EF331 Topics in Applied Economics

Dr. Silvia Rocchetta

silvia.rocchetta@dcu.ie
Course Outline

1. Foundations of Innovation
economics
2. Intellectual property and
knowledge spillovers
3. Evolutionary Economic
Geography
4. Inequality
Course Outline

5. International Trade
6. Behavioral Economics
7. Labour Economics
8. Macroeconomics and Fiscal
Policies
 INTERNATIONAL TRADE
Chapter 5
 Introduction to International Trade
What is international trade?
• Exchange of raw materials and manufactured goods (and
services) across national borders
Classical trade theories:
• explain national economy conditions--country advantages--
that enable such exchange to happen
New trade theories:
• explain links among natural country advantages, government
action, and industry characteristics that enable such
exchange to happen
 Rationale for International Trade
• Countries engage in trade in order to achieve gains:
• Countries are different from each other and have
different factor endowments, countries can therefore
benefit from specialisation in the production
• Through trade countries can specialise in production
produce on a bigger scale, assess larger markets and
reap benefits from economies of scale
• Gains from trade are an important driver of economic
growth
Development of Trade and Globalisation
• Development of international trade theory from Ricardo
through to Krugman all provide a theoretical basis for
trade and explain Globalisation
 Mercantilists
• Popular from 1500-1800 in Europe

• Assumption that a trade surplus (exports >

imports) would lead to a nation obtaining more
gold which would lead to increased domestic
production and employment
• Policy implication for domestic government to
limit imports through tariffs, import quotas, and
other methods
 Principle of Absolute Advantage
• Adam Smith – Wealth of Nations (1776)
• Capability of one country to produce
more of a product with the same amount
of input than another country
• Produce only goods where you are most
efficient, trade for those where you are
not efficient
Law of Absolute Advantage
Since the U.S. can produce more
cloth, it produce cloth and trade it to
the U.K. in exchange for wine, for
which the U.K. has greater
production capability
 Principle of Comparative Advantage
• David Ricardo - Principles of Political Economy
(1817)
• Trade as mutually beneficial even if one country is
more efficient than another
• Principle of comparative advantage – each country
should specialise in production of those goods for
which it is relatively more efficient and with a lower
opportunity cost
• No country has a comparative advantage in
everything
 Principle of Comparative Advantage

A country gains by specialising in the goods that it

can produce cheaply (relative to other goods), and
exporting these goods to other countries in
exchange for goods the country finds more
expensive to produce
Principle of Comparative Advantage: Trade
• Extends free trade argument

• Supports specialisation in production

• Efficient use of resources leads to more productivity.

• Should import even if the country is more efficient in the

product’s production than the country from which it is buying.

• Look to see how much more efficient. If only comparatively

efficient, then import.

• Trade is a positive-sum game.

 Trade Benefits for all Countries

According to comparative advantage, even a

country with a comparative disadvantage in the
production of all goods compared to other
countries, will gain from specialising in its most
efficient goods and importing the rest
 Absolute vs Comparative Advantage

• Absolute advantage refers to the uncontested

superiority of a country or business to produce a
particular good
• Comparative advantage introduces opportunity
cost as a factor for analysis in choosing between
different options for production diversification
 Why Comparative Advantage is Key
• Suppose that an American worker can produce 50 shirts
or 200 bushels of wheat per day. A Chinese worker can
produce only 25 shirts or 50 bushels of wheat
• The U.S. has an absolute advantage in shirt production
since a U.S. worker can produce more shirts
• The U.S. has an absolute advantage in wheat
production since a U.S. worker can produce more
wheat
 Why Comparative Advantage is Key
• To understand how each country decides which
good to produce when they interact, we calculate
opportunity cost:
• U.S.: 1 shirt costs 4 bushels of wheat—1 wheat
costs ¼ shirt

• China: 1 shirt costs 2 bushels of wheat –1 wheat

costs ½ shirt

• Therefore, China should specialize in shirts and

the U.S. in wheat
 Law of Comparative Advantage
Model developed by David Ricardo in 19th Century based on
differences in international labour productivity

