Chapter 2: World Trade Overview
How much countries trade with each other depend on:
- Size of GDP: the more trade there is, the larger is either economy.
- Large countries have large incomes → spend more on imports. Also produce
a wide variety of goods → more export.
- Distance: the larger the distance between countries, the less trade there is between
them.
- Barriers: barriers, such as tariffs, make trading harder → less trade
- Solution: Trade agreement: often includes no tariffs or other barriers →
means more trade. Doesn’t make national borders irrelevant: still more
internal trade than trade with a country with an agreement
- Borders: national borders have negative impact on trade.
gravity model: equation that predicts the volume of trade between two countries
- Tij = A * Yai * Ybj / Dcij
- A = constant, Tij = value of trade between countries, Yx is each country’s
GDP, Dij = distance between countries
- a, b, c measure how important size and trade impediments are (the bigger the
more important)
- So: VoT is proportional to the GDP’s and diminishes with distance.
- But: not always proportional → Y’s and D get exponents to fit data
- doesn’t always predict well → look at the anomalies → answer lies in impediments to
trade
Changing pattern of World Trade
Progress in transportation and communication have made the world smaller.
- Distance has a less negative effect on trade in the gravity models
- Political force is still stronger than innovation in determining trade.
(protectionism, war)
vertical disintegration: products being assembled partly in different countries, increases
world trade artificially. $100 Product can be worth $300 in international trade flows
Trade includes mostly manufactured products, then primary goods (agri, raw materials) and
in recent years more and more services (call centers).
third world / developing countries: poorest nations, mostly former colonies.
- used to export mainly primary products, but now also manufactured goods.
service offshoring/outsourcing: a service previously done within a country is shifted
abroad.
, - Might become very big, as due to communication technology a lot of services can be
done abroad.
Chapter 3: The Ricardian Model
Trade can be good because of opportunity costs: it is not worth it to produce a lower value
item, if we can produce a higher value item with the same resources. Let others with lower
opportunity costs make the lower value item, and then use trade to benefit of that. Everyone
is better off.
comparative advantage: if the opportunity cost of producing a good is lower than in other
countries.
- Trade between countries benefits both countries if each country exports the goods it
has a comparative advantage in.
One-factor economy
Imagine an economy (Home) with one factor of production, which produces wine and
cheese.
unit labor requirement: # hours required to produce a kilo/liter of cheese/wine. Basically
how technologically advanced the economy is.
- aLW , aLC are the unit labour requirements for wine and cheese. L = total labor supply.
production possibility frontier: because of limited resources, there
are tradeoffs for production. Producing more wine means producing
less cheese.
- The limit: aLW *Q
w + aLC*Qc ≤ L
- The opportunity cost: # liters of wine required to give up to
produce 1 kilo of cheese.
- Opportunity cost of cheese i.t.o. wine = aLC / aLW
- Equal to absolute value of the slope
To determine what to produce: look at relative prices. Let Pc and Pw be the respective prices.
It takes aLC hours to produce a kilo of cheese, the wage for producing this is the value of
each hour worked producing it: Pc / aLC. For wine the same, wage = Pw / aLW
Everyone wants to work in the highest paying industry, so only when the wages in both
sectors are the same, both goods will be produced. So when Pc / Pw = aLC / aLW = opportunity
cost (see above).
- An economy will specialize in the production of good X, if the relative price of good X
exceeds the opportunity cost of good Y.
In the absence of international trade, the relative prices of goods are equal to the relative
unit labor requirements. (Because they produce both, and they only do that if this is true).
,Trade in One-Factor world
Two economies: Home and Foreign. One factor: labour. Two products: wine and cheese.
We use an asterix (*) to signify it belongs to Foreign.
Assumption: Home is less productive in producing cheese, but more in wine.
- aLC / aLW < a*LC / a*LW or aLC / a*LC < aLW / a*LW
- As Home has lower opportunity cost in producing cheese, it has a comparative
advantage in producing cheese.
absolute advantage: if a country can produce a good with less labor than another country.
- Shouldn’t confuse it with CA.
general equilibrium analysis: equilibrium
analysis that takes into account multiple
markets. Good for analysis of international
markets and trade.
- Use relative supply and demand
RS: relative supply
RD: relative demand
Equilibrium: RS = RD
Why does the RS curve looks so weird?
● There is no supply of cheese if Pc / Pw<
aLC / aLW . This is because the wage for
making wine will be higher then, so only
wine will be produced (see above). The same holds for Foreign, of course.
● We made the assumption that aLC / aLW < a*LC / a*LW , so at relative price below aLC /
aLW there will not be cheesy production anywhere in the world.
