International Economics

Lecture 1. Introduction. World

Trade: An Overview
Outline
 Practicalities
 What is international economics about?
 Main issues in international economics
 Gains from trade
 Patterns of trade
 Effects of trade policy
 Road map for the course
 Explaining who trades with whom and how much?
 The gravity model
 Borders and trade agreements
 Globalization, past and present
 Changing composition of trade
 Multinational corporations and outsourcing
Practicalities
 Literature
 Krugman and Obstfeld, 9th edition, chapter 1-
11
 Difference compared to 8th edition explained
in the Preface

 Requirements
 Mandatory individual assignment (handed in 15
December)
 Final exam, 16 January (100 points)
 To pass need 40 points

 Office hours
 Tuesdays 15-17 (or by appointment)
Practicalities (cont.)
 Available on the web
 On the course’s web site:
 Outline
 Lecture notes
 Assignment
 On CourseCompass with student access kit
 Web resources related to the text book
 Course ID: ekholm97627
What Is International Economics
About?
 International economics is about how nations interact
through trade of goods and services, through flows of
capital and labor.
 This course will focus on interaction through trade in goods
and services and through flows of real capital and labor.
 It will not deal with trade in financial assets.
 Old subject that continues to grow in importance as the
world becomes more globalised.
 World trade has increased by ca 400 percent since 1970 while
world production has increased by ca 150 percent.
What Is International Economics
About? (cont.)

Source: Barba
Navaretti and
Venables (2004)
Main Issues in International
Economics
 Gains from trade

 Patterns of trade
 Who trades with whom and how much
 Which goods and services are exported/which are
imported

 The effect of government policies on trade

Gains from Trade
 A fundamental proposition in economics is that
there are gains from trade.

 Ideas underlying this proposition:

1. When a buyer and a seller engage in a voluntary
transaction, both receive something that they want
and both can be made better off.
 Swedes can buy tropical fruits and cut flowers through
international trade that they otherwise would have a
difficult time producing.
 The producers of the fruits and flowers receive income
that they can use to buy the things they desire.
Gains from Trade (cont.)
2. Even countries that are either the most or the least
efficient producer of everything may gain from trade.
 With a finite amount of resources, countries can use
resources to produce what they are most productive at
(compared to their other production choices), then trade
those products for goods and services that they want to
consume.
 Countries can specialize in production, while consuming
many goods and services through trade.
3. Trade is predicted to benefit a country by making it
more efficient when it exports goods which use
abundant resources and imports goods which use
scarce resources.
4. When countries specialize, they may also be more
efficient due to large scale production.
Gains from Trade (cont.)
 Trade is predicted to benefit countries as a whole
in several ways, but trade may harm particular
groups within a country.
 International trade can adversely affect the owners of
resources that are used intensively in industries that
compete with imports.
 Trade may therefore have effects on the distribution of
income within a country.
 Conflicts about trade should occur between groups
within countries rather than between countries.
Patterns of Trade
 Differences in climate and resources can explain why Brazil
exports coffee and Australia exports iron ore.
 But why does Sweden export automobiles, while the US
exports passenger aircraft?
 And why does Sweden import as well as export automobiles?
 Differences in productivity may explain why some countries
export certain products.
 Differences in the availability of capital, labor and land and
differences in the use of these resources in the production
of different goods may also explain why some countries
export certain products.
 Preferences for product variety and scale economies may
explain why similar goods are both exported and imported.
The Effects of Trade Policies
 Policy makers affect the amount of trade through
 tariffs: a tax on imports (or exports),
 quotas: a quantity restriction on imports or exports,
 export subsidies: a payment to producers that export,
 or through other regulations (e.g., product specifications)
that exclude foreign products from the market, but still allow
domestic products.
 What are the costs and benefits of these policies?
 If a government must restrict trade, which type of policy
gives the highest benefits at the lowest costs?
 If a government must restrict trade, how much should it
restrict trade?
 If a government restricts trade, what are the benefits and
costs if foreign governments respond likewise (retaliate)?
A Road Map
 Lecture 2-6
 International trade theory (chapters 3–7)
 Gains from trade
 Patterns of trade
 Includes analysis of flows of real capital (foreign direct investment) and labor
(migration)

 Lecture 7-8
 International trade policy (chapters 8–11)
 Effect of trade policy
 Determination of trade policy
 Controversies in trade policy

 Remaining part of lecture 1

 Who trades with whom and how much?
 Globalisation, past and present
Who Trades with Whom?
 The 5 largest trading partners with the
US in 2005 were Canada, China, Mexico Japan
and Germany.
 The largest 10 trading partners accounted for 56% of
the value of US trade in 2005.
 The 4 largest trading partners with Sweden in
2007 were Germany, Norway, Denmark and
the UK (the fifth was the US for exports and
Finland for imports).
 The largest 10 trading partners accounted for 66% of
Swedish exports and 71% of Swedish imports in
2007.
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Who Trades with Whom? (cont.)
Fig. 2-1: Total U.S. Trade with Major Partners, 2006

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 Who Trades with Whom? (cont.)
Total Swedish trade with major trade partners in 2007

Germany

Norway

Denmark

United Kingdo m

Finland

USA

Netherlands

France

Belgium

Italy

0 50000 100000 150000 200000

Source: Statistics Sweden 16

Size Matters: The Gravity Model
 The 3 largest European economies, Germany, UK
and France, are among the top 10 trading
partners for both the US and Sweden
 These countries are large in terms of GDP.
 The size of an economy is directly related to the
volume of imports and exports.
 Larger economies produce more goods and services, so
they have more to sell in the
export market.
 Larger economies generate more income from
the goods and services sold, so people are able
to buy more imports.

