Question

Ignoring the mathematics, please explain the operation of the Krugman model in economic terms, and indicate the principal lesson of it.

Answer 1

Krugman's model was about International Intra-Industry trade among various countries.Before Krugman,many models like Ricardo,Hekscher-Ohlin etc tried to explain International trade based on comparitive advantage,opportunity cost.They,to a good extent, explained Inter-industry trade  but they could not explain intra-industry trade.Intra industry trade implies trade within different segments of same industry.krugman explained it using Economies of scale and Product differentiation.Two countries can have firms specialising in particular parts of a industry taking advantage of larger international market to get Economies of scale and taking advantage by reducing average cost of production.

Krugman explained Intra industry trade not only by product differentiation but also by monopoly power generated by the firm due to their brand value.He defined demand function of firm as:-

Q=S/n +b(P* - P) where,

S= Size of market

n=number of firms in the market

b=responsiveness of Q to variation in price

P*=average price charged in the market

P=price charged by the firm

More firms in the market will result in downward sloping of AR curve(PP curve) because as number of firms increases,average price will fall and existing firms have to charge lesser price to keep their share in the market.Krugman's demand function shows that if a firm charges equal to average price P*,then its share becomes S/n.Any price above P* will reduce the market share and any price below P* will increase the market share with responsiveness 'b'.

Krugman also developed average cost(AC) curve of the firms with respect to number of firms in the market.AC curve is upward sloping with increasing number Of firms because an increase in number of firms will reduce share of individual firms in the market(S/n) and thus reduces its economies of scale and so increases the Average Cost.

Equilibrium in Krugman's model takes place when number of firms is such that Average revenue line PP intersects Average cost line CC

Now when the market opens up then CC curve shifts to right because larger size of market results in larger share of firms incentivising them to get economies of scale which reduces average cost of production.The market now has abnormal profit which continues to attract new firns till it attain new equilibrium e1.Thus intra-industry diversification allows particular firm to focus on particular section of market and therefore ripe greater Economies of scale by International trade.

Major conclusions of Krugman's theory:-

1. It explained intra-industry trade using economies of scale and accepted that inter industry trade will be based on comparative advantage. Therefore trade based on comparative advantage will be larger if countries have significant differences in their endowment of resources and similar preferences and intra industry trade will be domain if countries have similar endowment but different preferences or similar endowment and similar preferences but both countries want to take advantage of Greater economies of scale.

2. With different commodities introduced under Economics of scale, free trade price ratio may not be significant in explaining trade expansion. It is possible that with opening of trade,a relatively smaller country takes advantage of larger market improve its efficiency and exports a commodity in which it was earlier considered as inefficient.

3. In case of Hekscher-Ohlin model, owner of abundant factor gains and owner of relatively scare factor loses but in Krugman's model everyone can gain because size of market increases and trade is not based on factor endowment.

Krugman's model was first rigorously developed model which could explain global supply chain expansion by using combination of initial endowment, preferences of the country, existing market situation etc.