The Competitiveness of Nations

in a Global Knowledge-Based Economy

H.H. Chartrand

April 2002

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Ron Martin  and Peter Sunley

Paul Krugman’s Geographical Economics and Its Implications for Regional Development Theory:

A Critical Assessment (cont'd)

Economic Geography

Volume 72, Issue 3

July 1996, pp. 259-292


Abstract (Web 1)

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 (Web 2)

The Resurgence of Regional Economies

The New Political Economy of Trade

Krugman’s Model of Economic Integration and Regional Development: The Lessons of the United States for Europe?

Economic Integration and Regional Specialization

Economic Integration and Divergent Regional Growth

Trade and the Regional Policy Issue (Web 3)

Strategic Trade Policy

Geographical Clustering and Strategic Industrial Policy


References (Web 4)


Trade and the Regional Policy Issue

Strategic Trade Policy

Like much of his other work, Krugman’s views on the role of trade and industrial policy have shifted over time.  In his early writings he reacted against the idea of targeted industrial policies, on the grounds that they were based on crude misconceptions and that even if more-sophisticated theorizations could be found such policies were still unlikely to be effective in practice (Krugman 1983, 1983b, 1984).  Not long after, however, he had constructed a sophisticated theoretical argument for “strategic trade policy” (Krugman 1986).  One of the most contentious aspects of the new trade theory has been the debate it has generated over the question of strategic industrial policy.  Whereas conventional trade theory denies there is any case for “activist” trade or industrial policies, the new trade theory directly challenges the conventional view.  According to Krugman (1986) and other new trade theorists (for example, Brander and Spencer 1983, 1985), an “activist” trade policy can benefit a country relative to free trade in two ways.  The first is through “rent creation.”  If a government can promote a new or expanded monopoly position for domestic factors of production in industries that trade internationally, then a targeted industrial policy can in principle raise a country’s income at foreign expense.  Second, targeting can raise income if there are certain industries in which the resources committed by individual firms indirectly raise the earnings of other firms’ resources - that is, where external economies can be generated.  In both instances, the argument is that it may well be possible to identify some “strategic sectors” that at the margin are more valuable than others, and that the promotion of these sectors through protection, export subsidies, support of R&D, and so on could raise national income.

More recently, however, Krugman has reacted against strategic trade policy.  In


Peddling Prosperity (1994c), he questions the theoretical validity of strategic industrial policy and goes on to berate leading American politicians (especially President Clinton) and their economic advisors (especially Thurow and Reich) for misappropriating strategic trade theory and applying it in a “simple-minded way.”  Both Reich (1991) and Thurow (1994) are criticized for peddling the view that if the United States is to compete in the global economy, the government should abandon its notions of free trade and minimalist industrial intervention and instead pursue a more activist stance aimed at promoting the shift of American industry into “high value” (Reich) and “sunrise” (Thurow) sectors.  Krugman believes that such views are based on fallacious theory, impractical politics, and an erroneous obsession with the idea of competitiveness”: “While competitive problems could arise in principle, as a practical, empirical matter the major nations of the world are not to any significant degree in economic competition with each other” (Krugman 1994a, 35).  In his view, competitiveness relies on the metaphor of a country being a big corporation, when, in fact, countries (and regions) are nothing like corporations.  Hence it is very difficult to establish a meaningful definition of national or regional competitiveness.  Furthermore, he argues that it is wrong to see international trade as competition - as a sort of zero-sum game - when it is a process of exchange involving mutual benefit.  By the early 1990s, then, Krugman had come to denounce strategic trade policy as “bad economics.”  Yet, while Krugman has vigorously attacked the whole ensemble of policies that have come to be labeled as “strategic trade policy,” it appears that he now sees a role for a limited and focused industrial policy.