● If Pc / Pw= aLC / aLW , Home will produce both (can earn exactly the same no matter
what they produce) → flat line (flat due to relative price)
● If Pc / Pw> aLC / aLW → Home will specialize in cheese (only make that), because the
wages are higher. They produce L/aLC kilos of cheese. Then if Foreign specializes in
wine, they produce L*/a*LW litres of wine.
● So the relative production then is (L/aLC) / (L*/a*LW)
● IF Pc / Pw> a*LC / a*LW, then Foreign also only produces cheese → relative supply of
cheese is infinite → not on graph.
A Numerical example is on page 60.
, Gains from Trade
Countries gain from trade:
- Trade is indirect production. By producing cheese and not wine, but swapping this
cheese for wine it produces wine indirectly. This indirect production is more efficient
than producing it yourself
- Consider two ways to use an hour of labour. Home could produce 1 / aLW litres of
wine, or 1 / aLC kilos of cheese. The cheese could be traded for wine, for each kilo
you’d get Pc / Pw of wine. So: will gain from trading if (1 / aLC ) (PC / PW) > 1 / aLW
- Rewritten: you gain if PC / PW > aLC / aLW
relative wage: the amount a worker is paid per hour, compared to the wage of worker in a
different country. Ex, the rw could be 3
- The respective wages are based on the amount of each product they produce in an
hour multiplied by the price of the product.
- Lies between the ratios of the two countries’ productivities in the two industries.
- Home is 6x as productive in producing cheese, but only 1.5x in wine
- So relative wages (w / w*) lie between 6 and 1.5
Myths about free trade
Claim: Free trade is beneficial only if your country is strong enough to stand up to foreign
competition.
Actual: it is not necessary for a country to have an absolute advantage to gain from trade.
The gains depend on comparative advantages. The comparative advantage depends on the
domestic wage relative to foreign wage rate.
The Pauper Labor Argument
Claim: Foreign competition is unfair and hurts other countries when it is based on low
wages.
Actual: Whether a country gains from trade does not depend on the wage rate in the other
country. It only matters that is cheaper in terms of own labor f or the country to produce only
cheese and trade for wine.
Exploitation
Claim: Trade exploits a country and makes it worse off if its workers receive much lower
wages than workers in other countries
Actual: You should look at the alternative the low wage workers have. Often, by refusing
trade, the low wage workers would be paid even less.
How much countries trade with each other depend on:
- Size of GDP: the more trade there is, the larger is either economy.
- Large countries have large incomes → spend more on imports. Also produce
a wide variety of goods → more export.
- Distance: the larger the distance between countries, the less trade there is between
them.
- Barriers: barriers, such as tariffs, make trading harder → less trade
- Solution: Trade agreement: often includes no tariffs or other barriers →
means more trade. Doesn’t make national borders irrelevant: still more
internal trade than trade with a country with an agreement
- Borders: national borders have negative impact on trade.
gravity model: equation that predicts the volume of trade between two countries
- Tij = A * Yai * Ybj / Dcij
- A = constant, Tij = value of trade between countries, Yx is each country’s
GDP, Dij = distance between countries
- a, b, c measure how important size and trade impediments are (the bigger the
more important)
- So: VoT is proportional to the GDP’s and diminishes with distance.
- But: not always proportional → Y’s and D get exponents to fit data
- doesn’t always predict well → look at the anomalies → answer lies in impediments to
trade
Changing pattern of World Trade
Progress in transportation and communication have made the world smaller.
- Distance has a less negative effect on trade in the gravity models
- Political force is still stronger than innovation in determining trade.
(protectionism, war)
vertical disintegration: products being assembled partly in different countries, increases
world trade artificially. $100 Product can be worth $300 in international trade flows
Trade includes mostly manufactured products, then primary goods (agri, raw materials) and
in recent years more and more services (call centers).
third world / developing countries: poorest nations, mostly former colonies.
- used to export mainly primary products, but now also manufactured goods.
service offshoring/outsourcing: a service previously done within a country is shifted
abroad.
, - Might become very big, as due to communication technology a lot of services can be
done abroad.
Chapter 3: The Ricardian Model
Trade can be good because of opportunity costs: it is not worth it to produce a lower value
item, if we can produce a higher value item with the same resources. Let others with lower
opportunity costs make the lower value item, and then use trade to benefit of that. Everyone
is better off.
comparative advantage: if the opportunity cost of producing a good is lower than in other
countries.
- Trade between countries benefits both countries if each country exports the goods it
has a comparative advantage in.
One-factor economy
Imagine an economy (Home) with one factor of production, which produces wine and
cheese.
unit labor requirement: # hours required to produce a kilo/liter of cheese/wine. Basically
how technologically advanced the economy is.
