International Trade: ECON 713

Spring 2024

Professor Christian Schubert

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Structure of whole course
1. Introduction
2. Ricardo: comparative advantage
3. Exchange rates
4. Balance of payments
5. Specific factors
6. Heckscher-Ohlin: who wins, who loses?
7. Trade policy
8. Some controversies

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Structure of whole course
1. Introduction
2. Ricardo: comparative advantage
3. Exchange rates
4. Balance of payments
5. Specific factors
6. Heckscher-Ohlin: who wins, who loses?
7. Trade policy
8. Some controversies

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4
 Some trade-related news:
- Egypt trades a lot with member states of the European Union (EU),
totalling 31% of all exports.
- The EU has now issued several new standards for trade, one of which
is the Carbon Border Adjustment Mechanism (CABM) – effective as of
January 2026 – that affects Egyptian companies as follows:
- It works as a “carbon border tax“, i.e. it imposes an extra tax on export
goods (steel, cement, fertilizer, aluminum,...) that have a carbon
footprint that is considered “too large“. One goal is to keep EU
companies from moving dirty production into countries such as Egypt.
- Already this year, EU importers must report the carbon footprint of the
goods they import from non-EU countries such as Egypt.
- Starting in 2026, European importers must then pay an extra tax that is
supposed to bridge the gap between local carbon tax, if any, and the
EU‘s own carbon price (currently 85 USD per ton CO2).
- The EU will not use the revenues to help developing countries de-
carbonize.
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 Our model [see Krugman et al.: 50-59]

• Assume two countries, Home and Foreign

• Each country produces wine (W) and cheese (C)

• …with only one (homogeneous) production factor:

labor (L)

We will build the model in three steps…

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Schubert, International Trade, Spring 2021
STEP 2: A second country, called Foreign

Let‘s include the country Foreign in our model

(Foreign‘s variables are denoted with an asterisk *):

Let‘s assume:
aLC < a*LC,
aLC/aLW < a*LC/a*LW (e.g.: a*LC = 4; a*LW = 3)
Which is equivalent to:
aLC/a*LC < aLW/a*LW.
 this means...
(a) that Home has an absolute advantage in making cheese
(because aLC < a*LC), and, much more importantly,
(b) that Home also has a comparative advantage in cheese
(because aLC/a*LC < aLW/a*LW).
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 Let‘s have a look at Foreign‘s production possibility
frontier, assuming that L* = 1,000 hours.
Q*W
L*/a*LW

Foreign‘s PPF = - (a*LC/a*LW) = - 4/3; it‘s

steeper, because Foreign has higher opp. costs
of producing cheese (in terms of wine)!

L*/a*LC Q*C

 Formally: PPF = a*LCQ*C + a*LWQ*W  L*

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STEP 3: Let‘s trade!

The relative prices of cheese and wine in both countries

will be determined by the relative unit labor requirements
in both countries.
 Relative price of cheese in Home = aLC/aLW
 Relative price of cheese in Foreign = a*LC/a*LW
 Cheese will be relatively cheaper in Home than in Foreign,
while wine will be cheaper in Foreign than in Home
 Arbitrage: Clever and alert entrepreneurs will ship cheese
from Home to Foreign, and wine from Foreign to Home
 Let transport costs be zero: Relative prices will converge,
to some level between low [aLC/aLW] and higher
[a*LC/a*LW]

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A numerical example:

Home (H): aLC = 4; aLW = 8

Foreign (F): a*LC = 20; a*LW = 10

Also assume that L = 600; L* = 1,500

 What are the comparative advantages? [H: Home; F: Foreign]

H: Opp.cost of cheese = aLC/aLW = 4/8 = 1/2
F: Opp.cost of cheese = a*LC/a*LW = 20/10 = 2

 H has comp. advantage in cheese; F has comp. advantage in

wine: just compare aLW/aLC to a*LW/a*LC

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Schubert, GUC, International Trade
 What are the PPF equations?

H: 8QW + 4QC = 600

 If QW = 0: QC = 150; if QC = 0: QW = 75.

F: 10Q*W + 20Q*C = 1,500

 If QW = 0: Q*C = 75; if Q*C = 0: Q*W = 150

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 Sketch the PPFs and indicate the opportunity costs of
cheese for Home and Foreign!

