Macro- and International Economics – Compact Exam Handbook
International Economics
COMPACT EXAM HANDBOOK
KU Leuven – Faculty of Economics and Business
Prof. Eline Poelmans
Crash Course · Compact Textbook · Exam Survival Guide
Rania El Ghalbzouri Page 1
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
International Economics – Table of Contents
International Economics – Table of Contents ................................................................... 2
Chapter 1: Introduction to International Economics ........................................................ 4
1. What Is International Economics About? ................................................................. 4
2. The Gains and Losses from International Trade ....................................................... 5
3. The Pattern of Trade ................................................................................................ 6
4. How Much Trade? The Role of Government Policy ................................................... 6
5. International Finance ............................................................................................... 7
6. Course Overview and Scope .................................................................................... 7
7. Chapter Summary.................................................................................................... 7
Chapter 2: World Trade — An Overview .......................................................................... 8
1. Who Trades with Whom? ......................................................................................... 8
2. Impediments to Trade: The Border Effect ............................................................... 11
3. The Changing Pattern of World Trade .................................................................... 13
4. Chapter Summary.................................................................................................. 15
Chapter 3: Labour Productivity and Comparative Advantage — The Ricardian Model .... 16
1. Introduction........................................................................................................... 16
2. Who Was Ricardo? — Historical and Social Context .............................................. 16
3. Today — Is Ricardo’s Idea Still Valid? .................................................................... 16
4. The Ricardian Model: Assumptions and Concepts .................................................. 17
5. The Ricardian Model in Autarky ............................................................................. 20
6. International Trade in the Ricardian Model ............................................................ 21
7. Misconceptions about Comparative Advantage ...................................................... 27
8. Transportation Costs and Non-Tradable Goods ..................................................... 28
9. Empirical Evidence for the Ricardian Model ........................................................... 28
10. Chapter Summary ................................................................................................ 30
Chapter 4: Specific Factors and Income Distribution ..................................................... 31
1. Introduction........................................................................................................... 31
2. Assumptions of the Specific Factors Model ............................................................ 31
3. The Specific Factors Model in Autarky ................................................................... 32
4. International Trade in the Specific Factors Model .................................................. 38
5. Chapter Summary ................................................................................................ 42
Chapter 5: Resources, Comparative Advantage, and Income Distribution — The
Heckscher-Ohlin Model ................................................................................................ 43
1. Introduction........................................................................................................... 43
Rania El Ghalbzouri Page 2
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
2. Assumptions of the Heckscher-Ohlin Model........................................................... 43
3. The Model of a Two-Factor Economy ...................................................................... 43
4. International Trade Between Two Two-Factor Economies...................................... 50
5. Empirical Evidence ................................................................................................ 54
6. Chapter Summary.................................................................................................. 59
Chapters 7 & 8: Economies of Scale, Imperfect Competition, and International Trade ... 60
1. Introduction........................................................................................................... 60
2. Increasing Returns to Scale.................................................................................... 60
3. Economies of Scale and Market Structure .............................................................. 61
4. External Economies of Scale (Chapter 7) ................................................................ 61
5. External Economies and International Trade.......................................................... 62
6. Internal Economies of Scale (Chapter 8) ................................................................. 65
7. Comparative Advantage vs. Internal Economies: Pattern of Trade .......................... 66
8. Trade Costs and Export Decisions.......................................................................... 68
9. Chapter Summary.................................................................................................. 69
Chapter 9: The Instruments of Trade Policy .................................................................. 70
1. Introduction........................................................................................................... 70
2. Types of Trade Barriers.......................................................................................... 70
3. Cost-Benefit Analysis of a Tariff ............................................................................. 70
4. Chapter Summary.................................................................................................. 75
Exam Checklist — Key Concepts by Chapter ................................................................. 76
Rania El Ghalbzouri Page 3
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Chapter 1: Introduction to International Economics
1. What Is International Economics About?
International economics studies economic interactions between countries and the
problems that arise from those interactions. The field covers two broad areas: trade in
goods and services (International Trade) and trade in financial flows and investments
(International Finance). At the beginning of the 21st century, countries are more
interconnected than ever — through trade in goods and services, through capital flows,
and through direct and portfolio investments.