Geographical Clustering and Strategic Industrial Policy

In a recent paper Krugman (1993b, 160) states that he has “now changed his mind and … gone, at least slightly, soft on industrial policy.”  His initial skepticism of the theoretical credentials and practical applicability of the external economies rationale for targeted industrial policies was on the grounds that only technological, not pecuniary external economies are of concern, that technological externalities in any case are of limited significance, and that they are international rather than national in scope (Krugman 1983b, 1984).  But, as we have seen, he now believes that external economies associated with market-size effects are substantial and demonstrable (and often indistinguishable from technological external economies), and this means that targeted industrial policies have a potential role after all (Krugman 1987a, 1993b).  Moreover,

many of the important market-size effects apply not at the level of the international or even the national economy, but at a regional or local level.  The argument that the gains from support of industries that generate external economies will be dissipated abroad is therefore mostly wrong. (Krugman 1993b, 167)

In this revised view of industrial policy, not only are regional and local industrial clusters considered to provide empirical proof of the importance of external economies, such clusters help to define what industries should be supported.  Geographical clustering provides the justification for industrial intervention, and the aim of that intervention should be to foster local externalities.  In effect, what Krugman seems to be suggesting, though he does not use the term explicitly, is that the only justifiable form of industrial (trade) policy is in fact regional industrial development policy.  In line with strategic trade theory, the underlying premise is that national industrial comparative advantage can be created through supportive and targeted industrial policies which aim to create and facilitate key sectoral specializations.  The twist in Krugman’s argument, however, is that the most effective scale at which to create that advantage is at the level of regional clusters.  Essentially the same argument is

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implicit in Porter’s (1990) major work on national competitive advantage.  Indeed, he now sees local and economic development policies as having an instrumental role in fostering national industrial competitiveness (Porter 1994).

It is only a small step from this to argue that the promotion of specialized export clusters is also the most viable approach to reviving and regenerating old industrial regions.  This is, in fact, what certain writers on flexible specialization and industrial districts have implied.  These authors use the success of certain well-known specialized (usually export-orientated) industrial districts as a model for “indigenous” local economic regeneration more generally (see, for example, Hirst and Zeitlin 1989; Pyke, Becattini, and Sengenberger 1989; Sabel 1989; Stohr 1989; Cooke 1990; Scott 1992b).  The path to the reindustrialization of economically and structurally depressed regions is seen to be via the promotion and support of neo-Marshallian small-firm, flexibly specialized production complexes involving dense local networks of cooperation, competition, and horizontal interdependencies.  In some ways this support for a local industrial strategy based on multiple externalities is similar to Krugman’s rationale for industrial policy.  However, the advocacy of regional export specialization either as a local economic development strategy or as a form of trade policy is contentious.

The key question over the promotion of regional industrial specialization is whether the potential advantages are outweighed by the likelihood of greater regional instability and shocks, and the risk of structural depression.  As Krugman (1993d) notes for the case of Massachusetts, regional industrial specialization is a double-edged sword: it can be the basis of a high rate of export-led local economic growth in one period, but the source of prolonged local economic depression if that demand subsequently collapses or is captured by other competing regions (often in other countries).  This is precisely what happened to many of the specialized industrial districts celebrated by Alfred Marshall early this century (for example, see Sunley 1992).  An equally persuasive case can be made that industrial diversification rather than specialization is the most appropriate regional development policy route, that diversifying the regional industrial “portfolio” reduces the susceptibility of the regional economy to adverse demand shocks and localized structural crisis (this is the general conclusion of the portfolio studies referred to earlier; see also Geroski 1989).

Krugman, on the other hand, appears to believe that the most important policy response to the possibility of regional instability in more-specialized regions is fiscal stabilization.  In the case of European economic integration, for example, Krugman suggests that national budgets will have to be substantially centralized so that automatic federal European fiscal transfers can perform the required stabilization role when asymmetric regional shocks occur. 23  He notes the way in which the U.S. federal budget tends automatically to redistribute resources toward regions affected by negative economic shocks (via compensating adjustments in the tax-take and in welfare payments across regions):

While the US does not cope with the problems perfectly (as the current travails not only of New England but of the North East, in general, and increasingly of California, demonstrate), a highly federalized fiscal system helps a good deal.  The lack of such a system in Europe therefore is a real problem. (Krugman 1993d, 258)

23.  In the European case, although fiscal federalism is indeed a natural corollary to EMU, national governments in a future European monetary union would not lose all of their instruments of economic policy.  National budgetary policies would continue to have some, even if constrained, automatic stabilizing role (see Boonstra (1991) on the limits that EMU will impose on national budgetary autonomy).  In this sense member states in a European EMU would be somewhat different from the individual states in the United States.