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 Size Matters: The Gravity Model (cont.)
Fig. 2-2: The Size of European Economies, and the Value of Their Trade with the United States

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Source: U.S. Department of Commerce, European Commission
The Gravity Model
Other things besides size matter for trade:
1. Distance between markets influences transportation costs
and therefore the cost of imports and exports.
 Distance may also influence personal contact and
communication, which may influence trade.
2. Cultural affinity: if two countries have cultural ties, it is
likely that they also have strong economic ties.
3. Geography: ocean harbors and a lack of mountain
barriers make transportation and trade easier.
4. Borders: crossing borders involves formalities that take
time and perhaps monetary costs like tariffs.
 These implicit and explicit costs reduce trade.
 The existence of borders may also indicate the existence of
different languages (see 2) or different currencies, either of
which may impede trade more.

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The Gravity Model (cont.)
 In its basic form, the gravity model assumes that only size
and distance are important for trade in the following way:
Tij = (A × Yi × Yj)/Dij
where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country j

 In a slightly more general form, the gravity model that is

commonly estimated is
Tij = (A × Yia × Yjb)/Dijc
where a, b, and c are allowed to differ from 1.
 It works fairly well in predicting actual trade flows.
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Distance and Borders
 Estimates of the effect of distance from the
gravity model predict that a 1% increase in the
distance between countries is associated with a
decrease in the volume of trade of 0.7% to 1%.
 Improved technology in transportation and
communication along with trade liberalisation
have reduced trade frictions and increased trade.
 However, it does not appear to have reduced the
effect of distance on trade.
 Besides distance, borders increase the cost and
time needed to trade.

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Distance and Borders (cont.)
 Trade agreements between countries are
intended to reduce the formalities and tariffs
needed to cross borders, and therefore to
increase trade.
 US trade with Mexico and Canada large because of
proximity, but also because of the North American Free
Trade Agreement (NAFTA) which was signed in 1994.
 The gravity model can assess the effect of trade
agreements on trade: does a trade agreement
lead to significantly more trade among its
partners than one would otherwise predict given
their GDPs and distances from one another?

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Distance and Borders (cont.)
Fig. 2-3: Economic Size and Trade with the United States

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Source: U.S. Deparment of Commerce, European Commission
Distance and Borders (cont.)
 Yet even with a free trade agreement between
the US and Canada, which use a common
language, the border seems to be associated with
a reduction in trade.
 Studying trade flows between British Columbia
and other Canadian provinces, on the one hand,
and US states at similar distances, on the other,
shows that trade is substantially smaller in the
latter case.

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Distance and Borders (cont.)

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Distance and Borders (cont.)

26
Globalisation, Past and Present
 Two waves of globalization:
 1840–1914: economies relied on steam power,
railroads, telegraph, telephones.
 Globalization was interrupted and reversed by wars
and depression.
 1945–present: economies rely on telephones,
airplanes, computers, internet, fiber optics,…

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Changing Composition of Trade
 In the past, a large fraction of the volume of
trade came from agricultural and mineral
products.
 Today, most of the volume of trade is in
manufactured products such as automobiles,
computers, clothing and machinery.
 Services such as shipping, insurance, legal fees and
spending by tourists account for 20% of the volume of
trade.
 Mineral products (e.g., petroleum, coal, copper) and
agricultural products are a relatively small part of trade.

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 Fig. 2-6: The Composition of World
Trade, 2005

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Source: World Trade Organization
Changing Composition of Trade (cont.)

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Changing Composition of Trade (cont.)
 Low and middle-income countries have
also changed the composition of their
trade.
 In 1960, about 58% of exports from low and
middle-income countries were agricultural
products and only 12% of exports were
manufactured products.
 In 2001, about 65% of exports were
manufactured products, and only 10%
agricultural products.

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Changing Composition of Trade (cont.)

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Service Outsourcing (Offshoring)
 Service outsourcing (offshoring) occurs when a firm that
provides services moves its operations to a foreign location.
 It can occur for services that can be performed and transmitted
electronically.
 For example, a firm may move its customer service centers whose
telephone calls can be transmitted electronically to foreign location.
 The operations could be run by a subsidiary of a multinational
corporation.
 Or they could be subcontracted to a foreign firm.
 Currently not a significant part of trade, but about 19% of
service jobs estimated to be “tradeable” and thus have the
potential to be outsourced.
 In comparison, about 12% of manufacturing jobs are
“tradeable” and thus have the potential to be outsourced.
 Most jobs, however, are non-tradeable because they need to be
done close to the customer.
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 Fig. 2-8: Tradable Industries’ Share
of Employment

Source: J. Bradford Jensen and Lori G. Kletzer, “Tradable Services: Understanding the Scope and Impact of Services 34
Outsourcing,” Peterson Institute of Economics Working Paper 5-09, May 2005
Summary
1. Size and distance are important determinants of bilateral
trade volumes
2. This is captured by the gravity model, which predicts that
the volume of trade is directly related to the GDP of each
trading partner and is inversely related to the distance
between them.
3. Besides size and distance, borders have a strong effect on
trade.
4. Innovations in transportation and communication along
with trade liberalisation have reduced trade costs, but the
effect of distance and borders remain strong.
5. Today, most trade is in manufactured goods, while
historically agricultural and mineral products made up
most of trade. In the future services trade may become
the most important component of trade.

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