Figure 1.1 — US Exports and Imports as % of National Income, 1960–2019 (source:
U.S. Bureau of Economic Analysis): Line graph with two series — exports (red) and
imports (blue) — both trending upward over the full period. Key takeaways: (1)
International trade has roughly tripled since 1960. (2) Both series fell sharply in 2009
during the global financial crisis. (3) Import growth has exceeded export growth, raising
the question of how the US finances this gap — answered by an influx of foreign capital,
which connects international trade to international finance.
The sharp long-run rise in trade is explained by three main drivers. First, there has been a
substantial decrease in trade barriers such as tariffs and quotas. Second, transport and
communication costs have declined dramatically: real ocean freight, air transport, and
international calling costs have all fallen by 80–95% since 1930. Third, the creation of free
trade areas — such as the EU, NAFTA, and CETA — has eliminated internal tariffs across
large trading blocs.
Rania El Ghalbzouri Page 4
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
2015 Data
2019 Data
Figure 1.2 — Average of Exports and Imports as % of National Income, selected
countries, 2015 (source: World Bank): Bar chart comparing six countries: U.S. (~12%),
Canada (~32%), Mexico (~35%), Germany (~40%), South Korea (~42%), Belgium (~83%).
The key takeaway is that most countries depend far more heavily on international trade
than the United States does. Belgium’s exceptionally high share reflects both its small
domestic market and its role as a transit and distribution hub within the EU single market.
Figure 1.2 (updated, 2019 data — source: World Bank): Same bar chart framework with
updated data. The ranking is slightly different (South Korea and Germany swap) but the
overall finding is unchanged: Belgium (~82–85%) remains the most trade-dependent
country in the comparison, while the US (~12%) remains the least dependent.
2. The Gains and Losses from International Trade
The following advantages and disadvantages form the conceptual backbone of the entire
course. Some are immediately intuitive; others will only become clear after studying the
models in Chapters 3–9.
2.1 Advantages (Gains from Trade)
1. Voluntary exchange benefits both parties. When buyers and sellers engage in a
voluntary transaction, both sides are made better off. For example, Norwegian consumers
import lemons they cannot produce domestically, while lemon producers earn income to
purchase other goods.
2. Every country gains from free trade, regardless of its efficiency level. Even if one
country is more productive in all sectors, trade is still mutually beneficial. Each country
specialises in the good(s) in which it is relatively most efficient and imports the rest. This
allows specialisation in a limited range of goods while consuming a wide variety through
trade. The common belief that trade is harmful when large productivity or wage
differences exist between countries is therefore wrong.
3. Factor abundance determines trade advantage. Trade benefits a country when it
exports goods that make intensive use of its abundant production factors and imports
goods that use its scarce factors. A country abundant in cheap unskilled labour, for
instance, has a natural advantage in labour-intensive goods such as textiles (Bangladesh,
Vietnam).
Rania El Ghalbzouri Page 5
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
4. Specialisation enables economies of scale. When countries specialise, each good is
produced at larger scale, lowering unit costs for all trading partners.
5. Intertemporal trade creates gains. Countries can also gain by trading current goods
or financial claims against future ones. An illustration: in the years following the 2008
financial crisis, China offered African governments loans in exchange for long-term
resource extraction rights — an exchange of present capital for future resources.
2.2 Disadvantages (Losses from Trade)
Trade is beneficial to a country as a whole, but may be detrimental to certain groups
within that country — the distribution of gains is uneven. Specifically:
• International trade can harm the owners of resources used intensively in industries
that compete with imports.
• Trade therefore affects the distribution of income within a country.
• Trade conflicts arise not so much between countries as between groups within a
given country — for example, between import-competing producers on one side and
consumers and export-industry workers on the other.
3. The Pattern of Trade
The pattern of trade asks: who sells what to whom? Four main explanations are developed
in this course. Differences in climate drive inter-industrial trade — Brazil exports coffee,
Australia exports iron ore. Differences in labour productivity (Chapter 3) and
differences in factor endowments — the relative availability of land, labour, and capital
— (Chapter 5) explain additional patterns of inter-industrial trade. Finally, economies of
scale (Chapters 7–8) explain intra-industrial trade, where countries both export and
import within the same industry category (e.g. cars of different varieties).
