economics and contemporary economic
geography are very different academic genres, with different methodological
styles and conventions of analysis and writing (Krugman 1993a). Krugman’s method is to start with a real
world problem and then build a model to capture the “essence” of that problem
(Krugman 1989, 1992). The model,
which is usually mathematically specified, is made as simple as possible to
remove unnecessary clutter, although in most cases he also gives a highly
readable narrative account of the model. The mathematical aspect of his
methodology may well explain the strong location-theory flavor to much of his
geographical economics. 3 However, this methodological and theoretical disposition
is unlikely to appeal to many economic geographers, who have abandoned formal
models and rigorous exegesis for a more discursive approach, in which broad
master concepts (like “flexible specialization” and “post-Fordism”) are mingled
with anecdotal spatial stereotypes (“industrial spaces” and “industrial
districts”).
These differences probably largely explain why Krugman’s
writings have thus far had a limited impact on economic geography, and why they
have been summarily dismissed by certain geographers.
3. This location-theory orientation has if anything
become even more pronounced in his two most recent books on “spatial economics,”
Development, Geography and Economic Theory (Krugman 1995) and The
Self-Organising Economy (Krugman 1996). In the former, lamenting economic
geographers’ “retreat” from quantitative models into Marxist and regulationist
concerns with “post-Fordism,” Krugman resurrects what he calls the five “exiled
traditions” of economic geography: location theory, social physics, cumulative
causation, land use modeling, and Marshallian local external economies. In the latter, von Thunen’s model and
central place theory occupy a key role in his theorization of the
“self-organizing” space economy.
4. It is
not difficult to see how economic geographers might take offense at Krugman’s
view of their work. In Geography and Trade (1991a, 3-4) he writes: “The
decision by international economists to ignore the fact that they are doing
geography wouldn’t matter so much if someone else were busy… looking at
localization and trade within countries.
Unfortunately, nobody is. That is, of course an unfair statement.
There are excellent economic
geographers out there… However,…
economic geographers proper are almost never found in economics departments, or
even talking to economists… They may do excellent work, [but it does not inform
or influence the economics profession.”
It could equally be argued, of course, that it is the economists who have
failed to talk to economic geographers and that, as a result, like Krugman they
are largely ignorant of the major developments that have taken place in economic
and industrial geography over the past decade or so. Equally irritating is Krugman’s comment,
in Development, Geography and Economic Theory (1995, 88), that “in the
end, we [i.e., economists] will integrate spatial issues into economics through
clever models (preferably but not necessarily mine) that make sense of the
insights of the geographers in a way that meets the standards of the
economists.” Whether economists
have any such monopoly over analytical or theoretical standards may most
certainly be questioned.] HHC:
[bracketed] display on p. 262 of
original.
261
in his
review of the same book, Hoare (1992, 679) criticizes the particular economic
geography used by Krugman as “dated, historically and intellectually” and his
analysis as based on the “flimsiest of empirical support.” However, Krugman’s remarks are leveled
primarily at his own colleagues’ failure to admit that “space matters” (Krugman
1991a, 8), and he should at least be congratulated for wanting “to bring
geography back into economic analysis,” even if the particular form of geography
he uses - essentially a form of regional science - is open to criticism. Furthermore, Geography and Trade
gives only a partial glimpse into Krugman’s analyses, and any considered
judgment as to the significance of Krugman’s work for economic geography must
also be based on his numerous other writings in the field.
We too have criticisms to make of Krugman’s treatment of
economic geography, although we also believe that his work raises some
interesting issues for contemporary regional theory. We begin by outlining what we take to be
the essential arguments and components of his “geographical economics,” focusing
on his interpretation of the relationships between location and trade, the role
of increasing returns and externalities in the localization of industry, and the
significance of history, “lock-in,” and path dependence for regional
development. The subsequent section
examines these ideas in closer, more critical detail, and compares Krugman’s
theories with those that have emerged from the “new industrial geography” in the
past few years. We then examine his
arguments about the impact of economic integration on regional development,
especially his prognoses of the regional implications of integration within the
European Union and his views on regional stabilization and industrial policy.
We conclude the paper by drawing
together the main strengths and weaknesses of Krugman’s approach to economic
geography.
