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International economics is a macroeconomic discipline studying general principles,

conditions and participants of exchange in the world market. It can be divided into
two parts: International Trade and International Finance.

International trade deals with:

o International trade theory analysis of the basis for trade, trade
patterns, and gains from trade.
o International trade policy examination of reason for and effects of
different trade instruments, economic integration, international trade
institutions and organizations, international trade strategy
International finance deals with open-economy macroeconomics:
o Theory of international finance balance-of-payments, exchange rates
regimes, adjustment
o International monetary policy monetary integration, international


Trade theory is the product of an evolution of ideas in economic thought.

Mercantilism was the first complete view on international trade. It appeared during
the period of colonialism and the discovery of the new world.
The wealth of nations was measured by the stock of precious metals the more
gold and silver a nation had, the richer and more powerful it was.

The main goal of the economic policy was to increase wealth.

o By growth in production of precious metals
o By war and robbery
o By surplus in foreign trade (government regulation in foreign trade
restricting import and stimulating export)

Mercantilists preached economic nationalism national interests were basically in

conflict; one nation could gain only at the expense of other nations.

Zero-sum game if one wins, the other must lose.


Classical trade theories presented the beginning of scientific research of the basis
for trade and they provided cognition of importance of specialization and
international division of labor for international trade. They gave a partial
explanation of international trade flows.
Some limitations of classical theories include: simplified models with abstract
assumptions, statical view of comparative advantages, analysis of the supply side
only, failure to identify causes of cost differences, and failure to explain incomplete


Basic assumptions:

2 x 2 x 1 (2 countries, 2 goods, 1 factor of production)

Labor theory of value
Constant costs
Perfect competition
Full employment
Free trade
Zero transportation costs
Perfect mobility of production factors (labor) within and between countries

Production differences (costs differences) govern the movement of goods among

nations. A country has an absolute advantage if it is the most efficient country in
producing a certain good.
We calculate the absolute advantage by comparing production costs for a unit of
the certain product within two countries.

aLp< aL pf
aLp labor costs for production of a unit of a certain product in the domestic
aLpf labor costs for production of a unit of a certain product in the foreign country
Each country does not attempt to produce all the commodities it needs; it
specializes in the production of the products it can produce most efficiently and
then exchange it for all other products it needs.
World resources will be utilized most efficiently and the world output and welfare
will maximize if countries specialize according to their absolute advantages.

All countries benefit from mutual trade international trade is a positivesum game


Basic assumptions:

2 x 2 x 1 (2 countries, 2 goods, 1 factor of production)

Labor theory of value
Constant costs
Perfect competition
Full employment
Free trade
Zero transport costs
Perfect mobility of labor between industries within a country and no
international mobility
Fixed but different technology between countries
Fixed resources, technology, tastes, etc.

The Ricardian model is the simplest model that shows how differences between
countries give rise to trade and gains from trade. In this model, labor is the only
factor of production, and countries differ only in the productivity of labor in different
In the Ricardian model, countries will export goods that their labor produces
relatively efficiently and will import goods that their labor produces relatively
inefficiently. In other words, a countrys production pattern is determined by
comparative advantage.
We can show that trade benefits a country in either of two ways. First, we can think
of trade as an indirect method of production. Instead of producing a good for itself,
a country can produce another good and trade it for the desired good. The simple
model shows that whenever a good is imported, it must be true that this indirect
production requires less labor than direct production. Second, we can show that
trade enlarges a countrys consumption possibilities, which implies gains from

There is an equal distribution of gains international trade is a positive-sum


Comparative advantages are calculated by comparing relative unit costs of

production (comparing ratios of unit costs).

aLx aL x f
aLy aL y f
aLx time/labor costs for production of a unit of product x in the domestic country
aLy time/labor costs for production of a unit of product y in the domestic country
aLxf time/labor costs for production of a unit of product x in the foreign country
aLyf time/labor costs for production of a unit of product y in the foreign country


Former theories exclusively analyzed the supply side of the market as the
determinant of relative product prices. J.S.Mill left the labor theory of value and
introduced the demand side of the market.

Export price is determined by reciprocal demand intensity.

Reciprocal demand is the demand of each of two countries for the export product of
the other one.
A country with lower productivity can reach better terms of trade depending on
demand conditions in the market.