Krugman is at pains to distinguish this form of regional policy response from that needed to ameliorate “core-periphery” patterns of uneven regional development or the regional decline that stems from specialization in outmoded industries and products.  The policy response to these sorts of regional issues, he says, “is much less related to EMU than the stabilization problem” (Krugman 1993d, 259).

However, while automatic fiscal transfers may well help to alleviate and stabilize the income and growth problems associated with economically depressed regions, they are not an adequate response to uneven regional development.  By themselves, they are not sufficient to recast the structure and dynamics of regional development so as to improve the long-term economic performance and wealth of the regions concerned.  This is why, of course, historically many European countries have developed elaborate systems of region-specific developmental aid and assistance, and why the European Union has been strengthening and reforming its own centrally administered regional structural funds in the context of the movement toward increasing economic integration (and enlargement) of the Union (see, for example, Martin 1993; Collier 1994).  Krugman’s distinction between regional instabilities due to idiosyncratic demand shocks and regional problems of a more “core-periphery” and “structural” nature is surprising and questionable.  For if, as he argues, short-term regional shocks have long-term effects on regional growth, then interregional fiscal stabilization is an inadequate policy response, and other, more strategic forms of regional policy are required.

In our view, the proposal of fiscal federalism does not temper the worry that regional clusters of specialized industry will be unstable and fragile.  The basic tension in Krugman’s argument remains - namely, how to reconcile his suggestion that the aim of industrial policy should be to promote industrially specialized regional clusters with his thesis that increased regional industrial concentration and specialization leads to regional economic instability and divergent long-term growth paths.  The response of the new industrial geography to this dilemma, of course, is to insist that flexibly specialized industrial districts are more adaptable to economic and technological change by virtue of the dynamism and networking of the small enterprises of which they are (invariably assumed to be) composed.  However, this claim remains far from proven.  In addition, the number of flexibly specialized districts remains small, and their origins and dynamics are matters of debate (see Markusen 1993; Markusen and Park 1993).  This is not to dismiss the new “indigenous” approach to regional policy based on arguments of (flexibly) specialized industrial development; but it is to signal that this approach is no more of a general panacea for uneven regional development than was the old model of redistributive regional policy.  Nor do we wish to imply that increasing returns and external economies are unimportant in the regional policy debate.  To the contrary, not only is there evidence from Europe that increasing returns industries are more concentrated in regions with better infrastructures, especially technological and educational infrastructures (Martin and Rogers 1994a, 1994b), endogenous growth theory also suggests that external economies and technological spillovers are likely to play a key role in the local growth process in an integrated Europe.  But in our judgment, there is an urgent need for much more thought on how local and regional policies can foster and support these externalities without simultaneously narrowing the industrial base and increasing the vulnerability of regions to demand shocks.



A few years ago, Neil Smith (1989) argued for a rebuilding of regional theory within geography based on a synthesis of ideas from location theory and uneven development theory.  More recently, Krugman (1993a) has argued for a similar


