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Master in Human Development and Food Security

2014-2015

International Economics
Lecture 1

Dr. Silvia Nenci


University of Roma Tre
silvia.nenci@uniroma3.it

Silvia Nenci
Trade Issues’ Outline

First lecture:
• Introduction to International Trade
• Stylized facts
• Reasons for trade
• The law of comparative advantage
• The Ricardian Model

Silvia Nenci
The basics of world trade
 Movements of goods and services (imports &
exports)
 Trade balance: difference between a country’s total
value of exports and its total value of imports
• Trade surplus
surplus: when countries export more than they
import (i.e. China)
• Trade deficit:
deficit when countries import more than they
export (i.e. the USA)

Silvia Nenci
The evolution of international trade:
some key facts

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Is trade today different from the past?
Yes
1. There is more international trade today than in the
past

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The Volume of World Trade, 1850-2010

(in log scale)


Sources: Irwin & O’Rourke, 2011

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Percentage Change in World Trade
Volume, 1850-2010

U.S. Recession (1958) Volcker disinflation (1981-82)


U.S. Civil War (1861-62)
OPEC oil shock (1974)

Financial crisis (2009 - )


Great Depression (1930-32)

Notes: The declines in 1892, 1908, 1930-32, and 2009 were associated with financial or banking crises on a global scale

Sources: Irwin & O’Rourke, 2011


Silvia Nenci
Great Depression and world trade:
the Contracting Spiral of World Trade
January 1929-June 1933 (in
millions of U.S. (gold)
dollars)

Source: Eichengreen&Irwin, 1995


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Two waves of globalization

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Is trade today different from the past?
Yes
1. There is more international trade today than in the
past
2. And the type of trade has also changed

Silvia Nenci
The Changing Face of U.S. Import and Export
Industries
Goods category:
• foods, feeds, and
beverages;
• Industrial supplies and
materials (raw materials
and basic processed
goods – steel, textiles,
etc)
• Capital goods (durable
goods, i.e.aircraft, cars,
computers, machinery,
etc)
• Finished consumer goods

Figure 1.1 The Changing Face of U.S. Import and Export Industries, 1925–2009
Feenstra and Taylor: International Economics, Second Edition Silvia Nenci
Copyright © 2011 by Worth Publishers
What do we export today?
The types of goods traded have changed drastically over the last decades

Source: WTO, 2013


Silvia Nenci
World Trade Flows:
players and destinations

The amount of
trade is illustrated
by the width of the
lines

Main trends:
1. the leading role of Europe in world trade (31%); possible
reasons?
2. the large amount of trade flows at regional level (within
Europe, within the Americas (11%) and between Asian
countries);
3. a relevant trade link between the United States and Europe
(about 37%); why?
Figure 1.2 World Trade in Goods, 2006 ($ billions) 4. the important share of world trade coming from Asia; why?
Feenstra and Taylor: International Economics, Second Edition 5. the marginal position of Africa (that accounts for only 2.5%
Copyright © 2011 by Worth Publishers of World trade), and its close relationship with European
Silvia Nenci
countries.
Shares of World Trade

Table 1.1 Shares of World Trade, Accounted for by Selected Regions, 2006
Feenstra and Taylor: International Economics, Second Edition
Copyright © 2011 by Worth Publishers
Silvia Nenci
The Network of World Trade in Goods, 2007
(major two export partners)

Note: For each country, only the export flows toward the first and second trade partner are considered. The size of the circle
corresponding to a country is proportional to the number of receiving links
Source: De Benedictis, Nenci, Santoni, Tajoli, Vicarelli, 2013
Silvia Nenci
Barriers to trade
All factors that influence (restrict) the amount of goods
and services shipped across international borders
Main barriers are:
• Tariffs: A tax on a good coming into a country
• Quotas: Physical restriction on the number of goods
coming into a country
• Non-Tariff Barriers: Any methods not covered by a tariff,
most usually (ex: standards on fuel emissions from cars;
documentation required to sell drugs in different countries,
ingredients in products ; etc)
• Rules • Legislation
• Regulations • Exacting Standards or Specifications
• Voluntary Export Restraints (VERs)

Silvia Nenci
Average Worldwide Tariffs, 1860–2000

Figure 1.4 Average Worldwide Tariffs, 1860–2000


Feenstra and Taylor: International Economics, Second Edition
Copyright © 2011 by Worth Publishers
Silvia Nenci
Tariffs in modern history

Source: Nenci (2011) adapted from Coatsworth and Williamson (2002) and World Bank (2003)
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Who are the main players
in international trade? -1

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Who are the main players
in international trade? -2

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Trade in intermediates

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The evolution of international trade:
summing up
 International trade has grown tremendously in the last 30 years, much
faster than global output
• World merchandise and commercial services trade have increased by
about 7 per cent per year on average
 New players have risen to prominence in world trade, most notably large
developing countries and rapidly industrializing Asian economies
 The composition of trade has changed (i.e. the product breakdown of
merchandise trade and the relative importance of commercial services
trade)
 Countries have become less specialized over time in terms of their exports
and therefore more similar in terms of their export composition.
 Trade has tended to become more regionalized since 1990, particularly in
Asia, but intra-regional trade shares in Europe and North America have
remained steady or declined.