Neoclassical trade theories share numerous characteristics with classical trade
theories. At the same time, neoclassical theories have changed some key elements
of classical theories.

Several assumptions: full employment, perfect competition, free trade

Thesis on reason for trade based on comparative advantages principle

Neoclassical theories have made the next step offering an explanation (although
only a partial one) of causes of comparative costs differences.

Two or multi-factor models

Abandonment of labor theory of value
Costs expressed in money terms instead of physical product units
Both constant and variable costs
Both complete and incomplete specialization
Transportation costs


Basic assumptions:

2 x 2 x 3 (two countries, two commodities, three factors of production)

Perfect competition
Free trade
Full employment
Increasing costs

Haberler introduced a new element in his analysis the principle of marginal costs
(the price is equal to the marginal production costs, i.e. equal to the amount to be
paid for all factors required for production of an additional product unit).

A country has a comparative advantage in some product if it can produce an

additional unit of that product at lower opportunity costs (expressed in terms of
another product) than the other country can.
Opportunity costs can be illustrated by the production possibilities frontier; the
slope of the PPF is equal to opportunity costs.

PPF indicates the maximum amount of any two products an economy can
produce, assuming that all resources are used in their most efficient manner
(full employment)

Marginal rate of transformation:

The slope of the PPF provides a measure of the MRT, which indicates the
amount of one product that must be sacrificed in order for an additional
unit of another product to be produced.


M Cs
M Ct

Terms-of-trade between two products are equal to the relation of their marginal
costs. The production of one product can be increased only at the expense of
another product, indicating that terms-of-trade are equal to the relation of the
substitution costs:

P s MC s t
Pt MC t s

Under constant cost conditions, terms-of-trade between two products are

equal to the relation of their marginal costs and to the relation of their
o PPF is a straight line and identical to the price line
o Amount of some product to be sacrificed in order to produce a new
unit of another product is always the same.
Under changeable cost conditions, terms-of-trade are determined by marginal
not average costs (INCOMPLETE SPECIALIZATION a country meets its needs
in some product partly from domestic production and partly from imports)
o PPF is a concave line to the diagrams origin and it is not identical to
the price line the price line is tangent to the PPF.
o Under increasing-cost conditions sacrificed amount of some
product increases for each new unit of another product.
o Under decreasing-cost conditions sacrificed amount of some
product decreases for each new unit of another product.

The H-O theory is also known as the general-equilibrium theory, the factor
endowment theory, and the theory of factor proportions.
The H-O theory has some similarities with Ricardos theory:

The common basis the identical explanation of reason for trade by

comparative costs differences

Numerous identical assumptions of models

There are also many differences:

Different explanation of sources of comparative advantages in H-O theory,

comparative advantages do not stem from differences in productivity than
from differences in factor endowment.
Some of the basic assumptions are different.

The H-O theory relies on two main characteristics of countries and products:
countries differ by factor endowment and products differ by factor intensity.

Relative factor endowment can be defined in two ways:

o By physical units of factors the quantitative definition a country is
considered to be relatively capital abundant not if its total amount of
capital is bigger than total amount of capital in the other country. It is
capital abundant if its ratio of the total amount of capital to the total
amount of labor is higher than the ratio in another country

TK 1 TK 2

By factor prices the price definition a country is relatively capital

abundant if its ratio of interest rate (price of capital) to wage (price of

PK 1 PK 2

labor) is lower than that ratio in another country.

r1 r2
w1 w 2
A product is capital-intensive if the ratio of capital to labor in its production (K/L) is
bigger than that ratio in production of another product.

( KL ) >( KL )

As long as a country produces both goods, there is a one-to-one relationship

between the relative prices of goods and the relative prices of factors used to
produce the goods. A rise in the relative price of the labor-intensive good will shift
the distribution of income in favor of labor, and will do so very strongly: the real
wage of labor will rise in terms of both goods, while the real income of capital
owners will fall in terms of both goods.
An increase in the supply of one factor of production expands production
possibilities, but in a strongly biased way: at unchanged relative goods prices, the
output of the good intensive in that factor rises while the output of the other good
actually falls.