Trade, Externalities, and Industrial Localization:
The Bases of Krugman’s “Geographical
Economics”
The New Trade Theory and
Location
Krugman’s geographical economics and theorization of
uneven regional development are firmly rooted in his contributions to the “new
trade theory.” Conventional trade
economics is based on Ricardian comparative advantage theory (especially in its
Heckscher-Ohlin-Samuelson versions), which argues that under conditions of
perfect competition, and given the relative immobility of one or more factors of
production, nations will specialize in those industries in which they have
comparative factor advantages (favorable resources of raw materials, cheaper
labor, and so forth). The relative
factor endowments of different nations is thus the main reason for international
trade and specialization. The
principle of comparative advantage, then, predicts that countries with
dissimilar resource endowments will exchange dissimilar goods. The theory does not and cannot, however,
predict what sort of goods will be exchanged by countries that have similar
resource endowments. But much of
world trade, and most of Organization for Economic Cooperation and
Develop-
262
ment
(OECD) trade, is between countries with similar factor endowments, and they
exchange predominantly similar products. Such intraindustry trade has been
expanding rapidly in recent decades, even though countries have been converging
in skill levels and per capita endowments of capital (OECD 1994). The “new trade theory” is an attempt to
account for this form of trade. The
new trade theory acknowledges that differences among countries are one reason
for trade, but it goes beyond the traditional view in four main ways (Krugman
1990). 5
First, it argues that much trade between countries,
especially intraindustry trade between similar countries, represents
specialization to take advantage of increasing returns to scale rather
than to capitalize on inherent differences in national factor endowments. Contrary to the assumptions of perfect
competition and constant returns to scale that underpin the basic Ricardian
theory of comparative advantage and trade, according to the new theory
imperfect competition and increasing returns are pervasive
features of contemporary industrial economies. 6
If specialization and trade are driven by increasing
returns and economies of scale rather than by comparative advantage, the gains
from trade arise because production costs fall as the scale of output increases.
Second, with this view of the
world, specialization is to some extent a historical accident. The specific location of a particular
microindustry is to a large degree indeterminate, and history-dependent. But once a pattern of specialization is
established, for whatever reason, that pattern gets “locked in” by the
cumulative gains from trade. There
is thus a strong tendency toward “path dependence” in the patterns of
specialization and trade between countries: history matters. Third, the patterns of demand for and
rewards to factors of production under conditions of imperfect competition and
intraindustry trade will depend on the technological conditions of
production at the micro level, and nothing can be said a priori about the
evolution of factor demands. Fourth, whereas under the Ricardian model
free trade is assumed to be the appropriate policy stance, the new trade theory
argues that the existence of imperfect competition and increasing returns opens
up the possibility of using trade policies strategically to create
comparative advantage by promoting those export sectors where economies of scale
- and particularly external economies - are important sources of rent. In other words, strategic trade policy
may enable a nation to shift the pattern of international economic
specialization in its own favor (Krugman 1980).
In Krugman’s view, these developments in the “new trade
theory” both necessitate and facilitate a rapprochement between trade theory and
location theory. In recent work he
has compared the contrasting assumptions underlying these two, hitherto largely
separate, sets of economic literature (Krugman 1993a). His geographical economics is a hybrid of
the two. It combines the models of
imperfect competition and scale economies used in new trade theory with location
theory’s emphasis on the significance of transport costs. The interaction of external economies of
scale with transport costs is the key to his explanation of regional industrial
concentration and the formation of regional “centers” and “peripheries” (Krugman
1991a; Krugman and Venables 1990). His model suggests that
high
5. There are in fact several different versions of the
new trade theory, but the various strands all subscribe to the basic elements
elaborated by Krugman in his Rethinking International Trade
(1990).
6. Of course, the idea that increasing returns
and economies of scale could be alternatives to comparative advantage as
explanations of international specialization and trade goes back to Ohlin
(1933), if not to Adam Smith. But
while their importance has been recognized in principle, they invariably have
been assigned a subsidiary or supplementary role in formal trade theory. The novelty of the “new trade theory” is
that increasing returns and economies of scale are moved into the
mainstream.