Silvia Nenci
The evolution of international trade:
summing up -2
 Trade is essentially a North
North--North phenomenon (60-70%)
 Countries trade also in similar goods
 Trade is not only between producers and final consumers:
• Intra-firm trade (30%), intermediate products (35%), final products
(35%), according to WTO’s estimates
 Countries do not trade, firms do
do. But very few of them do it.

Silvia Nenci
Why do countries trade?

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Several reasons

• Differences in the technology used


• Differences in the total amount of resources (labor,
capital, land)
• The proximity of countries to each other (i.e., how
close they are to one another)

Silvia Nenci
Reasons for Trade
Resources
• Geography includes the natural resources
(such as land and minerals) found in a
country, as well as its labor resources (labor
of various education and skill levels) and
capital (machinery and structures).
• A country’s resources are often collectively
called its factors of production, the land,
labor, and capital used to produce goods and
services.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Reasons for Trade
Proximity
• The closer countries are the lower the costs of
transportation. For example, the largest
trading partner of most European countries is
another European country.

• Sometimes neighboring countries take


advantage of their proximity by joining into a
free-trade area, in which the countries have no
restrictions on trade between them.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Why countries trade
An overview of trade theories:

Silvia Nenci
Reasons for Trade
Absolute Advantage
 When a country has the best technology for producing a
good, it has an absolute advantage in the production of
that good
Comparative Advantage
 Absolute advantage is not a good explanation for trade
patterns. Instead, comparative advantage is the
primary explanation for trade among countries.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


The law of Comparative Advantage

•The law of comparative advantage is the basis for trade


•A country has a Comparative Advantage if it produces
a particular good or service at a lower opportunity cost
than another country.
•It means that it can produce a product with the highest
relative efficiency given all the other products that could
be produced.

Silvia Nenci
Where do the USA’s snowboards come from?

• In 2005 the United States imported (i.e.,


purchased from other countries) $59
million of snowboards from 20 different
countries.
countries

• China exported (i.e., sold to another


country) more than $18 million worth of
snowboards to the United States in 2005
and $21 million in 2009.

Silvia Nenci
U.S. Imports of Snowboards, 2005 and 2009
The table shows that the value of imports to the United States
has fallen in recent years and, in snowboards at least, has
become more focused on exports from China and Taiwan.

Silvia Nenci
Hence the US import snowboards from:

• Canada probably because of proximity


• and from Austria because of cold climates and
mountains makiing snowbording vary popular.

But why from Germany and China?

Silvia Nenci
The Ricardian Model

Silvia Nenci
David Ricardo (1772-1823) and
Mercantilism
• Mercantilists believed that exporting was good
because it generated gold and silver for the
national treasury and that importing was bad because it
drained gold and silver from the national treasury.
• To ensure that a country exported a lot and imported only a
little, the mercantilists were in favor of high tariffs.
• Ricardo was interested in showing that countries could
benefit from international trade without having to use
tariffs.
• Many of the major international institutions in the world
today are founded at least in part on the idea that free trade
between countries brings gains for all trading partners.
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
The Ricardian model
 The Ricardian model focuses on technology to explain trade
patterns
 In a model where labour is the only factor of production,
differences in technology are represented by differences in
labour productivity
 In a simplified world of 2 countries and 2 goods, Ricardo
shows that even when one of the two countries has an
absolute advantage in the production of both goods, i.e. it can
produce more output with one unit of labour in both goods,
there is scope for mutually beneficial trade if both
countries specialize in the goods where the opportunity
cost is lower (and the comparative advantage greater)
relative to other countries
Silvia Nenci
Technology differences as an explanation
for trade
 We focus on technology differences across countries
as an explanation for trade.
 This explanation is often called the Ricardian model.
 This model explains how the level of a country’s
technology affects wages and, in turn, helps to
explain how a country’s technology affects its trade
pattern.
 We also explain the concept of comparative
advantage and why it works as an explanation for
trade patterns.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian model
Assumptions
 2 goods (wheat & cloth)
 2 countries (Home & Foreign)
 1 production factor (L)
 production function:
• fixed coefficient
• different across countries
 perfect competition
 terms of trade are given (relative prices)

Silvia Nenci
Ricardian Model
2 countries (Home & Foreign), 2 commodities (wheat & cloth)
The Home Country
 We will assume that labor is the only resource used to
produce both goods.