A country that has a large supply of one resource relative to its supply of other
resources is abundant in that resource. A country will tend to produce relatively
more of goods that use its abundant resources intensively.

A capital-abundant country exports capital-intensive products and a laborabundant country exports labor-intensive products.

H-O-S Theorem: international trade will bring about equalization in the relative and
absolute returns to homogeneous factors across nations.
Stolper-Samuelson Theorem in free trade conditions
production factor gains and relatively scarce factor loses.



The H-O theory was the dominant explanation of international trade in the period
1930-1960. The first empirical test was undertaken by Wassily Leontief; unexpected
findings which contradicted the predictions of H-O theory, became known as the
Leontief Paradox.

Leontief found that the United States, despite having a relative abundance of
capital, tended to export labor-intensive goods and import capital-intensive


In conventional theories, the production possibilities are given and fixed.

Ricardos model no technological change, given but different technology

between countries.
H-O model no technological change, given but the same technology
available to all countries.

In new theories, there is a continuous moving of PPF due to:

Increase in factor supply

More efficient use of factors (because of technological exchange)

There is also different technology between countries and technological change as a

new reason for trade.
New theories consider technology as very important for the explanation of basis for
trade. Technological innovations have strong effects on production, thereby
influencing intensity, structure, and profitability of international trade. There are
different technological innovation types:

Improvement in production process of some product

Improvement in product characteristics
Introduction of a new product


Economic growth is the growth in potential output; the PPF shifts outward. It causes
change in production and consumption that have important implications on
international trade. The theory analyzes two types of effects:

Effect of growth in factor supply and effect of technological changes on

economic growth
o Factor endowments change over time
o Growth in factor supply might lead to balanced or imbalanced
economic growth
Balanced growth growth in supply of all factors at the same
rate PPF moves symmetrically (evenly in all directions)
Imbalanced growth (biased growth) growth in supply of only
one factor or faster growth in supply of one factor compared to
the growth of the other one PPF shifts out asymmetrically
Effect of economic growth on international trade

Rybczynski theorem: at constant product prices, an increase in the endowment of

one factor will increase the output of the product intensive in that factor and will
reduce the output of the other product which is intensive in the other factor.

Export-biased growth growth biased toward the good a country exports; PPF
expands disproportionately; tends to worsen a growing countrys terms-oftrade to the benefit of the rest of the world.
Import-biased growth growth biased toward the good of a country imports,
tends to improve a growing countrys terms-of-trade at the rest of the worlds
Immiserating growth

Technological progress changes a way of use of factors in production enabling the

same output to be produced with fewer inputs. There are three types of technical
progress neutral, labor-saving, and capital saving.
The effect of economic growth on trade depends on the net results of growth on
production and consumption (relation of production growth in export products and
import-substitutive products and on consumption structure).

Neutral growth trade and output grow at the same rate

Protrude growth faster growth of trade
Antitrade growth faster growth of output


The technological gap theory proposes that changes in international trade are
dictated by the relative technological sophistication of countries.
The basic assumption is that international trade can be based on differences in
technological changes over time among countries because of a time lag in transfer
of technology. Innovation creates a technological gap which provides for a
temporary monopoly in the world market.

Technological innovations create dynamic comparative advantages

comparative advantages can be changed or created due to technological
change and diffusion of technology.


This theory focuses on the role of technological innovation as a key determinant of
trade patterns in manufactured products.
Differences compared to conventional theories:

Different technology between countries

Technology changes over time
Capital moves among countries
Focus on a product and not on a country
Limited usability only for technology-intensive products
Analysis of both supply-side factors (costs) and demand-side factors (income)
Dynamic comparative advantages

Phases of the product life cycle:

1. New product phase highly skilled labor
2. Product-growth phase scale economy
3. Product-maturity phase cheaper labor
There are different factor requirements in each phase and therefore each phase has
a different effect on trade patterns.
The more standardized a product becomes, the more his production moves to lower
income countries with low labor costs that in this phase are more important than
R&D expenses.
During this cycle, an innovator country initially is an exporter, then loses its
advantage vis--vis its trading partners, and eventually may become an importer of
the product at the end of the cycle. Later phases are characterized by lack of
innovation and by emphasis on factor endowments. When a product life cycle foes
toward its end, explanation of comparative advantages becomes closer to the
explanation given in the H-O theory.