The US can produce twice as much wine as the UK but four

times as much cloth. Therefore the US should specialise in
producing cloth while the UK should specialise in producing
wine
 Law of Comparative Advantage - Example

q Two countries
A simple 2 x 2 model:
q Two goods The labour
hours it takes
to produce a
car in China

The labour hours it takes to produce a ton of

clothing in USA
 Law of Comparative Advantage - Example

Keep it simple: assume

that the price of each gods
is equal to the labour cost
in terms of hours

!
q The price of a US car, relative to US clothing, is = 0,5
"

q The price of a Chinese car, relative to Chinese

#$
clothing is = 1,5
%

Chinese consumers will prefer to buy US cars

Law of Comparative Advantage - Example
• Using all its resources, country A can
produce 30m cars or 6m trucks, and
country B can produce 35m cars or 21m
trucks.
• Country B has the absolute advantage in
producing both products, but it has a
comparative advantage in trucks
because it is relatively better at
producing them. Country B is 3.5 times
better at trucks, and only 1.17 times
better at cars
• Country B should specialise in producing
trucks, leaving Country A to produce cars
Law of Comparative Advantage - Graphs
• If the law of comparative
advantage is applied output will
be increased in comparison with
the output that would be
produced if the two countries
tried to become self-sufficient
and allocate resources towards
production of both goods.

• Comparative advantage is where

a country is able to produce
goods using fewer resources i.e.
at a lower opportunity cost
Law of Comparative Advantage - Graphs
• If countries A and B are self sufficient and
allocate resources evenly to both goods
combined output is: Cars = 15 + 15 = 30;
Trucks = 12 + 3 = 15, therefore world output
is 45 m units

• If both countries specialise based on their

comparative advantage then if countries A
and B allocate resources evenly to both
goods combined output is: Cars produced
by country A = 30 Trucks produced by
country B = 21 , therefore world output is
51m units

• Overall world production and income have

increased
Law of Comparative Advantage - Graphs
Having a comparative advantage in X,
Country A sacrifices less of Y than Country B
in order to produce one more unit of X.

In our example in order to get 5 more units

of X Country B must give up three units of Y
while Country A can produce 5 more units
of X while only giving up one unit of Y.

This means that Country A has the

comparative advantage in the production of
X (Cars) and Country B has the comparative
advantage in the production of Y (Trucks)

Both countries should specialise to increase

combined output and income
 Benefits from Trade

• A country has a comparative advantage in a good

if produces the good at lower opportunity cost
than other countries
• Countries can gain from trade if each country
exports the goods in which it has a comparative
advantage
• Using the tools of welfare economics we can
illustrate the gains from trade.
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 Price Assumptions
• PW = the world price of the good in the world market
• PD = domestic price in the domestic market prior to
trade
• If PD < PW,
• If country has comparative advantage in the good
under free trade, it becomes an exporter of the
good
• If PD > PW,
• If country does not have comparative advantage
then under free trade, country becomes importer
of the good
 Market Assumptions
• A small economy is a price taker in world
markets: Its actions have no affect on the world
price PW
• When a small economy engages in free trade PW
is the only relevant price
§ No seller would accept less than PW, given that
they could sell the good for PW in world markets
• No buyer would pay more than PW given that
they could buy the good for PW in world
markets
 A Country That Exports Potatoes
Without trade,
PD = €4, Q = 400 P
Potatoes
S
In world markets,
€6
PW = €6
€4
Under free trade,
Country A as an exporter D
Q
200 600
consumes Q=200 but
produces Q=600
 A Country That Exports Potatoes
Without Trade,
Consumer Surplus = A + B
Producer Surplus = C
Total Surplus
=A+B+C
With Trade,
Consumer Surplus = A
Producer Surplus = B + C + D
Total Surplus
=A+B+C+D
Gains from Trade for Exporting Country

Before Trade After Trade Change

Consumer Surplus A + B A -B

Producer Surplus C B+C+D + (B + D)

