How to win the Nobel prize by a whisker

15th November, 2008

The Nobel memorial prize in economics is typically awarded to researchers who have jointly advanced some important method or idea. When the 2008 prize was awarded to Paul Krugman alone, for his contributions to trade theory and economic geography, other candidates who might have shared the prize – but didn’t – must have counted themselves one small step further away from receiving the call from Stockholm.

Among them are Jagdish Bhagwati, Krugman’s teacher and champion, and a giant in the field of international trade; and Elhanan Helpman, who wrote an influential book with Krugman on the new trade theory.

But I thought in particular of Avinash Dixit, without whom Krugman might have abandoned economics 30 years ago and so never formulated his new trade theory. Krugman has said he left graduate school “directionless … I was not even sure whether I really liked research.”

That was changed by what is now known as the “Dixit-Stiglitz” model. In 1977, Dixit and Joseph Stiglitz – one of the Nobel laureates in 2001 – published a new way of modelling how companies compete. The Dixit-Stiglitz model described “monopolistic competition” between many products in a particular market.

Monopolistic competition sounds like an oxymoron, and Dixit-Stiglitz certainly addressed a longstanding tension. Adam Smith had emphasised the importance of competition, but also the power of specialisation and the division of labour. His famous account of a pin factory, in which 10 men produced thousands of times as many pins as could one man, illustrated this point and thus the significance of economies of scale.

That poses a conundrum. Economies of scale push towards larger and larger companies. Logically, a monopolist should be the lower-cost provider. The tension between economies of scale and competition is obvious.

Yet while obvious, it is hard to model mathematically in a useful way. Dixit and Stiglitz resolved the problem by observing that consumers have a taste for variety as well as a taste for low prices. In the market for cars, for instance, Volvos compete with Fords and Ferraris. It would be cheaper if there was only one model of car; it would be nicer if there was an infinite variety. Somewhere in the middle is the equilibrium where economies of scale are balanced by customers’ desire for variety.

The elegant mathematics of the Dixit-Stiglitz model was new, even if the tension it described was as old as Smith’s Wealth of Nations. Krugman described it is as “beautiful”. It quickly became a workhorse, pulling economists to new frontiers of trade theory, growth theory and economic geography. Dixit later said he and Stiglitz had not realised the model would have so many uses – “obviously, otherwise we would have written all those subsequent papers ourselves!”

That is typically generous of a man who has often praised others, especially Krugman. He once told young economists that a good place to have ideas was in front of the shaving mirror. Krugman has a beard. Imagine, quipped Dixit, how much he could have achieved if he shaved!

Although the Nobel now seems overdue, Dixit hardly languishes in obscurity. He is president of the American Economic Association. He is a brilliant game theorist whose book with Barry Nalebuff, Thinking Strategically (now revised as The Art of Strategy) is a model of popular economics. And he may yet win the Nobel for his research with Robert Pindyck of MIT on “real options”, which describes how economic uncertainty can delay the most promising of business investments. It is a body of work that looks alarmingly relevant today.

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