Basic assumptions:

Imperfect competition
Increasing return (economies of scale)
Product differentiation

Structure of international trade is different than it has been presented in

conventional models: developed countries trade much more mutually than with

developing countries, and they trade in similar products, not in products of different
The basis for trade in primary and secondary products is not identical explanation
of trade in primary products is supply-side based, and explanation of trade in
industrial products is demand-side based.

Basis for trade in primary products difference in relative factor endowment

Basis for trade in industrial products similarity in demand structure
o Thesis on similar consumers preferences international trade in
industrial products depends much more on similarities of consumers
preferences, than on cost differences.

The more similar demand structure among countries is, the bigger their mutual
trade in industrial products will be.

Demand structure is determined by consumers preferences and income by

producers preferences.
Domestic demand determines both exports and imports commodity structure,
providing they are similar.

Implicitly, Linders theory concludes that the same products can be traded in both
directions a country can export and import the same products simultaneously.


Basic assumptions:

Imperfect competition
Increasing returns economies of scale
Product differentiation

Economies of scale means decrease of average costs of a product in long-term,

based on the increase of output. Increasing returns to scale refers to the production
situation where output grows proportionately more than the increase in inputs or
factors of production (if all inputs are doubled, output is more than doubled).
Internal economies of scale:

Average costs depend on the size of an individual company but not

necessarily on that of the industry
A company specializes in only one or a few product varieties
A company with an internal economy of scale is large and can monopolize an
Internal economy of scale creates imperfect competition in the industry

External economies of scale:


Average costs depend on the size of the industry but not necessarily on the
size of any company
Single companies might not be large, but they cooperate within an industry

The market consists of many small companies and is perfectly competitive

A country can dominate the world market


Emphasis on productivity as the key determinant of international competitiveness,
Porters theory successfully combines some thesis and characteristics from
conventional and new theories.

It combines macro and micro view competitiveness and international trade

are analyzed both from the point of view of a company as the main subject
and from the point of view of a national economy as the creator of business
It combines elements of supply-side of the market (factor endowment) and
demand-side (market conditions).

According to Porter, the primary economic goal of a country is high and increasing
level of living standards. The countrys capability to reach the main goal depends on
productivity in using its resources, i.e. of business and institutional environment
enabling a productive use and improvement of countrys resources.
Porter has explained his theory by creating the diamond of national advantages:

Factor conditions
Demand conditions
Related and supporting industries
Firm strategy, structure, rivalry

Outside factors are chance and government.


Inter-industry trade is international trade in products of different industries.
Intra-industry trade is international trade in product within the same industry. It is a
two-way trade in products connected either in supply and/or demand. Three criteria
are frequently used to classify products in the same industry:
1. Substitution in production
2. Substitution in consumption
3. Identical technology intensity
Explanation of circumstances in which IIT appears is in geographical, temporal,
production, and/or market factors.
Reasons for IIT:

In homogenous products
o Aggregation bias

o Cross-border trade
o Differentiation in time (trade in seasonal goods)
o Joint production and consumption
o Re-export
o Offshore processing
o Oligopolistic behavior
In horizontal/vertical differentiated products:
o Consumer preferences
o Scale economy
o Foreign direct investment

It is more possible for intensive IIT to appear between larger, more developed
countries and countries that are more similar or geographically closer.
There are two types of IIT:
1. Horizontal exchange of products within the same industry that are imperfect
substitutes, since they satisfy the same need and are of approximately same
quality but have different individual features.
2. Vertical exchange of similar products within the same industry, but products
of different quality levels.
Determinants of IIT:

Country-specific characteristics (demand side)

o Common characteristics (all countries in a model)
o Specific characteristics (certain countries in a model)
Industry-specific characteristics (supply side) characteristics of products
and characteristics of market of an industry


An open economy is one with a high level of trade liberalization while a closed
economy is one with numerous and very high trade barriers.
In todays world, practically all nations impose some restrictions on flows of goods
and services.
A foreign trade policy is a system of instruments or measures used by the
government in order to regulate the exchange of goods (to limit or to stimulate).