4. How Much Trade? The Role of Government Policy
Since World War II, industrialised countries have sought to remove obstacles to
international trade through bilateral agreements (e.g. NAFTA, CETA) and multilateral
frameworks (e.g. GATT and the WTO). At the same time, governments regularly intervene
to protect domestic industries from the adjustment costs of import competition. The anti-
globalisation movement, which gained significant influence after the 1999 Seattle WTO
protests, reflects broader public concern about the uneven distribution of trade’s gains.
The main trade policy instruments are (each analysed in detail in Chapter 9):
• Tariffs — a tax levied on imports (or, less commonly, exports).
• Import quotas — a legal limit on the quantity of a good that may be imported in a
given period.
• Export subsidies — government payments to domestic firms for each unit
exported.
• Voluntary Export Restrictions (VERs) — arrangements in which an exporting
country agrees to limit its own exports to avoid more severe restrictions being
imposed against it.
Rania El Ghalbzouri Page 6
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
5. International Finance
International finance (also called the international capital market) covers financial flows
between countries. Just as trade in goods has grown, cross-border capital flows have
expanded substantially. The main motives for these flows are: to finance trade; to finance
deficits in the balance of payments; for foreign direct investment (FDI) — involving direct
control over an enterprise abroad; and for portfolio investment — the purchase of stocks,
bonds, and other securities without direct management control. The distinction between
international trade and international finance is not always clean: decisions in either
domain can have significant consequences for the other.
6. Course Overview and Scope
Due to the limited number of contact hours, this course focuses exclusively on
international trade and primarily on its theoretical models. The course covers Chapters
1–9 of Krugman, Obstfeld & Melitz.
International trade theory (Chapters 2–8) examines how the international economy
works and which models explain trade patterns and their welfare effects. International
trade policy (Chapter 9) covers the costs and benefits of policy instruments such as tariffs
and quotas. Chapters 10–12 of the textbook and the full range of trade agreements are
covered in the separate elective master’s course International Trade and Politics, which
examines real-world trade relationships without formal models.
International finance (exchange rate policy, balance of payments, and the international
monetary system) is not covered in this course. Note also that Chapter 6 of Krugman,
Obstfeld & Melitz is not part of the syllabus and is omitted from these notes.
7. Chapter Summary
International economics studies economic interactions between countries, covering two
broad areas: international trade (goods and services) and international finance (capital
flows). The long-run rise in trade since 1960 is driven by lower trade barriers, falling
transport and communication costs, and the creation of free trade areas.
Trade benefits countries as a whole through five main channels: voluntary exchange gains,
comparative advantage (every country gains regardless of absolute efficiency), factor-
abundance advantages, economies of scale, and intertemporal trade. However, trade can
harm specific groups within a country — particularly those in import-competing industries
— generating distributional conflicts within rather than between nations.
The pattern of trade is driven by climate differences, labour productivity differences,
factor endowment differences, and economies of scale. Government policy instruments —
tariffs, quotas, export subsidies, and voluntary export restrictions — are used to affect
trade volumes, typically to protect domestic producers. These instruments and their
welfare effects are the subject of Chapter 9.
This course focuses on international trade theory (Chapters 2–8) and one chapter of trade
policy (Chapter 9). International finance and extended trade policy topics are covered in
separate elective courses.
Rania El Ghalbzouri Page 7
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Chapter 2: World Trade — An Overview
1. Who Trades with Whom?
1.1 The Gravity Model: Size and Distance
The gravity model asks: what determines the intensity of trade between two countries? The
name is borrowed from Newton’s law of universal gravitation (1687): just as every physical
particle attracts every other, with greater mass increasing attraction and greater distance
reducing it, so too in trade. Larger economies trade more with each other, and greater
distance reduces trade. The formal gravity model was developed in 1962. It captures both
effects in a single equation:
Tij = A × Yi × Yj / Dij
Tij = value of trade between country i and country j
A = a constant
Yi = GDP of country i; Yj = GDP of country j
Dij = distance between country i and country j
Interpretation: Trade volume between two countries is proportional to the
product of their GDPs and inversely proportional to the distance between them.
