Was It All In Ohlin

Paul Krugman

October 1999

WAS IT ALL IN OHLIN?

Let me begin with an embarrassing admission: until I began working on this paper, I had never actually read Ohlin's Interregional and International Trade. I suppose that my case was not that unusual: modern economists, trained to think in terms of crisp formal models, typically have little patience with the sprawling verbal expositions of a more leisurely epoch. To the extent that we care about intellectual history at all, we tend to rely on translators - on transitional figures like Paul Samuelson, who extracted models from the literary efforts of their predecessors. And let me also admit that reading Ohlin in the original is still not much fun: the MIT-trained economist in me keeps fidgeting impatiently, wondering when he will get to the point - that is, to the kernel of insight that ended up being grist for the mills of later modelers.

Moreover, one can argue that Ohlin actually gains something in the translation: Samuelson famously found implications in Ohlin's own view of trade that the great thinker himself, due to his "diplomatic style" (in Tjalling Koopman's phrase), had missed. Ohlin seemed to say that while trade shifts the distribution of income against scarce factors, it nonetheless probably improves their lot in absolute terms; Stolper and Samuelson showed that in a simple model the stark fact is that scarce factors lose by any measure. Ohlin definitely viewed factor-price equalization as only a tendency, surely incomplete; Samuelson showed that under the assumptions of Ohlin's Part I, "Interregional trade simplified", it was quite possible that trade would in fact fully equalize factor prices. So just as a modern student of evolution might be forgiven for preferring to get his Darwin courtesy of John Maynard Smith, a modern economics student might be forgiven for preferring to get his Ohlin via Samuelson, and indeed via Krugman-Obstfeld.

And yet what Ohlin disparagingly called "model mania" can lead to a narrowing of vision. Samuelson himself entitled his 1971 article expounding what has since come to be known as the specific-factors model "Ohlin was right", conceding that in a multi-factor model some of Ohlin's skepticism about the full factor-price equalization and strong Stolper-Samuelson effects that arise in a two-by-two model turns out to be justified after all. What else might Ohlin have been right about?

Some years back I gave a short series of lectures (the Ohlin lectures, as it happens, written up in my book Development, Geography, and Economic Theory ) on the way that a growing emphasis on formal modeling led economists to "forget" insights about the role of increasing returns in industrialization and economic location, only to rediscover those insights when modeling techniques became sufficiently advanced. Was the same true in international trade theory? In particular, did Ohlin's informal exposition of a theory of interregional and international trade contain the essence of what later came to be known as the "new trade theory" and the "new economic geography"?

The answer, it turns out, is yes and no. Ohlin did indeed have a view of international trade that not only gave a surprisingly important role to increasing returns (surprising because in Samuelsonian translation that role disappeared), but also one that suggested a sort of "unified field theory" of factor-based and scale-based trade that is a clear antecedent of the "integrated economy" approach that ended up playing a central role in post-1980 trade theory. On the other hand, despite Ohlin's title and his repeated suggestion that he was offering a unification of trade and location theory, there is little in Interregional and International Trade that seems to point the way to the distinctive features of "new economic geography". And there were a number of insights in modern trade theory that Ohlin did not, as far as I can tell, anticipate at all.

But let me start with my startling discovery: the extent to which Ohlin in the original anticipates a view of trade that the "new trade" theorists had to rediscover some 50 years later.

1. Increasing returns as a cause of trade

What did international economists know and think about increasing returns in trade circa, say, 1975? Certainly they were aware of the issue: R.C.O. Matthews' 1950 integration of external economies and offer-curve analysis showed up as a supplemental reading in graduate courses, as did later papers such as Chacoliades (1970). But I think my description in an essay of a few years ago (Krugman 1996) still captures pretty accurately the state of general understanding:

"The observation that increasing returns could be a reason for trade between seemingly similar countries was by no means a well-understood proposition: certainly it was never covered in most textbooks or courses, undergraduate or graduate. The idea that trade might reflect an overlay of increasing-returns specialization on comparative advantage was not there at all: instead, the ruling idea was that increasing returns would simply alter the pattern of comparative advantage. Indeed, as late as 1984 many trade theorists still regarded the main possible contribution of scale economies to the story as being a tendency for large countries to export scale-sensitive goods. The essential arbitrariness of scale-economy specialization, its dependence on history and accident, was hardly ever mentioned. To the extent that welfare analysis was carried out, it focused on the concern that small countries might lose out because of their scale disadvantages."

Now it turns out that while this description is, I submit, a good characterization of what the typical trade theorist thought before the rise of the new trade theory, it is not at all what Ohlin said in 1933. But let me maintain the suspense a bit, and next describe how one might model increasing returns in trade today.

The particular model I want to exposit is not the monopolistic competition, intraindustry-versus-interindustry story that has become emblematic of the new trade theory; you will see why shortly. Rather, it is the integration of external economies with factor proportions first suggested in Helpman and Krugman (1985), and subsequently presented in too many survey papers, including my recent survey in the Handbook of International Economics (1998).

The starting point for that model is an economy without trade, or more accurately one without borders - that is, one in which factors of production can work freely with each other, regardless of national origin. In the simplest case we think of a world with two factors of production, and (at least) three goods: X, Y, and Z, ranked in order of capital intensity. Of these, one of the goods - say X - is subject to external economies in production.

This "integrated economy" will have an equilibrium, with goods prices, factor prices, and resource allocation (assume away the possibility of multiple equilibria). In Figure 1 - a rather cluttered picture, but the clutter has a purpose - I show the resources allocated to the three industries as the vectors OX, XY, and YZ; OZ is, given full employment, the resource endowment of the economy as a whole.

To turn this into a trade model, we now invoke Samuelson's Angel, a character who appears in his "International factor price equalization once again" (1949). The angel - presumably the same one who stopped work on the Tower of Babel - divides up the world's factors of production into different nationalities, unable to work with each other. The angel's handiwork can be represented graphically by letting O be the origin for measuring the factor endowment of one country, Z the origin for the other; then the division of the world is indicated by a single point like E.

Can this divided world still reproduce the economic outcome of the integrated economy? Yes, if it is possible to figure out an international allocation of the pre-angel industries that uses all of each country's resources while meeting two criteria: non-negative production of each good in each country (Samuelson's criterion) together with concentration of the X industry in only one country (so as not to dissipate the external economies). To do this, one must be able to put all of the factors originally producing X in one country, together with some of the factors producing Y and Z. Geometrically, the integrated economy can be reproduced as long as E lies within either of the two parallelograms in Figure 1. If E lies inside both parallelograms - as it does in this picture - there are two trading equilibria that reproduce the integrated economy, one in which X is concentrated in the country whose origin is at O, one with X concentrated in the other. (There might also be other equilibria that do not reproduce the integrated economy - but let us leave that possibility on one side). This immediately implies that the pattern of production and trade may be indeterminate - but not that one cannot say quite interesting things about it.

For one thing, we know right away that whichever country gets the increasing-returns industry X will export that good. For another, we can surmise that whichever country has a higher capital-labor ratio will tend on average to export capital-intensive goods. This surmise can be made precise if we assume identical homothetic preferences, which means that each country's consumption of embodied factor services will lie along the diagonal OZ. Draw a line with slope equal to the wage-rental ratio

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