It is based on the dominant view on foreign trade in a certain period

There is an emphasis on import restrictions

There are two types of foreign trade policy:

1. Passive includes restrictions on import and export flows
a. Protection of domestic producers
b. Protection of domestic consumers
c. Protection of balance-of-payments

d. Increasing budget revenues

2. Active includes instruments of export promotion
a. Promotion of production and export
Necessary conditions for creating and implementing an adequate protection policy:

Single national economic area

Political willingness for protection of domestic production
Instruments for protection and criteria for their use (what, which industries,
industrial policies, by what, how much, and how long to protect)

Main groups of instruments:

Non-tariff barriers
o Traditional barriers quantitative restrictions and others
o Indirect protectionism administrative and technical barriers
Export promotion measures

A tariff is a tax (duty) levied on a product when it crosses national boundaries.
There are many different ways to classify tariffs:

By type of trade flow

o Import tariffs most widespread
o Export tariffs rare or prohibited
o Transit tariffs do not exist anymore
By main function
o Protective tariffs work to protect domestic producers and consumers
as well as the balance of payment.
A prohibitive tariff is one that reduces imports to zero.
o Revenue tariffs work to increase budget revenues.
By trade relations
o Autonomous (maximal) tariffs no trade agreements
o Conventional (minimal) tariffs trade agreements
By way of determination
o Ad valorem tariffs based on value; expressed as a fixed percentage of
the products value.
Advantages: distinguishing among small differentials in product
quality, maintaining a constant degree of protection in the
period of changing prices.
Disadvantage: customs valuation
o Specific tariffs based on quantity or weight; expressed in a fixed
amount of money per physical unit of a product
Advantages: easy to apply and administer, particularly to
standardized products, easy to determine

Disadvantages: cannot be applied on all kinds of goods, degree

of protection varies inversely with changes in import prices
o Compound tariffs a combination of ad valorem and specific tariffs
By country of origin
o Unitary tariffs
o Differential tariffs leads to a different treatment of goods originated
from different countries (they have political character).
Preferential tariff a lower (or zero) tariff on a product from one
country than is applied to imports from most countries
Retorsive tariff a tariff imposed for a purpose to force other
country to release.
For equalizing
o Anti-dumping for neutralizing dumping tariff levied on dumped
Dumping is when the export price is unfairly low either below
the home market price or below cost.
o Countervailing for neutralizing export subsidies tariff levied against
imports that are subsidized by the exporting countrys government,
designed to countervail the effect of the subsidy.

Effect on import: tariffs reduce import directly through their impact on product

Tariff increase in import price decrease in import demand decrease in


Effect on prices: a tariff can raise the prices of imported goods for the amount of the
tariff, less than the amount of the tariff, or more than the amount of the tariff.
Effect on domestic production: tariff increase in price of imported goods
increase in demand for domestic substitute increase in domestic production
Effect on domestic consumption: decreasing and diverting of domestic consumption
Protective effect:

In the short-run, the effect is positive because of the increase in domestic

In the long-run, the effect is negative because of the isolation of domestic
producers from foreign competition.
It depends on the elasticity of foreign export supply:
o In case of perfectly inelastic foreign supply, there is no protective
effect at all.
o In case of perfectly elastic foreign supply, protective effect becomes
prohibitive and import stops.

Revenue effect: increase in budget revenue; revenues from tariffs can be used for
increasing budget surplus, increasing of government spending (reduction of income
taxes). It decreases the deflationary effect and increases protective effect (because
of increased consumption of domestic goods)
Redistributive effect: redistribution of income from domestic consumers to domestic
producers. It is biggest for most efficient producers who get extra profit from tariffs.
Effects on terms-of-trade: depends on the price elasticity of foreign supply:

In case of an elastic foreign supply, a tariff does not improve terms of trade
In case of inelastic foreign supply, a tariff improves terms of trade, but
eliminates the protective effect, effect on domestic consumption, and
redistributive effect.

Effect on employment: leads to reallocation of resources to protected industries if

there are not unemployed capacities.

Tariff decrease in import increase of consumption of domestic goods

increase of domestic production increase of income in protected industries.