Empirical finding: A 1% increase in distance between two countries is associated
with a 0.7–1% decrease in trade volume. The model predicts well but not perfectly
— cultural ties, trade agreements, and geography also matter.
1.1.1 What Do the Empirics Tell Us?
Figure — Total U.S. Trade with Major
Partners, 2015 (source: U.S. Department
of Commerce): Horizontal bar chart
ranking approximately 15 countries by total
trade with the US (in USD billions). Top 5:
China (~$660B), Canada (~$580B), Mexico
(~$530B), Japan (~$190B), Germany
(~$175B). South Korea, United Kingdom,
France, Taiwan, India, Italy, Brazil,
Netherlands, Belgium, and Switzerland
follow.
Looking at 2015 data, the five biggest US trading partners were China, Canada, Mexico,
Japan, and Germany. China ranks first due to the sheer size of its economy. Canada and
Mexico, despite being relatively small economies, rank among the top three — an
observation that requires explanation beyond size alone, and which the gravity model
helps clarify. Germany, the UK, and France — the three largest European economies at the
time — were also in the top 10. Note: all textbook data pre-dates Brexit, so the UK is treated
as an EU member.
Rania El Ghalbzouri Page 8
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Figure — Total U.S. Trade with Major
Partners, 2019 (source: U.S. Department
of Commerce): Updated bar chart. Mexico
leads (~$670B), Canada follows closely, then
China (~$560B), Japan, Germany. Vietnam
and Ireland have entered the top 15. The
shift in China’s ranking from 1st to 3rd
reflects the trade tensions during Trump’s
first presidency.
By 2019, the same major traders dominated but the ranking shifted: Mexico moved to 1st,
Canada to 2nd, and China fell to 3rd. This reflects the tariff tensions introduced during
Trump’s first presidency, which discouraged US–China trade.
Two questions arise from these rankings: (A) why does the US trade more with some
European countries than others, given that all EU countries are roughly equidistant from
the US? And (B) why does the US trade so much with the relatively small economies of
Canada and Mexico?
A. Why does the US trade more with some European economies than others?
Since distance is roughly constant across EU countries, the key factor is the size of the
economy. Countries that account for a larger share of EU GDP also account for a
proportionally larger share of US–EU trade.
Figure — Size of European Economies and Value of Their Trade with the US, 2019:
Scatter plot with % of EU GDP on the horizontal axis (0–25) and % of US trade with the EU
on the vertical axis (0–25). A diagonal trend line runs from the origin to the top right.
Germany (largest EU economy at ~23% of GDP) plots furthest right and highest. United
Kingdom and France are in the middle. The Netherlands, Ireland, and Belgium plot above
the trend line — they trade more with the US than their GDP alone would predict. Austria,
Sweden, and Spain plot below the line.
Rania El Ghalbzouri Page 9
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Size matters because larger economies produce more goods and services, giving them
more to export; and higher incomes allow them to buy more imports. This relationship is
direct: a country that represents x% of EU GDP will account for roughly x% of US–EU trade
if size is the only factor.
However, some countries systematically deviate from the trend. The Netherlands and
Belgium trade more with the US than their GDP share predicts, reflecting their favourable
geography (major ports, river access, railway hubs) and their role as transit and
distribution centres for continental Europe. Ireland also exceeds expectations, partly due
to strong cultural ties with the US (shared language, large Irish-American diaspora) and
partly due to a business-friendly tax environment that attracts US multinationals. Spain,
Italy, and France trade somewhat less than their size would predict, likely reflecting
language barriers and different commercial orientations.
B. Why does the US trade so much with Canada and Mexico?
The Canadian economy is only slightly larger than the Spanish economy, yet US trade with
Canada alone equals approximately 70% of total US trade with the entire EU. The
explanation is distance and proximity: Canada and Mexico are small economies relative
to the EU, but they are immediate neighbours of the US, sharing land borders and
benefiting from the NAFTA agreement (1994, renegotiated by Trump in 2018 as USMCA).
Proximity reduces transport costs and facilitates the personal contacts and shared
business culture that support trade.