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Schubert, GUC, International Trade
 What are the prices for cheese (in terms of wine) in
autarky? How much could a cheese arbitrageur benefit
per unit (assuming transport costs of zero)?

 In Home: aLC/aLW = 1/2

 In Foreign: a*LC/a*LW = 2

 Cheese arbitrageur: would buy cheese in Home for ½ ,

ship it to Foreign, sell at 1.99 → profit of 1.49 per unit

(Next arbitrageur buys for 0.51, sells for 1.98 and so on…)

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Schubert, GUC, International Trade
 Assume that H consumes 75 pounds of cheese and that
F consumes 75 liters of wine. Assume further that with trade, the
price of cheese (in terms of wine) will converge to 1. Show both
production and consumption of both goods in autarky and under
free trade
Home:
• Consumption in autarky: QC = 75, pluck into the PPF equation:
8×QW + 4 (75) = 600  QW = 300/8 = 37.5
Autarky means that Consumption = Production, therefore:
QC = 75; QW = 37.5

• With trade, Home specializes in cheese, so it produces QC = 150.

Since Home consumes only 75, it exports 75, which it can exchange
for 75 liters of wine (remember: new world market price of 1:1!)
with trade, Home can consume 75 instead of 37.5 liters of wine!

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with
both countries‘ PPFs!
Home Foreign
QW Q*W

QC Q*C

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with
both countries‘ PPFs!
Home Foreign
QW Q*W

•
•
QC Q*C
Home‘s consumption Foreign‘s consumption
in autarky: (37.5;75) in autarky: (75;37.5)

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with
both countries‘ PPFs!
Home Foreign
QW Q*W
•

•
•
• QC Q*C

With trade, prices converge to, for example, 1:1 (new blue
line)
 Both countries specialize (red dots), H in cheese, F in wine

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with
both countries‘ PPFs! Focus on wine trade!
Home Foreign
QW Q*W
•

• •
•
• QC Q*C

Trade allows H to import 75 liters of wine (exported

by Foreign) and to consume more wine than before.

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with
both countries‘ PPFs! Focus on cheese trade!
Home Foreign
QW Q*W
•

• • •
•
• QC Q*C

Trade also allows Foreign to import 75 pounds of

cheese (exported by Home) and to consume more
cheese than before.
Schubert, GUC, International Trade
 Show the gains from trade in a diagram with
both countries‘ PPFs! Focus on cheese trade!
Home Foreign
QW Q*W
•

• • •
•
• QC Q*C
 Both Home and Foreign end up on higher
indifference curves!

Schubert, GUC, International Trade

 Show the gains from trade in a diagram with both
countries‘ PPFs! Focus on cheese trade!
Home Foreign
QW Q*W
•

• • •
•
• QC Q*C
Trade also allows Foreign to import 75 pounds of cheese
(exported by Home) and to consume more cheese.
 Both Home and Foreign end up on higher indifference
curves!
Schubert, GUC, International Trade
How exactly do both countries benefit from trade?

(1)Trade can be understood as an indirect means of

production: In our example, Home could of course
produce wine directly, but it‘s more efficient to
“produce“ wine indirectly by first producing
cheese and then exporting that cheese to Foreign.

To illustrate, in our example, under autarky cheese

costs ½ in Home; with trade, its price rises to 1.
Home would need to employ 8 hours of labor to
produce 1 liter of wine. Trade allows Home to get
that liter by only using 4 hours of labor (that
produces 1 pound of cheese) and then to exchange
that pound of cheese for 1 liter of wine.

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Schubert, GUC, International Trade
How exactly do both countries benefit from trade?

(2) Trade also enlarges both countries consumption

possibilities. Under autarky, every country
cannot consume more than it itself produces.
Trade allows countries to move beyond their
own production possibility frontiers.

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What is missing in the Ricardo model?

