Yet another Sheep

That prize. He got it "for his analysis of trade patterns and location of economic activity". So this would be the first Nobel memorial prize for economic geography. New economic geography that is. Krugman has really started a revolution in the area. A surveys of new economic geography can be found here. Those who can access it are advised to read The new economic geography: Past, present and the future , which is really a long interview with Krugman and Fujita. It is also very encouraging as it shows that the models being used require a quite restrictive methodology that is in conflict with usual economic thinking:

Interlocutor: I have a reasonably clear idea about the goals of the new economic geography. But in practice, what kind of “silly assumptions” or modelling strategies do people use?

Fujita: Let Paul, the master player, explain the games played by modellers in the new economic geography.

Krugman: In our book The Spatial Economy (1999), Masa, Tony and I offer a slogan only an economist could love: “Dixit-Stiglitz, icebergs, evolution and the computer”. Yet the slogan captures the essence of the intellectual tricks that we and other new economic geography theorists have used in order to cope with the technical difficulties involved in trying to deal with the subject. Everyone recognises that these are strategic simplifications, which is to say, intellectual cheap tricks; but they do allow us to get past the technical issues and tell stories about the real economics.

“Dixit-Stiglitz” refers to an ingenious analytical model introduced by Avinash Dixit and Joseph Stiglitz more than twenty years ago (Dixit and Stiglitz 1977). What they did was take an old idea, that of “monopolistic competition”, and give it a much sharper-edged formulation. Monopolistic competition, in turn, may be described as an attempt to recognise the existence of monopoly power – and the increasing returns that give rise to that power – while sacrificing as little as possible the simplicity of good old-fashioned supply and demand. Thus firms have market power and use it; but they are assumed to act in a purely unilateral fashion, never trying to organise cartels or even tacitly collude on prices. Every firm has a monopoly on its own distinctive product, but other firms can introduce products that are (imperfect) substitutes for that product. Telling this story in an uncomplicated fashion requires some funny assumptions both about consumer behaviour and about the technology of production; but it has the virtue of producing in the end a picture of an economy in which there are increasing returns, in which one need not get into the fascinating but messy issues posed by realistic oligopoly.

“Icebergs” refers to a clever model of transportation introduced by Paul Samuelson (1952) in one of the relatively few papers in traditional trade theory that does put transport costs into the story. Instead of describing an industry that produces transportation services, using capital and labour to get stuff from here to there, Samuelson proposed imagining that goods can be shipped freely but that part of the shipment “melts” in transit. Silly, yes, but it sidesteps the need to analyse transportation itself as another industry, and it also turns out to simplify the description of how monopolistic firms set their prices (specially, it removes the incentive to absorb transport costs, charging a lower f.o.b. price for exports than for domestic sales).

“Evolution” refers to how one thinks about how the economy “selects” one of several (or many) possible geographical structures. It is typically true of new economic geography models that they have multiple equilibria: to put a realistic gloss on it, if somehow Philadelphia rather than NewYork had become established as the centre of the financial industry in 1860, that leadership would be just as selfsustaining today as the one we actually see. It may seem obvious that this means that history determined which of many possible structures actually emerges. But in fact it is not so obvious: what happens if individuals themselves try to forecast the future, and base their decisions on those forecasts? Then one faces the possibility of self-fulfilling prophecies: if most financial firms believed that most other financial firms were about to move to Philadelphia, their belief would be indicated, but so would a corresponding belief that they would all go to New York or, for that matter, Boston. The slogan of evolution in the new economic geography essentially refers to the decision not to let the hypothetical players be that forward-looking, to assume that decisions about where to locate are based on current conditions, and therefore to rule out self-fulfilling prophecies. The geography of an economy therefore evolves in a way that reflects history and accident, but not expectations of the future.

Finally, the “computer” refers to the tendency of new geography theorists to use high-technology numerical examples, the sort of thing that would have been a major undertaking a generation ago, but can now be carried out almost casually on any desktop computer as an intuition pump, away to gain a sense of the possibilities implied by the underlying models. It is still possible to learn a great deal from paper-and-pencil analysis, and often the results both of that analysis and of simulation can be given clear intuitive explanations; but both the analysis and the intuition in general are attained on ground first explored with the computer.

So theorists have a lot to do. And that´s good news.


Btw: I first wanted to become an economist when I read Krugmans The Accidental Theorist and Other Dispatches from the Dismal Science. He was the one who showed me how one can think systematically about social issues.