Krugman’s Nobel Prize: How we put his theory to practice

Krugman’s Nobel Prize: How we put his theory to practice

April 13, 2015

Paul Krugman (Princeton University) is awarded the 2008 Nobel Prize in Economic "for his analysis of trade patterns and location of economic activity".


At Copenhagen Economics, we use the contribution from Paul Krugman when we advise our clients on international trade issues. We put his theories to practice. Krugman’s theories help us to understand the benefits of free trade agreements, and the two central features (economies of scale and love of variety) are in fact incorporated in some of the numerical models we apply. With these tools at our disposal, we have assessed the potential welfare impact of free trade agreements between for example the EU and trading partners in Asia.


His analysis of trade patterns offers a formal explanation on why countries with similar conditions trade in similar products. For instance, that Germany and Sweden trade in cars. Traditional trade theory could not explain this pattern, but since it dominates world trade, and indeed trade between rich countries, a formal model of this type of trade was in great demand.


Krugman’s basic idea is simple. It is based on two observations. First, the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Second, that consumers value choice between a large variety of goods – it is nice for Swedish consumers to have the choice between a Volvo and a BMW (and many other brands). This concept is generally coined as love of variety.


In a short and clearly written article of just 10 pages in a 1979 edition of Journal of International Economics he showed how these two features could be incorporated in a formal model explaining why rich countries trade in similar goods. The implications of the model resemble what we indeed have seen over the past 30 years of globalisation: small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities.


Krugman’s other contribution is in new economic geography – i.e. explaining the location patterns of economic activity, i.e. why people live where they live and why firms locate where they locate. In his very readable book, Geography and Trade from 1991, he explains why economic activity tends to cluster in a few densely populated areas, and leave the periphery with less economic activity. We use this line of thinking when we advice governments and regions on regional growth issues. For instance, we helped the German and Danish Transport ministers to assess the long-term growth impacts of the Femern Belt Fixed link. The fixed link will bring Copenhagen and Hamburg closer and make Lolland-Falster and Ost-Holstein centre regions rather than periphery regions.


In addition, in a brand new PhD research project, used and supported by the Ministry of Welfare, we use Krugman’s theoretical findings to build an applied model for the analysis of the Danish regions.

  For further information, please contact: Partner Martin H. Thelle