 The marginal product of labor (MPL) is the extra output


obtained by using one more unit of labor.

 At Home, one worker produces 4 bushels of wheat, so MPLW


= 4.
 Alternatively, one worker can produce 2 yards of cloth, so
MPLC = 2.
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Marginal product of labor

The home country has an absolute advantage in the production of both goods, but
both countries have a comparative advantage
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Ricardian Model
The Home Country
Home Production Possibilities Frontier
 Using the marginal products for producing wheat and cloth, we
can graph Home’s production possibilities frontier (PPF).
 The slope of the PPF is also the opportunity cost of wheat
wheat, the
amount of cloth that must be given up to obtain one more unit of
wheat.
 Assume there are 25 workers in Home:
• If all the workers were employed in wheat, the country could
produce 100 bushels (25*4).
• If they were all employed in cloth they could produce 50 yards
(25*2).
 The PPF connects these two points.
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Ricardian Model
 The Home Country - Home Production Possibilities Frontier
½ yard of cloth is the opportunity cost of obtaining 1 more bushel of wheat and is the slope of the PPF
FIGURE 2-1

The Home PPF is a straight


line between 50 yards of
cloth and 100 bushels of
wheat.
The slope of the PPF equals
the negative of the
opportunity cost of wheat.
Equivalently, the magnitude
of the slope can be expressed
as the ratio of the marginal
products of labor for the two
goods.

Silvia Nenci
Ricardian Model
1. Home equilibrium in the absence of trade
 With this PPF, what combination of wheat and cloth
will Home actually produce?

 It depends on the country’s demand for each of the


2 goods

Silvia Nenci
Ricardian Model
Home Indifference Curve
 There are several ways to represent demand in the Home
economy, but we will start by using indifference curves.
• Each indifference curve shows the combinations of two
goods, such as wheat and cloth, that a person or economy
can consume and be equally satisfied.
• All points on an indifference curve have the same level of
utility.
• Points on higher indifference curves have higher utility.
• Indifference curves are often used to show the preferences
of an individual.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian Model: Home Indifference Curve
The PPF acts like a budget constraint, the country will produce at the point of highest utility subject to the
limits imposed by its PPF
FIGURE 2-2 Home Equilibrium with No Trade

Points A and B lie on the same


indifference curve and give
the Home consumers the level
of utility U1.
The highest level of Home
utility on the PPF is obtained
at point A, which is the no-
trade equilibrium.
Point D is also on the PPF but
would give lower utility.
Point C represents a higher
utility level but is off of the
PPF, so it is not attainable in
the absence of international
trade.

Silvia Nenci
Ricardian Model
 Opportunity Cost and Prices
 Whereas the slope of the PPF reflects the opportunity
cost of producing one more bushel of wheat, under
perfect competition the opportunity cost of wheat should
also equal the relative price of wheat.

 Price reflects the opportunity cost of a good.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian Model
 Wages
• In competitive markets, labor hired up to the point where
wage equals P • MPL for each industry.
• If we assume the labor mobility between industries, and that
workers will choose to work in the high-wage industry, then
wages will be equalized across the 2 industries

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian Model
Wages
We can use the equality of the wage across industries to obtain the
following equation:
PW • MPLW = PC • MPLC

By rearranging terms, we see that

PW/PC = MPLC/MPLW

The right-hand side of this equation is the slope of the production


possibilities frontier (the opportunity cost of obtaining one more
bushel of wheat).
The left-hand side of the equation is the relative price of wheat.
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Ricardian Model
The Foreign Country
• Assume a Foreign worker can produce 1 bushel of wheat or 1
yard of cloth.
• It has an absolute disadvantage in producing both goods as
compared to Home
• MPL*W = 1, MPL*C = 1

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Marginal product of labor

The Foreign country has an absolute disadvantage in producing both goods as


compared to Home.
Silvia Nenci
Ricardian Model
The Foreign Country
• Assume a Foreign worker can produce 1 bushel of wheat or 1
yard of cloth. It has an absolute disadvantage in producing
both goods as compared to Home
• MPL*W = 1, MPL*C = 1
• Assume there are 100 workers available in Foreign.
• If all workers were employed in wheat they could produce
100 bushels (1x100).
• If all workers were employed in cloth they could produce 100
yards (1x100).