Effect on balance of payments: decrease in import and outflow of foreign currencies

(biggest in case of prohibitive tariff)
Effect on currency: reduces import by raising price of imported goods, similar to
selective currency devaluation.
Effect on reallocation of resources: resources are reallocated to less efficient
Costs and benefits for a small nation: an import tariff in a small nation redistributes
income from domestic consumers (who pay higher price for the commodity) to
domestic producers of the commodity (who receive the higher price). This leads to
inefficiencies (protection costs of a tariff).

A small nation always loses form the imposition of the import tariff.

Consumer surplus is the difference between what consumers are willing to pay for
each unit of the commodity and what they actually pay.
Producer surplus is a payment that need not to be made in the long run in order to
induce producers to supply a specific amount of a commodity.
Costs and benefits for a large nation: a tariff raises the price of a good in the
importing country, making its consumer surplus decrease (making its consumers
worse off consumption effect) and making its producer surplus increase (making
its producers better off redistributive effect)

Government revenue will increase



Import Quota


Net Revenue











falls for small


no change:
rents to license
falls for small

no change:
rents to


International economic integration is a process or a stage of institutional integrating
of countries, mostly at the regional level, by liberalization of trade and/or
liberalization of factor movement.

It is a process of eliminating restrictions on international trade, payments,

and factor mobility.

There are different types of integration:

By subjects:
o Functional integrations trans-national corporations
o Institutional integrations countries
By sectoral scope:
o Sectoral integration
o Total integration
By level of development of members
o Among developed countries
o Among developing countries
o Among developed and developing countries
By symmetry of obligations
o Symmetrical
o Asymmetrical

There are two aspects of economic integration: trading aspect (merchandise

exchange) and non-trading aspect (monetary arrangement, factor movements).
Stages of Economic Integration:

Preferential trading agreement

Free trade area (FTA)
o Free movement of goods, individual customs tariffs, rules of origin
Customs union (CU)

Free movement of goods, common customs tariff, dividing of tariff

revenues (Benelux, MERCOSUR)
Common market (CM)
o Free movement of goods, free factor movement, common customs
tariff (CARICOM)
Economic union (partial or total)
o Partial economic union free movement of goods, services, and factors
of production, common trade policy, harmonized fiscal, monetary,
industrial, and other economic policies.
o Total economic union free movement of goods, services, and factors
of production, single currency, single economic policy, supranational
institutions (EU)


Import substitution is an attempt to replace import by domestic production. It
encourages domestic industry.

Prominent state intervention in foreign trade

Subsidies for protected industries

1. Raising trade barriers, especially on import of consumer goods
2. Development of domestic industry, first in production of consumer goods,
than in intermediate goods
3. Increase in export
Motives and arguments:

Infant industry argument protection for industries in the early stage of

development in order to achieve scale economy and high level of
Balance-of-payment arguments
Decrease in economic dependence on foreign market
Increase in public revenues
Increase in employment
Attracting foreign direct investment

Potential long-term effects: benefits from industrialization and increase in export

Positive results at the very beginning: relatively easy and fast development in
manufacturing production and increase in production and employment.
Weaknesses and costs: inefficient and expensive industries, further worsening of
trade balance, overvalued currency in order to encourage import of capital goods
but therefore decreasing in competitiveness of export on primary products.

Export promotion improves exports, based on free trade and higher competition.

Trade liberalization reduction in barriers to import

Declaratively advocating free trade and market forces as drivers of efficiency,
but in practice: prominent state intervention industrial policies and export

Export promotion of primary products:

Largely implemented in developing countries

Best results in export of oil and some minerals
Insufficient export expansion because of:
o Bad climate conditions, old technology and limited resources
o Low price elasticity of demand decreasing trend in prices of primary
products and export revenues
o Low population growth in developed countries
o Development of synthetic substitutes

Export promotion of industrial products:

1. Improvement in production and export of cheap labor-intensive products
2. Production of more sophisticated industrial products based on improvement
in technology, infrastructure development, and skilled labor force.

Concentration on cheap labor-intensive products because of endowment of

cheap labor
Protection measures in developed countries.

Economic Integration
The strategy of economic integration means orientation to joining some economic
integration that already exists or establishing a new economic integration, mostly
with countries belonging to the same region.

Trade liberalization within the integration

Increasing barriers in trade with outsider
Characteristics of trade policy of member countries mostly depend on
integration level.

Motives for integration political and economic most common motives: broader
market, foreign investment