263
transport costs will act to prohibit the geographical
concentration of production. With
some reduction in transport costs, however, firms will want to concentrate in
one site to realize economies of scale both in production and in transport. In Krugman’s words, “Because of the
costs of transacting across distance, the preferred locations for each
individual producer are those where demand is large or supply of inputs is
particularly convenient - which in general are the locations chosen by other
producers” (1991a, 98). If
transport costs continue to fall, the model suggests that the need to locate
near to markets will disappear and production may disperse. However, given that some transport costs
will remain, the circular relation, or positive feedback, between production and
demand means that regions which have a head start in manufacturing, typically as
a result of accidental good fortune, will attract industry and growth away from
regions with less favorable initial conditions. Krugman (1991a, 1991d) argues that this
model explains the rise of the manufacturing belt in the
On the basis of this location model, Krugman (1993b)
argues that large-scale regions are more significant economic units than
nation-states. He writes that a
satellite image of the world at night shows regional agglomerations rather than
national concentrations. Furthermore, in his view, “The best
evidence for the practical importance of external economies is so obvious that
it tends to be overlooked. It is
the strong tendency of both economic activity in general and of particular
industries or clusters of industries to concentrate in space” (Krugman 1993b,
173). This tendency, he argues,
provides a decisive refutation of the competitive model of economic equilibrium,
for when one turns to the location of production in space the “irrelevance of
equilibrium economics” is compelling and there are multiple possible
equilibria. An economy’s form is
determined by contingency, path dependence, and the initial conditions set by
history and accident. Forward and
backward linkages mean that once an initial regional advantage is established it
may become cumulative. There is
therefore no automatic tendency toward an optimum solution, as apparently
“irrational” economic distributions may be “locked in” through increasing
returns. So that while Krugman
associates economic geography with path dependence, or what he calls “the
economics of qwerty,” 7
he does not neglect the possibility
of reversal and change. Rather, he
argues that when change in regional fortunes occurs it will be sudden and
unpredictable. He repeatedly uses
the example of
Increasing Returns and Imperfect
Competition
According to
7. This term derives from the first line of letters
(QWERTYUIOP) on the keyboard of a typewriter or word processor. That this order is the same today as it
was on the first mechanical typewriters of the nineteenth century, even though
more efficient sequences are possible, represents a form of “lock-in” and
persistence that has analogous parallels in the economy.
264
it
echo Ohlin (1933), Hirschman (1958), and Myrdal (1957), it strongly resembles
Weber’s (1929) model of the overlaying of transport costs on agglomeration
economies. Whereas Weber identified
spatial overlaps, the Krugman-Venables model adds the general level of transport
costs as a variable that can fluctuate over time. Given these predecessors, we should
consider whether there is anything really new in Krugman’s geographical
economics. In several places he
himself states that he is simply retelling an old story in a more rigorous way.
It would be tempting to conclude,
as some critics have done, that there is nothing new in this. However, this conclusion overlooks the
way in which Krugman’s reading of agglomeration has been shaped both by the
developments in trade theory and by recent models of industrial organization.
One of the main reasons for trade
theory’s traditional neglect of the advantages which arise from increasing
returns and economies of scale was the difficulty of modeling market structure.
In one sense, recent developments
in modeling market structure with nonconstant returns have facilitated the new
trade theory (Helpman 1984; Krugman 1983a; Buchanan and Yoon 1994; Smith 1994).
Hence the best place to start, in
order to understand Krugman’s interpretation of increasing returns, is with
these models. Two approaches are
particularly relevant to Krugman’s account of geographical concentration, namely
the Marshallian and Chamberlinian models.
The Marshallian approach to understanding increasing
returns is already familiar in economic geography. It is based in a long tradition that sees
economies of scale as primarily external, as arising from the specialization of
the social division of labor (Young 1928; Stigler 1951). Typically, economies of scale have been
taken to be purely external, so that the assumptions of perfect competition may
be retained (Chipman 1970). While
Krugman is aware of this long tradition, he suggests that recent advances in the
modeling of such external economies (see, for example, Romer 1990) have given
them a new tractability. He argues,
in one paper (Krugman 1981), that external economies at a national level are the
key to the uneven development of countries. Yet, increasingly, Krugman has been
reluctant to treat nations as economic units and has emphasized the significance
of external economies at a local and regional scale. Indeed, in Geography and Trade his
account of the localization of industries and agglomeration at a relatively
small scale is based on
Further reasons for Krugman’s lack of emphasis on
technological spillovers become apparent when we turn to the second model of
market structure that has been influential in new trade theory, namely the
Chamberlinian model (Chamberlin 1949). This model of market equilibrium
envisages competition among similar firms producing differentiated products
which are close but not perfect substitutes. Each firm faces a downward sloping demand
curve and has some monopoly power. The entry of new firms producing slightly
different products eliminates monopoly profits and means that there are many
little monopolists. Many
explanations of intraindustry trade
265
by new
trade theorists have been developed from this model, with the assumption of
economies of scale that are internal to firms. 8
According to Helpman and Krugman (1985), these internal
economies are easy to justify. They
argue that firms could both achieve economies of scale and meet a demand for
differentiated products from other producers and consumers by locating at one
site and engaging in intraindustry trade (Krugnian 1989). Krugman sees this approach as especially
relevant to intermediate products and components, where the scope for
differentiation is high and the market often too small for an exhaustion of
scale economies. Moreover, he
argues that
where intermediate goods produced with economies of
scale are not tradeable, the result will be to induce the formation of
“industrial comp1exes” - groups of industry tied together by the need to
concentrate all users of intermediate goods in the same country. In this case the pattern of
specialisation and trade in the Chamberlinian world will come to resemble the
pattern in the Marshallian world described previously. (Krugman 1987c, 319;
compare Losch 1967, 109)
Both of these models of competition are implicit in
Krugman’s discussion of regional and local
externalities.