synthesis of location theory and trade theory, for using economic geography as a key component in the construction of a new “geographical economics” of trade.  In this paper we have sought to provide a critical assessment of Krugman’s ideas on economic geography and his attempts to use these ideas to forge a “geographical economics.”  Because of the enormous volume and breadth of his writings we have had to skate across many of his ideas, and as a result we have no doubt failed to accord some of them the full attention they deserve.  In addition, Krugman’s tendency to constantly revise and even reject his earlier ideas renders the task of assessment akin to tracking a moving target.  Nevertheless, we believe we have succeeded in isolating the core components of his arguments sufficiently to be able to identify some of their main strengths and weaknesses, particularly as they relate to the question of regional growth and development.  In many ways, Krugman’s approach to economic geography is a regional science one, a reworking of traditional location theory concepts and models.  The new economic and industrial geography, of course, has moved well away from that tradition.  For this reason, it might well be questioned whether Krugman’s work contains anything that is new or useful for economic geographers.  It would be wrong to be so readily dismissive, however; Krugman’s work is not as simplistic as Johnston and others have suggested (nor for that matter is geographical work always as sophisticated as its practitioners appear to believe).  For it is perhaps less the specific results of Krugman’s analyses that are important for economic geography than the general stimulus they provide for further inquiry.  In this respect we concur with the view that Krugman’s work “is rich in ideas, seductive in taking us though simple logical arguments to surprising conclusions and so self-confident in the discussion of its assumptions and its premises that reading it is at the same time great fun and a continuous challenge” (Casella 1993, 261-62).  The challenge, as we see it, is to pursue a closer exchange between Krugman’s “geographical economics” and the new industrial and economic geography.  Neither can claim to have a monopoly of insight, but an exchange of ideas between the two would, we believe, be beneficial.

One strength of Krugman’s work, without doubt, is that his linking of external economies and regional industrial agglomeration with trade provides an important corrective to the flexible specialization thesis of the new industrial geography, in which regional industrial development is viewed overwhelmingly as an indigenous process and the role of trade is typically either subordinated or neglected altogether.  Furthermore, Krugman’s emphasis on imperfect competition and pecuniary externalities likewise exposes the limitations of the conceptions of externalities now prevalent within the geographical literature.  The thrust of flexible specialization ideas in economic geography is that agglomeration is associated with the shift from vertical integration to the horizontal integration of related activities among small, competitive firms which cluster together to minimize transaction costs.  Williamsonian transaction costs economics - itself a neoclassical-oriented form of institutional economics  - has been used to give a new theoretical underpinning to Marshall’s notion of industrial localization.  Krugman’s focus on pecuniary externalities, especially market-size effects, and the role that large, oligopolistic producers can play in industrial agglomeration suggests that industrial geographers need to reassess their theoretical accounts accordingly.  Yet, at the same time, one of the most important limitations of Krugman’s geographical economics is his stubborn concentration only on those externalities that can be mathematically modeled, and thus his reluctance to discuss the geographical impacts of technological and knowledge spillovers.  Although the recent geographical literature has begun to assign key importance to technical change and technological externalities in shaping and

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transforming the space economy, and hence to some extent holds some important lessons for Krugman’s analysis in this respect, it too has yet to explore fully the cumulative and spillover effects associated with technological change.

A second significant aspect of Krugman’s geographical is the recognition that regional economic development is a historical, path-dependent process.  His repeated exhortation that “history matters,” both in terms of the arbitrary initial conditions and accidental events that set in motion particular patterns of industrial development over time and space and in terms of the subsequent “locking in” of those patterns via self-reinforcing effects, is not of course particularly novel to economic geographers.  Geographers have long recognized that a given pattern of uneven regional development, once established, tends to exhibit a high degree of persistence or ‘inertia” over time, and that this inertia can operate either to foster regional growth or to retard it.  The more recent interest by geographers in the local socio-institutional “embedded-ness” of economic activity also bears upon the issues of path dependence and lock-in.  In Krugman’s view the role played by geography in determining “lock-in” is strictly an increasing returns phenomenon, in the form of the Marshallian externalities associated with local industrial agglomeration (or, under certain circumstances, in the form of self-fulfilling expectations).  What he fails to consider is the influence exerted by local institutional, social, and cultural structures in facilitating or constraining local economic development.  This neglect would seem to stem in large part from Krugman’s complaint that noneconomic or “social” factors are not easily modeled and that they should therefore be left to sociologists.  But as recent studies in the new industrial and economic geography have begun to show, the “thickness” and nature of such socio-institutional “externalities” are fundamental to the initial emergence, trajectory, and adaptability of industrial districts and regional economies.  Thus Krugman is right to stress the role of geography in the historical, path-dependent nature of the economic process, but he fails to explicate the nature of that role.