• Effect of international trade on the income

distribution within countries, which heavly affects
the political economy of trade (→ sect. 5)
• Allowing more than one factor, as countries differ
with respect to resource endowments (e.g. Egypt:
abundant factor: human labor; scarce factor: capital;
Switzerland: the opposite); those differences are
another cause for international trade (→ sect. 3)
• Specialization may conflict with the policy goal of
developing one‘s own manufacturing sector (→
dynamic comp. advantage; infant-industry argument,
prime ex.: S. Korea, China; will be discussed later)

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Summing up:

• Ricardo model explains that part of international trade

that is due to differences in labor productivity across
countries;
• The model predicts that countries will export those
goods/services in which they are relatively more
productive (where their opportunity costs are lower);
• The model explains how trade gives rise to mutual
benefits;
• Trade can be understood either as an indirect method
of production or as a tool that enlarges a country‘s
consumption possibities;
• A country benefits from trade even if it has a lower
productivity in all industries that participate in trade.25
Before we continue…

A story about dealing with immigration (factor

movement)
(and about some unintended effects of intervening in
complex economic systems of trade/specialization)

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1964: U.S. President Johnson abolishes the Bracero
program (Bracero = manual laborer/farmhand), with
the goal to protect U.S. farm workers from “unfair“
foreign competition and to increase their wages
(“America first!“).
As a consequence, 500.000 Mexican farm workers are
expelled, U.S. farms lost 80% of their labor force,
almost over night.

How did U.S. farmers react? Did they hire U.S.

laborers instead of Mexicans, at higher wages?
Problem: domestic workers were unwilling to accept
the hard working conditions → Serious shortage of
labor
 U.S. Farm owners substituted capital for labor. 28
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This had further effects:

 Farms were merged into larger units (consolidation),

to make the increased use of capital efficient (in
California, only 400 out of 5,000 tomato-growing
farms survived)
 32,000 U.S. farm workers lost their jobs...!
 Along the U.S. Mexican border, Mexico‘s government
initiated the Maquiladoras program, facilitating the
establishment of tariff-free economic zones where
Mexican firms produced goods to be exported to the U.S.
 Change in product range: e.g. in California, farm owners
bred a uniform tomato hybrid variety with harder skin
that was not easily smashed by the harvesting machines.
It was also rather tasteless...
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Let‘s go back in time, to 1840s England (then the most
developed country in Europe)

There was a political fight between free trade advocates

and “mercantilists“ (keen on minimizing imports,
maximizing exports; we‘ll learn more about mercantilists
later in this course)

Mercantilists defended the high Corn Laws that

protected English agriculture from foreign (esp. German
and French) competition, by imposing high tariffs on
foreign grain (wheat, barley, oats, etc.)
Free traders wanted to abolish those Corn Laws,
because those tariffs kept price of bread artificially high
in England. 32
33
 Problem:

• Those owning large estates in the

countryside (the “landed gentry“, 3%
of the population) benefitted
enormously.
• The large majority of the common people (workers in the
cities, consuming bread) suffered, due to artificially high
prices.
• Manufacturing industries also suffered, because high food
prices kept down disposable incomes, hence
general/aggregate consumption.
 Hence, a distributional conflict (between aristocrats and
the middle class/the poor) affected England‘s macroeconomy. 34
Only in 1832 was the right to vote extended beyond
those 3%, to rich landowners.
But it took the Irish famine (1845-1849) to finally shift
the political power in favor of liberalizing trade. So, a
milestone in England‘s economic history happened:
The protectionist ‘Corn Laws‘ were repealed (in 1846)

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Let‘s take a deeper look into that conflict over the Corn
Laws!

• Almost all economists back then agreed that repealing

the Corn Laws clearly was beneficial for England. And
it‘s true: 97% of its citizens benefitted (esp. through
lower bread prices).
• BUT... didn‘t we learn that economists only accept
Pareto-efficiency as a criterion of ‘improvement‘?
• In other words: Unless all citizen benefit (or at least
don‘t lose) from some policy/policy change,
economists are not allowed to call that policy/policy
change an ‘improvement‘!
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 Recall Pareto-efficiency?

A policy (causing a re-allocation of resources) is Pareto-

efficient if it benefits at least one person without harming
anyone.

U2 B C This is a mini-society‘s utility

D possibilities frontier. A move (re-
allocation of resources) from initial
A E
point A to C, D or E is Pareto-
efficient (a move to D would
U1 probably be also “fair“). A move
from A to B is not Pareto-efficient.
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