The
Role and Implications of Externalities
Krugman uses
Over the past decade . . . it has become a familiar
point that in the presence of imperfect competition and increasing returns,
pecuniary externalities matter; for example, if one firm’s actions affect the
demand for the product of another firm
8. Hanink (1988, 1994) describes these approaches as the
theory of differentiated markets, and uses an extended Linder model to explain
the consequences of geographical product differentiation.
9. The term “pecuniary externalities” was used by
Scitovsky (1954) to refer to externalities arising from market imperfections of
both demand and supply. Market-size
effects are an important form of pecuniary external economy; the larger the
market, the more individual firms can increase their output without having to
cut prices. Increasing market size
permits increasing returns. Such
market-size effects may operate at various geographical scales, from the
international to the local. Technological externalities refer to the
situation where there are spillovers from the production function of one firm
into those of other firms, for example when a firm makes an innovation that
other firms can imitate.
266
whose price exceeds marginal cost, and this is as much a
“real” externality as if one firm’s research and development spills over into
the general knowledge pool. At the
same time, by focusing on pecuniary externalities, we are able to make the
analysis much more concrete than if we allowed external economies to arise in
some invisible form. (Krugman 1991b, 485)
This focus on pecuniary externalities shapes Krugman’s
interpretation of
Krugman’s analysis emphasizes that externalities
operating within and between industries in these regional agglomerations make a
difference to the competitive advantage of the constituent firms. In this sense, then, Krugman’s work
conveys a sense of regional competitiveness. 11 At the same time, his recent writings on
the international economy have criticized certain popular definitions and uses
of competitiveness, and it is important to set his regional work within the
context of his more general understanding of the consequences of trade (Krugman
1994a, 1994b, 1994c, 1994d). The
primary issue here is that Krugman sees all forms of international economic
integration, including trade and capital and labor mobility, as essentially
beneficial. For example, the
specialization produced by trade raises the efficiency of the world economy as a
whole and produces mutual benefits to the trading nations (Krugman 1994d). This view is partly founded on his belief
that comparative advantage still remains important and useful. It is also based on his belief that the
“new” trade theory’s recognition of externalities and imperfect competition
highlights the potential gains from economic integration. Increased trade may allow greater
economies of scale through rationalization and, in other situations, it may have
a beneficial effect on oligopolistic markets by increasing
competition.
The complexity of much of Krugman’s work also reflects
the fact that the existence of significant externalities and nonconstant returns
also opens up possible ways in which increased trade and integration may have
adverse effects. Krugman (1989)
highlights two main sources of adverse effects. The first is the possibility of the
uneven distribution of benefits associated with the existence of excess returns
in imperfectly competitive industries. A country that gains a disproportionate
share of high-returns industries can gain at others’ expense, raising the
possibility that trade policies designed to
10. Krugman also praises Fujita (1989) for his emphasis
on market-size effects as explanations of urban
agglomeration.
11. In a similar fashion, Porter (1990) argues that the
geographical concentration of leading industries often reinforces and
intensifies their competitive advantage.
267
foster
these industries will lead to trade conflict. Hence, “While the possibility of actual
losses from trade is probably purely academic, there is a real issue of conflict
over the division of the gains” (Krugman 1989, 361). (For a global example, see Krugman and
Venables 1994.) There is clearly
also a regional dimension to this problem of uneven distribution. As a result of the importance of external
economies and the accumulated, path-dependent advantages of certain regions, it
is possible that these leading regions will capture a disproportionate share of
the benefits of increased integration. A major obstacle to integration, in this
view, is that its benefits are not equally shared across regions within
countries.
This forms the basis of the second set of adverse
consequences identified by Krugman, namely adjustment costs. He argues that although it is costly for
capital and labor to shift into new industries, these costs represent a type of
investment. They may be deserving
of compensation, but they are not reasons to prevent or delay change. On the other hand, where these
adjustments involve significant social costs, most importantly unemployment, he
concedes that this may provide a case against moving too fast. The possibility of adjustment costs
becoming real social costs should not be dismissed lightly. One ameliorating factor that Krugman
notes is that the growth of trade between the industrialized nations since the
Second World War, especially within
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