A third aspect of Krugman’s geographical economics that we want to highlight, and which also has both strengths and weaknesses, is his analysis of the way that region-specific shocks can have long-term growth consequences.  How regions respond and adjust to demand and supply shocks, both in the short term and in the long run, in an increasingly deregulated, market-propelled, and uncertain world is an important research issue, but one that has been neglected by the new industrial geography.  Krugman’s analysis for the EU regions, using the U.S. regions for comparison, provides a useful basis for developing this research agenda.  However, as we have seen, his analysis is far from unproblematic.  Apart from being too American-centered (as exemplified by his emphasis on the central role of labor mobility, which is considerably higher in the United States than in Europe), his models do not adequately explain why a successful regional economy (like Massachusetts, for example) can suddenly go into reverse, or why the geography of uneven regional development can and does undergo significant reconfigurations (“spatial switching”), or why some regions seem better able than others to withstand or adjust to negative external shocks.  Krugman singles out industrial specialization as the main factor shaping the relative stability of different regions and the labor market as the key determinant of the regional adjustment process.  But a full account must surely also consider other reasons for regional crisis and restructuring and mechanisms other than labor market flexibility in order to explain the degree of and differences in regional adjustment.

There is, then, considerable scope for a potentially fruitful cross-fertilization of ideas between Krugman’s geographical economics and the new industrial-economic geography, and for the elaboration of each.  Both draw heavily on a Marshal-


lian view of industrial localization.  But whereas the new industrial geography has sought to reinterpret the Marshallian account in terms of transaction cost economics, Krugman instead has tried to link Marshallian industrial localization with the economics of imperfect competition, increasing returns, path dependence, and cumulative causation.  These concerns were at the center of Nicholas Kaldor’s (1978, 1981, 1985) earlier seminal work on trade, endogenous growth, and regional development, a debt that Krugman acknowledges:

This clear dependence on history is the most convincing evidence available that we live in an economy closer to Kaldor’s vision of a dynamic world driven by cumulative processes than to the standard constant returns model. (1991a, 9-10)

Krugman even goes so far as to admit that in a sense his own work is only “a repetition” of Kaldor’s ideas.  There are significant differences between the two, however.  In his quest for economic rigor, Krugman’s mathematical formalization of the processes of industrial agglomeration and uneven regional development has taken him away from the richness of Kaldor’s original approach toward the limited abstract landscapes of regional science.  Indeed, in Development, Geography and Economic Theory (Krugman 1995) and The Self-Organising Economy (1996), his role model seems to be that doyen of regional science Walter Isard, rather than Nicholas Kaldor, who, one suspects, would have been extremely skeptical of the unrealistic, deductive model-building that is the hallmark of the regional science tradition.  And despite Krugman’s apparent agreement with Kaldor’s argument for the “irrelevance of equilibrium economics,” the ghosts of constrained maximization and equilibrium solutions still haunt much of his analysis. 24

There would be much to be gained, in our view, if both Krugman’s geographical economics and the new industrial and economic geography revisited the method and the message of Kaldor’s work.  But that, as Krugman would say, is another story.

24. The same is true of the new trade theory and the new endogenous growth theory more generally.  Many of the ideas found in these theories were in fact anticipated by Kaldor.  But whereas he eschewed the deductive and mathematical for the inductive and realistic (as expressed in his emphasis on “stylized facts” and nonequilibrium), the new theorists have deliberately sought to “systematize” his ideas through mathematical formalism and appeal to all-embracing principles of optimizing economic behavior (see the assessments by Kitson and Michie 1995; Skott and Auerbach 1995).



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