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ZAKARIA: This year's Nobel Prize for economics was won by Paul Krugman. Paul is also the "New York Times'" columnist. He's also a professor at Princeton University. And I'm going to ask him now in his capacity as a professor to explain a few things to us. That's why we have the chalkboard -- Krugman 101. First question, Paul, do you think that the fixes that have been put in place now -- that is, that the governments of the world basically seem to have decided we're just going to pour money into the system to recapitalize the banks, which is where we are now -- is that fundamentally going to fix this? PAUL KRUGMAN, NOBEL PRIZE WINNER FOR ECONOMICS, "NEW YORK TIMES" COLUMNIST AND PRINCETON UNIVERSITY PROFESSOR: You know, the U.S. have thrown $250 billion in. That sounds like a lot of money. But given the scale of the problem, it may not actually be a lot of money. Britain is actually putting in more, given the size of its economy.

KRUGMAN: Right. They're putting in, effectively, half again that much relative to the size of the economy. And they may need to do more, as well. And also, you know, there's this -- there is a panic out there. You can see. I mean, right now, the government took over Fannie Mae and Freddie Mac, which means that their debts are, for all practical purposes, government debts. And yet, people are still reluctant to lend to them, because they're sort of saying, you know, I don't know. Is it really, really, truly a government debt? You know. And people are still rushing to buy Treasury bills, which are the only thing that people seem to think is safe. So, even if -- this is going to be really hard. I mean, once you get to the stage we're in now, restoring even a sort of minimal level of trust is very difficult.

ZAKARIA: All right. Now that I have you and I have the blackboard, explain to me, what did you win the Nobel Prize for?

KRUGMAN: OK. Yes. I'll draw you a picture. OK? So, this is the temperate countries, temperate zone countries, and these are tropical. Think about it that way. Right? And this is not the only -- but the traditional trade theory looks like this. Well, you know, these are different. These countries are different. And so, well, you know, the tropical countries are going to sell bananas to the temperate countries, and the temperate countries are going to sell wheat to the tropical countries. And trade is going to be about how countries are different. And that's the theory of comparative advantage. And, of course, there's much more to it than that, but that's the basic story.

ZAKARIA: And this is sort of what David Ricardo said, which is ...

KRUGMAN: Right.

ZAKARIA: ... the British and temperate countries would sell textiles to the Portuguese. They would make wine ...

KRUGMAN: Right.

ZAKARIA: ... and sell it back to the British.

KRUGMAN: So, and that's a good story, and it's probably about half of world trade. Actually, if you're going to go back, in 1913 it was most of world trade. If you looked, you know, trade was European countries trading with their colonies, or former colonies, and manufactures for raw materials. But if we were looking at the world around 1980 -- which is when I started doing this stuff -- what you would have found is that a large part of world trade was back and forth among the industrial countries. A lot of the trade was France trading with Germany, the United States trading with Canada, and actually trading similar looking things back and forth. So ...

ZAKARIA: So, like that, (UNINTELLIGIBLE) the Americans buying cars from Sweden ...

KRUGMAN: Right.

ZAKARIA: ... when they're similar countries.

KRUGMAN: Yes. So, in fact, in the case -- one of the classics was in 1964, we signed a free trade agreement in automobiles with the Canadians. And suddenly there was huge trade in automobiles and automotive products back and forth across the U.S.-Canadian border -- in some cases actually the same model of car being shipped both south and north in different parts of the continent.

ZAKARIA: And so, you try to answer the question, why is that happening.

KRUGMAN: That's right. And the story that I and others came up with is that -- it sounds obvious in retrospect -- there are economies of scale. There are -- you don't want to have 200 car plants producing a given model of car. In general, you want only a few. Or if you look at something like aircraft, there are basically two places in the world where wide-body passenger jet aircraft are manufactured, because of the economies of scale. It's extremely inefficient to have very small plants. You want to have just a few. And wherever that plant is, whatever country it's in, it's going to be exporting those goods to the rest of the world. So, why does ...

ZAKARIA: Even to countries that have the same kind of endowments. That is to say, they're capital-rich countries. They have -- their labor ...

KRUGMAN: Right.

ZAKARIA: ... costs the same amount.

KRUGMAN: Yes. So, I mean, why does the United States export wide-body jets to Japan? Is it that the Japanese are incapable of doing that? You know, probably if they had gotten there first, they would be better at it than we are. We got there first, so we're better. But the main point is that there are just these enormous advantages to producing them in just one place. Now, people were sort of aware of that, but then they got really bogged down on the question: Well, what determines where that aircraft plant is? What determines why is a particular model of car produced here rather there? And what I and some other people realized was that, actually, that wasn't an important question to answer. What really matters is -- you know, because there are lots of goods like this. And the real -- you want to sort of step back, step back from the blackboard and take off your glasses, and realize that the broad pattern is what matters. There are lots of goods. Every country is producing a different set of goods. They may be only slightly differentiated, but enough so that people are buying. The economies of scale mean that you don't produce the same set of goods in each country. And so, you get all of this back-and-forth trade among even similar countries, which is, you know, something like half of world trade, and is a big source of trade that sort of gains from trade. It's actually, mostly a pro-free trade argument, though there are some possible market imperfections that might lead you to do something different.

ZAKARIA: And that imperfection is this. If it turns out that, by getting to someplace first you can accumulate the advantage -- so, by setting up the aircraft industry first, you can be the world's aircraft producer -- it might make sense for governments to help countries get there first.

KRUGMAN: If producing aircraft is an especially good thing to do.

ZAKARIA: What was the equation that won the Nobel Prize look like?

KRUGMAN: It's not one equation, but, you know, you start with preferences that look like -- where n is a very large number. And then you start working forward from there. So ...

ZAKARIA: All clear.

KRUGMAN: ... perfectly clear.

ZAKARIA: Thank you, Paul.

KRUGMAN: Thanks a lot.

ZAKARIA: Known around the world for her intelligence, elegance and outspokenness, Queen Rania of Jordan has divided opinion between those who feel she should take a more traditional role and those who see her as a shining example for modern Arab women. She was in New York recently, and she joined me to talk about the role of women in Islam and how to promote the voices of moderation within that religion.

Originally broadcast, 10.19.08