International Economics

It is the subject which analyze the pattern of trade: Who trade with whom, How much trade…
To answer these questions, we should find the pattern, and construct the model for the final theory.
The globalization of our world led to complex international trade and likewise theories.
1. The Gravity model
Who trade with whom? A question like this could seem simple, but find an answer in one of
the first international economics theories. The Gravity Model, which explain us how size
and distance influence the trade between two states. In fact, the data tell that the trade is
proportional to the size of the country and inversely proportional to the distance between
𝑌𝑖𝑎 ∗𝑌𝑗𝑏
two country. This “pattern” can be formulated as: 𝑇 = 𝐴 𝑐 .
𝐷𝑖𝑗

Where T is Trade, 𝑌𝑖 is the GDP of country “i”, a, b and c are used to let the formula fit the
actual data. It is important to notice why the distance affect the trade in the first place and if
are there any other factors which can influence it. As we can imagine, higher the distance,
greater the transportation cost. But it’s not just a question of distance, for example some
Canadian state which are actually closer of some other USA states, have a smaller trade then
the farther ones. Even if there aren’t tariffs between Canada and the USA, culture and trade
agreement have a great influence in trade, explaining the aforesaid phenomenon. Other
factors which can influence trade are: border (borders usually require bureaucracy, which
require international lawyer and increase the costs), language (actually if there is a
different language the costs will raise, due to translator’s cost and creation of different
label), historic ties(France will surely be the biggest importer for all the African France’s
ex-colonies due to historic ties), free-trade agreement(It reduces costs, by avoiding tariffs
and by simplifying the export procedures, e.g. EU), geography(e.g. Netherland and
Belgium, which have a high percentage of the trade between US and EU, because they
control the most important ports in Europe[again, a question of costs, in fact it could be
cheaper to ship to Antwerp or Rotterdam which find themselves in the center of Europe and
sending all over EMEA than shipping to Genova and then again sending all over EMEA]).
The countries could have a deficit or a surplus in trade, the first one mean that the country
exports less than how much it imports. The opposite for the second one. We say that these
countries pay for their deficit with debts, by borrowing. One of the biggest importer in the
world are the USA which are a net importer of material and goods.
Size matters!

2. The Comparative advantage (Ricardo D.)

This theory is one of the oldest, nevertheless it is applicable today and very useful to
understand “The Pattern of Trade”. We will simplify the reality with some assumptions: we
are acting in an economy composed by two countries, two good and one factor; we do not
consider transportation costs, there are no tariffs, the labor force is free to move within the
country but not from one to another and the opportunity cost is a constant.
Thanks to all this assumption now we find ourself in a very simple economy, in which there
are two country, let’s say Germany and Italy, and two goods, let’s say, food (F) and
beverage (B) and just one production factor, labor. This theory explain how international
trade could benefit everyone. It starts by considering the factor used to produce the goods,
let’s say “how many hours to produce…”, if we say that it takes 2 and 4 hours, respectively,
to produce an unit of F and B in Italy, we will know that “technically”, we can trade two
 units of F for one unit of B. Without international trade, Italy will produce both food and
beverages. Now let’s say Germany can produce an unit of F and B respectively in 2 and 1
hours, here we will be able to trade one unit of F for two unit of B. We define “opportunity
cost” the ratio between the “costs” of the goods, in this case we can consider the labor
needed as the cost of production. If international trade was possible, the smartest people
would take the opportunity of producing Food in Italy and selling it in Germany for
Beverages. Until now we didn’t consider prices, if we consider the market in perfect
competition, the price of the goods can be described in a supply function: 𝑃 = 𝜔 ∗ 𝑎
where 𝜔 is the wage, 𝑎 is the quantity of the factor required to produce 1 unit of the good. In
conclusion with the start of international trade, the country with a comparative advantage in
one good will focus its production in that good, in our case Italy has a comparative
advantage in the production of food, so will move his production to produce only food,
while Germany will produce the beverages and both the countries will trade their goods for
the other’s ones; both countries will, theoretically, gain from international trade, because
each will “produce” the good with no comparative advantage by trading the other good for
it, more efficiently, in our example, Italy will produce beverages by trading food for it, *and
actually will be more efficient, because instead of using 4 hour of labor, it will use 2 hour to
produce food and then sell for 2 unit of beverages same thing for Germany, which will be
able to produce food by trading beverages with Italy, same reasons of before*.
It's not about absolute advantage, rather it’s about comparative one!

3. Specific Factor and Income Distribution:

Without international trade: A specific factor is a factor which
can be employed in a specific sector and can not be moved in
any other sector (e.g. A fighter jet is a specific factor that can be
used in combat but will hardly find utility in others sectors).
This model will have different assumptions: we are in an
Economy that can produce two good, has three factors of
production, of which 2 are specific factors and one mobile.
Let’s say our economy’s mobile factor is
labor, while the others are capital and land, our
goods are cloth (which don’t need capital, only
land and labor) and guns (which don’t need
land, just capital and labor). We assume that
the marginal product of labor, MPL (the first derivative [derivata prima]
of the production function of one good) is a decreasing function greater
than zero (it mean that the production function is increasing but more slow
more labor we employ in the production of that good). If we consider
𝑑𝑄 𝑑𝑄 𝑀𝑃𝐿
𝑀𝑃𝐿𝑐 = 𝑑𝐿 𝑐 and 𝑀𝑃𝐿𝑔 = 𝑑𝐿𝑔 we can say that, the ratio 𝑀𝑃𝐿 𝑐 will be the
𝑐 𝑔 𝑔