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian Model
 The Foreign Country - Foreign Production Possibilities Frontier
FIGURE 2-3

The Foreign PPF is a


straight line between
100 yards of cloth and
100 bushels of wheat.
The slope of the PPF
equals the negative of
the opportunity cost of
wheat, that is, the
amount of cloth that
must be given up (1
yard) to obtain 1 more
bushel of wheat.
wheat

Silvia Nenci
Ricardian Model

 The Foreign Country -Comparative Advantage


FIGURE 2-4

Foreign Equilibrium
with No Trade The
highest level of
Foreign utility on the
PPF is obtained at
point A*, which is the
no-trade
equilibrium.

In Foreign, the relative price of wheat is P*w/P*c=1 while in Home is Pw/Pc=1/2


Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Determining the Pattern of International
Trade -1
International Trade Equilibrium
 What happens when goods are traded between Home
and Foreign?
 The pattern of exports and imports will be determined by
the opportunity costs of production in each country—
their comparative advantage.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Ricardian Model: Comparative Advantage
Opportunity cost

• The opportuniy costs of wheat in terms of cloth is: 2/4=1/2 in Home and
1/1=1 in Foreign, while the opportuniy costs of cloth in terms of wheat is
4/2=2 in Home and 1/1=1 in Foreign
• A country has a comparative advantage in a good when it has a lower
opportunity cost of producing than another country.
• By looking at the chart we can see that Foreign has a comparative
advantage in producing cloth. Home has a comparative advantage in
producing wheat
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Determining the Pattern of International
Trade -2
 The relative price of cloth in Foreign is PC/PW = 1.
 The relative price of cloth in Home is PC/PW = 2.
 The difference in prices across countries create an
opportunity for trade
 Therefore Foreign would want to export its cloth to
Home
 The opposite is true for wheat.
 Home will export wheat and Foreign will export
cloth.
 Both countries export the good for which they have
the comparative advantage
Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci
Determining the Pattern of International
Trade -3

 The two countries are in an international trade equilibrium


when the relative price of wheat is the same in the two
countries.
• This means that the relative price of cloth is also the same in
both countries.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


International Trade Equilibrium - Change in
Production and Consumption
FIGURE 2-5 (2 of 3) Home Equilibrium with Trade (continued)

As wheat is exported,
Home moves up the
world price line BC.
Home consumption
occurs at point C, at the
tangent intersection with
indifference curve U2,
since this is the highest
possible utility curve on
the world price line.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


International Trade Equilibrium - Change in
Production and Consumption
FIGURE 2-5 (3 of 3) Home Equilibrium with Trade (continued)

Given these levels of


production and
consumption, we can see
that total exports are 60
bushels of wheat in
exchange for imports of 40
yards of cloth and also that
Home consumes 10 fewer
bushels of wheat and 15
more yards of cloth relative
to its pre-trade levels.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


International Trade Equilibrium
FIGURE 2-5 (revisited) International Trade
Home obtains a higher
utility with international
trade than in the absence of
international trade (U2 is
higher than U1); the finding
that Home’s utility
increases with trade is our
first demonstration of the
gains from trade, by which
we mean the ability of a
country to obtain higher
utility for its citizens under
free trade than with no
trade.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


International Trade Equilibrium - Pattern of
Trade and Gains from Trade
FIGURE 2-6 (2 of 2) Foreign Equilibrium with Trade (continued)

Foreign consumption
occurs at point C*, and total
exports are 40 yards of cloth
in exchange for imports of
60 bushels of wheat.
Relative to its pre-trade
wheat and cloth
consumption (point A*),
Foreign consumes 10 more
bushels of wheat and 10
more yards of cloth.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Pattern of Trade and Gains from Trade

• Each country is exporting the good for which it has the


comparative advantage.
• This confirms that the pattern of trade is determined by
comparative advantage.
advantage
• This is the first lesson of the Ricardian model.
• There are gains from trade for both countries.
countries
• This is the second lesson of the Ricardian model

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


KEY POINTS of the Ricardian Model

1. the pattern of trade is determined by comparative


advantage.
• A country has comparative advantage in producing a good
when the country’s opportunity cost of producing the good
is lower than the opportunity cost of producing the good in
another country.
• Even countries with poor technologies can export the goods
in which they have comparative advantage
2. There are gains from trade for both countries.
• By exporting the good in which a country has the lowest
opportunity cost, the country could benefit from
participating in international trade (i.e. more consumption)

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci


Comparative Advantage

 Can Comparative Advantage Be Created? The Case of


“Icewine”

• In some cases, a country can export


a good without having any advantage
in the natural resources needed to produce it.

• One example is “icewine,” which is a type of wine invented in Germany


(it is produced by allowing grapes to freeze on the vine) but now also
produced in the Niagara Falls region of Canada and the United States

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Silvia Nenci