Rania El Ghalbzouri Page 10
MBA Bridging Programme
International Economics
COMPACT EXAM HANDBOOK
KU Leuven – Faculty of Economics and Business
Prof. Eline Poelmans
Crash Course · Compact Textbook · Exam Survival Guide
Rania El Ghalbzouri Page 1
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
International Economics – Table of Contents
International Economics – Table of Contents ................................................................... 2
Chapter 1: Introduction to International Economics ........................................................ 4
1. What Is International Economics About? ................................................................. 4
2. The Gains and Losses from International Trade ....................................................... 5
3. The Pattern of Trade ................................................................................................ 6
4. How Much Trade? The Role of Government Policy ................................................... 6
5. International Finance ............................................................................................... 7
6. Course Overview and Scope .................................................................................... 7
7. Chapter Summary.................................................................................................... 7
Chapter 2: World Trade — An Overview .......................................................................... 8
1. Who Trades with Whom? ......................................................................................... 8
2. Impediments to Trade: The Border Effect ............................................................... 11
3. The Changing Pattern of World Trade .................................................................... 13
4. Chapter Summary.................................................................................................. 15
Chapter 3: Labour Productivity and Comparative Advantage — The Ricardian Model .... 16
1. Introduction........................................................................................................... 16
2. Who Was Ricardo? — Historical and Social Context .............................................. 16
3. Today — Is Ricardo’s Idea Still Valid? .................................................................... 16
4. The Ricardian Model: Assumptions and Concepts .................................................. 17
5. The Ricardian Model in Autarky ............................................................................. 20
6. International Trade in the Ricardian Model ............................................................ 21
7. Misconceptions about Comparative Advantage ...................................................... 27
8. Transportation Costs and Non-Tradable Goods ..................................................... 28
9. Empirical Evidence for the Ricardian Model ........................................................... 28
10. Chapter Summary ................................................................................................ 30
Chapter 4: Specific Factors and Income Distribution ..................................................... 31
1. Introduction........................................................................................................... 31
2. Assumptions of the Specific Factors Model ............................................................ 31
3. The Specific Factors Model in Autarky ................................................................... 32
4. International Trade in the Specific Factors Model .................................................. 38
5. Chapter Summary ................................................................................................ 42
Chapter 5: Resources, Comparative Advantage, and Income Distribution — The
Heckscher-Ohlin Model ................................................................................................ 43
1. Introduction........................................................................................................... 43
Rania El Ghalbzouri Page 2
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
2. Assumptions of the Heckscher-Ohlin Model........................................................... 43
3. The Model of a Two-Factor Economy ...................................................................... 43
4. International Trade Between Two Two-Factor Economies...................................... 50
5. Empirical Evidence ................................................................................................ 54
6. Chapter Summary.................................................................................................. 59
Chapters 7 & 8: Economies of Scale, Imperfect Competition, and International Trade ... 60
1. Introduction........................................................................................................... 60
2. Increasing Returns to Scale.................................................................................... 60
3. Economies of Scale and Market Structure .............................................................. 61
4. External Economies of Scale (Chapter 7) ................................................................ 61
5. External Economies and International Trade.......................................................... 62
6. Internal Economies of Scale (Chapter 8) ................................................................. 65
7. Comparative Advantage vs. Internal Economies: Pattern of Trade .......................... 66
8. Trade Costs and Export Decisions.......................................................................... 68
9. Chapter Summary.................................................................................................. 69
Chapter 9: The Instruments of Trade Policy .................................................................. 70
1. Introduction........................................................................................................... 70
2. Types of Trade Barriers.......................................................................................... 70
3. Cost-Benefit Analysis of a Tariff ............................................................................. 70
4. Chapter Summary.................................................................................................. 75
Exam Checklist — Key Concepts by Chapter ................................................................. 76
Rania El Ghalbzouri Page 3
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Chapter 1: Introduction to International Economics
1. What Is International Economics About?
International economics studies economic interactions between countries and the
problems that arise from those interactions. The field covers two broad areas: trade in
goods and services (International Trade) and trade in financial flows and investments
(International Finance). At the beginning of the 21st century, countries are more
interconnected than ever — through trade in goods and services, through capital flows,
and through direct and portfolio investments.