slope of the production possibility (the function with 𝑄𝑔 represent the independente variable
and 𝑄𝑐 the dependent one. Moreover it’s crucial to consider the fact that the profit-
maximizing employers will demand labor until the marginal profit of labor (the profit
genereted by the increase in the quantity produced by the increase in one unit of labor[𝑃 ∗
𝑀𝑃𝐿 price for the added quantity if we add one more unit of labor]) will be equal to the
wage: 𝑃 ∗ 𝑀𝑃𝐿 = 𝜔. If the labor is a mobile factor, we are sure that the wage will be the
 𝑀𝑃𝐿𝑐 𝑃
same for both sectors and so: = − 𝑃𝑔 . We will employ our labor to produce the two
𝑀𝑃𝐿𝑔 𝑐
𝑃
quantity that, in the production possibility frontier, have a slope of − 𝑃𝑔 .
𝑐
If the price increase proportionally (e.g. both increase 5%, the same) the quantity produced
will remain constant as the real wage and everything else. What happen if, instead, one price
increase more than the other? Let’s analyze it. Consider an alien invasion, demand for guns
increase and so do its relative price, say an increment of 5% while the rest remain the same.
𝑃𝑔 ∗ 𝑀𝑃𝐿𝑔 = 𝜔 = 𝑀𝑃𝐿𝑐 ∗ 𝑃𝑐
We consider the price of guns increasing more than proportionally, relatively to the price of
clothes, leading to a minor increase in the wage, say 2%, this will lead to ambiguous results
for the workers, which will see their real wage, relative to guns’ prices, decreasing, while
the one of cloth increase; we can say that who considered more important guns the clothes is
getting worse off, the opposite for who considered clothes more important. The capital
owner, (capital is the specific factor of the guns) will find a more than proportional increase
in guns’ prices than in wages very convenient. In conclusion:
- The factor specific to the sector whose relative price increases is definitely better off
(guns);
- The factor specific to the sector whose relative price decrease is definitely worse off
(clothes);
- For the mobile factor sector, the wealth change are ambiguous (workers).
→
With international trade:
- The specific factor of the exporting sector gains
- The specific factor of the importing sector loses

4. Heckscher and Ohlin theorem

Model assumption: Two factors(labor and capital), Two
goods(Rolex and food), Two countries(Italy and Germany); even
said “2x2x2”.
A good is considered labor/capital intensive when it is needed to
employ more labor/capital compared to capital/ratio in order to
produce it. In our economy, Rolex are labor intensive, as it need
more human labor than machinery (capital); instead, Food is
capital intensive, as to produce it, you need to employ more
machinery (capital) and less human labor. While labor costs 𝜔
(the wage), machinery/capital costs r (the rent for machinery/the
borrowing rate). Before considering prices, it’s important to
𝜔
understand the 𝑟 ratio, it is the slope of the Isocost function (it’s the function which define
the costs in terms of labor and capital employed); if the ratio increase, it will lead to a move
in labor/capital intensiveness (if the wages are increasing more proportionally than rates
are, the firms will shift more production to machinery[capital]). The function of the value of
the production will be: 𝑉 = 𝑃𝐹 𝑄𝐹 + 𝑃𝑅 𝑄𝑅 , by considering the isoquants V = n
𝑃 𝑛
𝑄𝐹 = − 𝑃𝑅 𝑄𝑅 + 𝑃 (the blue part is essentially a constant value, we will not consider it).
𝐹 𝐹
𝑃𝑅
− 𝑃 is the opportunity cost of producing one more Rolex, in terms of food. Furthermore, we
𝐹
 𝜔
know that the opportunity cost is influenced by the ratio, in fact we see that an increase
𝑟
this same ratio (the wages are increasing more than proportionally compared to rents) lead
to an increase in the opportunity cost (the price of Rolex will increase more proportionally
than the price of food, as Rolex production is labor intensive), same thing in the opposite
case, where the relative price increase. It seems obvious (and it is) that an increase in labor
supply will increase the production of the Rolex (labor intensive good).
After international trade:
International trade, as we already know, lead to a focus on the production of good,
depending on the opportunity cost. If italy’s food price relative to Rolex one is less than
Germany’s, Italy will export food, while Germany Rolex. It means that after international
𝑃 𝑃 𝑃
trade the opportunity cost will find himself between the two initial prices, 𝑃𝑅𝐺 < 𝑃𝑅 < 𝑃𝑅𝐼 .
𝐹𝐺 𝐹 𝐹𝐼
Why? We know that the relative price is influenced by the wage-rent ratio, and we know
that this last one is “reflection” of the labor-capital ratio. So the theory state: ”Countries
tend to export foods that are intensive in the factors with they are abundantly supplied”.
What? As we said, the rerlative price influence the wage-rent ratio, so if the relative price
𝜔
for rolex in italy decrease, the same do the 𝑟 ratio, which mean that 𝜔 are decreasing
relatively to rents. The distribution of income is not equal, in fact owners of the exported
factor (we say the abundant factor of the country) will gain, but the owners of scarce
(imported) factors lose.
In real life: Despite the utility of this theorem in predicting some pattern of trade between
developed and developing countries, it remains just theory. In the real world trade, there are
a lot of factors to consider, we can not just say that a country will export its relative
abundant factor, in fact we must consider the different technologies used in production,
tariffs and so on, which make very difficult to separate the effect of factors with other
influencing conditions.