In standard textbook neoclassical trade theory ("Heckscher-Ohlin"), countries specialize according to their factor (resource) endowments - e.g. a country with a large amount of arable land (relative to other factors) will specialize in food production, while a capital-abundant country will specialize in manufactured goods. The countries will exchange food for manufactured goods. That is, trade occurs because the countries are different, and they specialize in different goods.
One significant weakness of this theory is that much of the trade that actually occurs in the world is between similar countries, trading similar products ("intra-industry" trade) - e.g. Canada exports cars to the US, and the US exports cars to Canada; Italy exports wine to France, and France exports wine to Italy.
In his earth-shattering paper "Increasing Returns, Monopolistic Competition and International Trade" (Journal of International Economics, 1979), Krugman developed a model to explain how two similar countries gain from trading similar products. In Krugman's model, firms in each country produce differentiated varieties of similar goods (e.g. Heineken and Samuel Adams are both varieties of beer). Trade allows the firms to produce on a larger, more efficient scale, because they can sell their product in a larger market, and consumers gain access to more varieties of goods.
This is what he is talking about here:
Trade between high-wage countries tends to be a modest win for all, or almost all, concerned. When a free-trade pact made it possible to integrate the U.S. and Canadian auto industries in the 1960s, each country’s industry concentrated on producing a narrower range of products at larger scale. The result was an all-round, broadly shared rise in productivity and wages.What is new, according to Krugman, is:
We now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages.On his blog, he provides a graph. In terms of trade theory, what is going on is that a larger share of trade is with countries that have different factor endowments - e.g. China is abundant in unskilled labor and the US is abundant in skilled labor (this recent Washington Post story has some good examples of this type of trade). Krugman:
Although the outsourcing of some high-tech jobs to India has made headlines, on balance, highly educated workers in the United States benefit from higher wages and expanded job opportunities because of trade. For example, ThinkPad notebook computers are now made by a Chinese company, Lenovo, but a lot of Lenovo’s research and development is conducted in North Carolina.
But workers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation.
That is, a growing share of our trade is explained by the neoclassical model (and a smaller share by the Krugman model). Neoclassical theory has very clear distributional implications - trade increases the relative returns to the abundant factor. For the US that means skilled workers will see increased wages, and wages for unskilled workers will fall. This leads to the conclusion:
It’s often claimed that limits on trade benefit only a small number of Americans, while hurting the vast majority. That’s still true of things like the import quota on sugar. But when it comes to manufactured goods, it’s at least arguable that the reverse is true. The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose.
As I said, I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.
Greg Mankiw promises we will hear more from Krugman in the Brookings Papers on Economic Activity.
Update (12/29): On his blog, Krugman responds (He says: "Earth-Shattering? I’m proud of my early work on trade, but not this proud still, thanks for the compliment." I could have said "seminal" but I don't think that would have quite done it justice... he, along with a few others, really did change trade theory. Unfortunately trade pedagogy and trade policy discussion haven't really caught up). Krugman also offered some background on the issue of trade and wages. His column prompted thoughts from KNZN on the politics and economics of trade, and Free Exchange weighed in, too.