Figure 1.1 — US Exports and Imports as % of National Income, 1960–2019 (source:
U.S. Bureau of Economic Analysis): Line graph with two series — exports (red) and
imports (blue) — both trending upward over the full period. Key takeaways: (1)
International trade has roughly tripled since 1960. (2) Both series fell sharply in 2009
during the global financial crisis. (3) Import growth has exceeded export growth, raising
the question of how the US finances this gap — answered by an influx of foreign capital,
which connects international trade to international finance.
The sharp long-run rise in trade is explained by three main drivers. First, there has been a
substantial decrease in trade barriers such as tariffs and quotas. Second, transport and
communication costs have declined dramatically: real ocean freight, air transport, and
international calling costs have all fallen by 80–95% since 1930. Third, the creation of free
trade areas — such as the EU, NAFTA, and CETA — has eliminated internal tariffs across
large trading blocs.
Rania El Ghalbzouri Page 4
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
2015 Data
2019 Data
Figure 1.2 — Average of Exports and Imports as % of National Income, selected
countries, 2015 (source: World Bank): Bar chart comparing six countries: U.S. (~12%),
Canada (~32%), Mexico (~35%), Germany (~40%), South Korea (~42%), Belgium (~83%).
The key takeaway is that most countries depend far more heavily on international trade
than the United States does. Belgium’s exceptionally high share reflects both its small
domestic market and its role as a transit and distribution hub within the EU single market.
Figure 1.2 (updated, 2019 data — source: World Bank): Same bar chart framework with
updated data. The ranking is slightly different (South Korea and Germany swap) but the
overall finding is unchanged: Belgium (~82–85%) remains the most trade-dependent
country in the comparison, while the US (~12%) remains the least dependent.
2. The Gains and Losses from International Trade
The following advantages and disadvantages form the conceptual backbone of the entire
course. Some are immediately intuitive; others will only become clear after studying the
models in Chapters 3–9.
2.1 Advantages (Gains from Trade)
1. Voluntary exchange benefits both parties. When buyers and sellers engage in a
voluntary transaction, both sides are made better off. For example, Norwegian consumers
import lemons they cannot produce domestically, while lemon producers earn income to
purchase other goods.
2. Every country gains from free trade, regardless of its efficiency level. Even if one
country is more productive in all sectors, trade is still mutually beneficial. Each country
specialises in the good(s) in which it is relatively most efficient and imports the rest. This
allows specialisation in a limited range of goods while consuming a wide variety through
trade. The common belief that trade is harmful when large productivity or wage
differences exist between countries is therefore wrong.
3. Factor abundance determines trade advantage. Trade benefits a country when it
exports goods that make intensive use of its abundant production factors and imports
goods that use its scarce factors. A country abundant in cheap unskilled labour, for
instance, has a natural advantage in labour-intensive goods such as textiles (Bangladesh,
Vietnam).
Rania El Ghalbzouri Page 5
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
4. Specialisation enables economies of scale. When countries specialise, each good is
produced at larger scale, lowering unit costs for all trading partners.
5. Intertemporal trade creates gains. Countries can also gain by trading current goods
or financial claims against future ones. An illustration: in the years following the 2008
financial crisis, China offered African governments loans in exchange for long-term
resource extraction rights — an exchange of present capital for future resources.
2.2 Disadvantages (Losses from Trade)
Trade is beneficial to a country as a whole, but may be detrimental to certain groups
within that country — the distribution of gains is uneven. Specifically:
• International trade can harm the owners of resources used intensively in industries
that compete with imports.
• Trade therefore affects the distribution of income within a country.
• Trade conflicts arise not so much between countries as between groups within a
given country — for example, between import-competing producers on one side and
consumers and export-industry workers on the other.
3. The Pattern of Trade
The pattern of trade asks: who sells what to whom? Four main explanations are developed
in this course. Differences in climate drive inter-industrial trade — Brazil exports coffee,
Australia exports iron ore. Differences in labour productivity (Chapter 3) and
differences in factor endowments — the relative availability of land, labour, and capital
— (Chapter 5) explain additional patterns of inter-industrial trade. Finally, economies of
scale (Chapters 7–8) explain intra-industrial trade, where countries both export and
import within the same industry category (e.g. cars of different varieties).