- aLW , aLC are the unit labour requirements for wine and cheese. L = total labor supply.
production possibility frontier: because of limited resources, there
are tradeoffs for production. Producing more wine means producing
less cheese.
- The limit: aLW *Q
w + aLC*Qc ≤ L
- The opportunity cost: # liters of wine required to give up to
produce 1 kilo of cheese.
- Opportunity cost of cheese i.t.o. wine = aLC / aLW
- Equal to absolute value of the slope
To determine what to produce: look at relative prices. Let Pc and Pw be the respective prices.
It takes aLC hours to produce a kilo of cheese, the wage for producing this is the value of
each hour worked producing it: Pc / aLC. For wine the same, wage = Pw / aLW
Everyone wants to work in the highest paying industry, so only when the wages in both
sectors are the same, both goods will be produced. So when Pc / Pw = aLC / aLW = opportunity
cost (see above).
- An economy will specialize in the production of good X, if the relative price of good X
exceeds the opportunity cost of good Y.
In the absence of international trade, the relative prices of goods are equal to the relative
unit labor requirements. (Because they produce both, and they only do that if this is true).
,Trade in One-Factor world
Two economies: Home and Foreign. One factor: labour. Two products: wine and cheese.
We use an asterix (*) to signify it belongs to Foreign.
Assumption: Home is less productive in producing cheese, but more in wine.
- aLC / aLW < a*LC / a*LW or aLC / a*LC < aLW / a*LW
- As Home has lower opportunity cost in producing cheese, it has a comparative
advantage in producing cheese.
absolute advantage: if a country can produce a good with less labor than another country.
- Shouldn’t confuse it with CA.
general equilibrium analysis: equilibrium
analysis that takes into account multiple
markets. Good for analysis of international
markets and trade.
- Use relative supply and demand
RS: relative supply
RD: relative demand
Equilibrium: RS = RD
Why does the RS curve looks so weird?
● There is no supply of cheese if Pc / Pw<
aLC / aLW . This is because the wage for
making wine will be higher then, so only
wine will be produced (see above). The same holds for Foreign, of course.
● We made the assumption that aLC / aLW < a*LC / a*LW , so at relative price below aLC /
aLW there will not be cheesy production anywhere in the world.
● If Pc / Pw= aLC / aLW , Home will produce both (can earn exactly the same no matter
what they produce) → flat line (flat due to relative price)
● If Pc / Pw> aLC / aLW → Home will specialize in cheese (only make that), because the
wages are higher. They produce L/aLC kilos of cheese. Then if Foreign specializes in
wine, they produce L*/a*LW litres of wine.
● So the relative production then is (L/aLC) / (L*/a*LW)
● IF Pc / Pw> a*LC / a*LW, then Foreign also only produces cheese → relative supply of
cheese is infinite → not on graph.
A Numerical example is on page 60.
, Gains from Trade
Countries gain from trade:
- Trade is indirect production. By producing cheese and not wine, but swapping this
cheese for wine it produces wine indirectly. This indirect production is more efficient
than producing it yourself
- Consider two ways to use an hour of labour. Home could produce 1 / aLW litres of
wine, or 1 / aLC kilos of cheese. The cheese could be traded for wine, for each kilo
you’d get Pc / Pw of wine. So: will gain from trading if (1 / aLC ) (PC / PW) > 1 / aLW
- Rewritten: you gain if PC / PW > aLC / aLW
relative wage: the amount a worker is paid per hour, compared to the wage of worker in a
different country. Ex, the rw could be 3
- The respective wages are based on the amount of each product they produce in an
hour multiplied by the price of the product.
- Lies between the ratios of the two countries’ productivities in the two industries.
- Home is 6x as productive in producing cheese, but only 1.5x in wine
- So relative wages (w / w*) lie between 6 and 1.5
Myths about free trade
Claim: Free trade is beneficial only if your country is strong enough to stand up to foreign
competition.
Actual: it is not necessary for a country to have an absolute advantage to gain from trade.
The gains depend on comparative advantages. The comparative advantage depends on the
domestic wage relative to foreign wage rate.
The Pauper Labor Argument
Claim: Foreign competition is unfair and hurts other countries when it is based on low
wages.
Actual: Whether a country gains from trade does not depend on the wage rate in the other
country. It only matters that is cheaper in terms of own labor f or the country to produce only
cheese and trade for wine.
Exploitation
Claim: Trade exploits a country and makes it worse off if its workers receive much lower
wages than workers in other countries
Actual: You should look at the alternative the low wage workers have. Often, by refusing
trade, the low wage workers would be paid even less.