4. How Much Trade? The Role of Government Policy
Since World War II, industrialised countries have sought to remove obstacles to
international trade through bilateral agreements (e.g. NAFTA, CETA) and multilateral
frameworks (e.g. GATT and the WTO). At the same time, governments regularly intervene
to protect domestic industries from the adjustment costs of import competition. The anti-
globalisation movement, which gained significant influence after the 1999 Seattle WTO
protests, reflects broader public concern about the uneven distribution of trade’s gains.
The main trade policy instruments are (each analysed in detail in Chapter 9):
• Tariffs — a tax levied on imports (or, less commonly, exports).
• Import quotas — a legal limit on the quantity of a good that may be imported in a
given period.
• Export subsidies — government payments to domestic firms for each unit
exported.
• Voluntary Export Restrictions (VERs) — arrangements in which an exporting
country agrees to limit its own exports to avoid more severe restrictions being
imposed against it.
Rania El Ghalbzouri Page 6
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
5. International Finance
International finance (also called the international capital market) covers financial flows
between countries. Just as trade in goods has grown, cross-border capital flows have
expanded substantially. The main motives for these flows are: to finance trade; to finance
deficits in the balance of payments; for foreign direct investment (FDI) — involving direct
control over an enterprise abroad; and for portfolio investment — the purchase of stocks,
bonds, and other securities without direct management control. The distinction between
international trade and international finance is not always clean: decisions in either
domain can have significant consequences for the other.
6. Course Overview and Scope
Due to the limited number of contact hours, this course focuses exclusively on
international trade and primarily on its theoretical models. The course covers Chapters
1–9 of Krugman, Obstfeld & Melitz.
International trade theory (Chapters 2–8) examines how the international economy
works and which models explain trade patterns and their welfare effects. International
trade policy (Chapter 9) covers the costs and benefits of policy instruments such as tariffs
and quotas. Chapters 10–12 of the textbook and the full range of trade agreements are
covered in the separate elective master’s course International Trade and Politics, which
examines real-world trade relationships without formal models.
International finance (exchange rate policy, balance of payments, and the international
monetary system) is not covered in this course. Note also that Chapter 6 of Krugman,
Obstfeld & Melitz is not part of the syllabus and is omitted from these notes.
7. Chapter Summary
International economics studies economic interactions between countries, covering two
broad areas: international trade (goods and services) and international finance (capital
flows). The long-run rise in trade since 1960 is driven by lower trade barriers, falling
transport and communication costs, and the creation of free trade areas.
Trade benefits countries as a whole through five main channels: voluntary exchange gains,
comparative advantage (every country gains regardless of absolute efficiency), factor-
abundance advantages, economies of scale, and intertemporal trade. However, trade can
harm specific groups within a country — particularly those in import-competing industries
— generating distributional conflicts within rather than between nations.
The pattern of trade is driven by climate differences, labour productivity differences,
factor endowment differences, and economies of scale. Government policy instruments —
tariffs, quotas, export subsidies, and voluntary export restrictions — are used to affect
trade volumes, typically to protect domestic producers. These instruments and their
welfare effects are the subject of Chapter 9.
This course focuses on international trade theory (Chapters 2–8) and one chapter of trade
policy (Chapter 9). International finance and extended trade policy topics are covered in
separate elective courses.
Rania El Ghalbzouri Page 7
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Chapter 2: World Trade — An Overview
1. Who Trades with Whom?
1.1 The Gravity Model: Size and Distance
The gravity model asks: what determines the intensity of trade between two countries? The
name is borrowed from Newton’s law of universal gravitation (1687): just as every physical
particle attracts every other, with greater mass increasing attraction and greater distance
reducing it, so too in trade. Larger economies trade more with each other, and greater
distance reduces trade. The formal gravity model was developed in 1962. It captures both
effects in a single equation:
Tij = A × Yi × Yj / Dij
Tij = value of trade between country i and country j
A = a constant
Yi = GDP of country i; Yj = GDP of country j
Dij = distance between country i and country j
Interpretation: Trade volume between two countries is proportional to the
product of their GDPs and inversely proportional to the distance between them.
Empirical finding: A 1% increase in distance between two countries is associated
with a 0.7–1% decrease in trade volume. The model predicts well but not perfectly
— cultural ties, trade agreements, and geography also matter.
1.1.1 What Do the Empirics Tell Us?
Figure — Total U.S. Trade with Major
Partners, 2015 (source: U.S. Department
of Commerce): Horizontal bar chart
ranking approximately 15 countries by total
trade with the US (in USD billions). Top 5:
China (~$660B), Canada (~$580B), Mexico
(~$530B), Japan (~$190B), Germany
(~$175B). South Korea, United Kingdom,
France, Taiwan, India, Italy, Brazil,
Netherlands, Belgium, and Switzerland
follow.
Looking at 2015 data, the five biggest US trading partners were China, Canada, Mexico,
Japan, and Germany. China ranks first due to the sheer size of its economy. Canada and
Mexico, despite being relatively small economies, rank among the top three — an
observation that requires explanation beyond size alone, and which the gravity model
helps clarify. Germany, the UK, and France — the three largest European economies at the
time — were also in the top 10. Note: all textbook data pre-dates Brexit, so the UK is treated
as an EU member.
Rania El Ghalbzouri Page 8
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Figure — Total U.S. Trade with Major
Partners, 2019 (source: U.S. Department
of Commerce): Updated bar chart. Mexico
leads (~$670B), Canada follows closely, then
China (~$560B), Japan, Germany. Vietnam
and Ireland have entered the top 15. The
shift in China’s ranking from 1st to 3rd
reflects the trade tensions during Trump’s
first presidency.
By 2019, the same major traders dominated but the ranking shifted: Mexico moved to 1st,
Canada to 2nd, and China fell to 3rd. This reflects the tariff tensions introduced during
Trump’s first presidency, which discouraged US–China trade.
Two questions arise from these rankings: (A) why does the US trade more with some
European countries than others, given that all EU countries are roughly equidistant from
the US? And (B) why does the US trade so much with the relatively small economies of
Canada and Mexico?
A. Why does the US trade more with some European economies than others?
Since distance is roughly constant across EU countries, the key factor is the size of the
economy. Countries that account for a larger share of EU GDP also account for a
proportionally larger share of US–EU trade.
Figure — Size of European Economies and Value of Their Trade with the US, 2019:
Scatter plot with % of EU GDP on the horizontal axis (0–25) and % of US trade with the EU
on the vertical axis (0–25). A diagonal trend line runs from the origin to the top right.
Germany (largest EU economy at ~23% of GDP) plots furthest right and highest. United
Kingdom and France are in the middle. The Netherlands, Ireland, and Belgium plot above
the trend line — they trade more with the US than their GDP alone would predict. Austria,
Sweden, and Spain plot below the line.
Rania El Ghalbzouri Page 9
MBA Bridging Programme
, Macro- and International Economics – Compact Exam Handbook
Size matters because larger economies produce more goods and services, giving them
more to export; and higher incomes allow them to buy more imports. This relationship is
direct: a country that represents x% of EU GDP will account for roughly x% of US–EU trade
if size is the only factor.
However, some countries systematically deviate from the trend. The Netherlands and
Belgium trade more with the US than their GDP share predicts, reflecting their favourable
geography (major ports, river access, railway hubs) and their role as transit and
distribution centres for continental Europe. Ireland also exceeds expectations, partly due
to strong cultural ties with the US (shared language, large Irish-American diaspora) and
partly due to a business-friendly tax environment that attracts US multinationals. Spain,
Italy, and France trade somewhat less than their size would predict, likely reflecting
language barriers and different commercial orientations.
B. Why does the US trade so much with Canada and Mexico?
The Canadian economy is only slightly larger than the Spanish economy, yet US trade with
Canada alone equals approximately 70% of total US trade with the entire EU. The
explanation is distance and proximity: Canada and Mexico are small economies relative
to the EU, but they are immediate neighbours of the US, sharing land borders and
benefiting from the NAFTA agreement (1994, renegotiated by Trump in 2018 as USMCA).
Proximity reduces transport costs and facilitates the personal contacts and shared
business culture that support trade.
Rania El Ghalbzouri Page 10
MBA Bridging Programme