Total Surplus A+B+C A+B+C+D D

 A Country That Imports Computers
Without trade,
PD = €300, Q = 40 P
Computers
S
In world markets,
PW = €150

Under free trade, €300

Country A as an €150
importer consumes D
Q
Q=60 but produces 20 40 60
Q=20
 Gains from Trade
Without Trade,
Consumer Surplus = A
Producer Surplus = B + C
Total surplus
=A+B+C
With Trade,
Consumer Surplus = A +
B+D
Producer Surplus = C
Total Surplus
=A+B+C+D
Gains from Trade for Importing Country

Before Trade After Trade Change

Consumer A A+B+D + (B + D)
Surplus

Producer Surplus B + C C -B

Total Surplus A+B+C A+B+C+D +D

Benefits of International Trade
• Consumers enjoy increased variety of goods.

• Producers sell to a larger market and may

achieve lower costs through economies of scale.
• Competition from abroad may reduce market
power of some firms, which would increase
total welfare.
• Trade enhances the flow of ideas, facilitates the
spread of technology around the world.
Misconceptions about International Trade

• Free Trade is only beneficial if your country is

strong enough to stand up to foreign
competition
• Foreign competition is unfair and hurts other
countries when it is based on low wages
• Trade exploits a country and makes it worse off
if its workers receive lower wages than in other
countries
Tariff: An Example of a Trade Restriction

• Tariff: a tax on imports

• Example: Market for Shirts

PW = €20
Tariff: T = €10/shirt
Consumers must pay €30 for an imported shirt.
So, domestic producers can charge €30 per shirt.

• In general, the price facing domestic buyers & sellers

equals (PW + T ).
Analysis of a Tariff on Market for Shirts
P
PW = €20
• free trade: Markets for Shirts
buyers demand 80 S
Local sellers supply
25
imports = 55 €30
• T = €10/shirt €20
price rises to €30 imports D
buyers demand 70 4 7 8 Q
25
0 0 0
Local sellers supply
40
imports = 30
 Analysis of a Tariff on Market for Shirts
P
Free trade Cotton shirts
Deadweight
• Consumer Surplus = A + B loss = D + F
+C+D+E+F
• Producer Surplus = G S
• Total surplus = A + B
+C+D+E+F+G A
Tariff B
€30
• Consumer Surplus = A + B C D E F
€20
• Producer Surplus = C + G G
D
• Revenue = E
4 7 8 Q
• Total Surplus = A + B 25
0 0 0
+C+E+G
Analysis of a Tariff on Sale of Shirts
P
Cotton shirts
Deadweight
D= Deadweight loss loss = D + F
from the S
overproduction
of shirts A
F = Deadweight loss B
€30
from the under- C D E F
consumption €20
G
D
of shirts 4 7 8 Q
25
0 0 0
 Limitations of Ricardian Model
• A number of assumptions:
• Perfect mobility of factors of production between
sectors but not between countries
• Constant returns to scale

• Goods are identical across firms and countries

• Goods and labour markets are assumed to be

perfectly competitive
• Transportation costs are ignored
 Empirical Evidence

• Despite the limitations of the Ricardian Model this

theory does offer some important insights into
causes and drivers of world trade
• Productivity differences between countries do
matter
• Comparative advantage rather than absolute
advantage is the key in determining trade patterns
 Heckscher (1919) - Olin (1933) Theory
• The Heckscher-Ohlin theory argues that trade
occurs due to differences in labor, labor skills,
physical capital, capital, or other factors of
production across countries
• Countries have different relative abundance of
factors of production.
• Production processes use factors of production
with different relative intensity
 Heckscher (1919) - Ohlin (1933) Theory
• Factor endowments: extent to which a country is
endowed with such resources as land, labour,
and capital.
• Export goods that intensively use factor
endowments which are locally abundant.
§ Corollary: import goods made from locally
scarce factors.
• Patterns of trade are determined by differences in
factor endowments
• Relative advantage, not absolute advantage
 Heckscher-Ohlin Model: Assumptions

1. Two countries: home and foreign.

2. Two goods: cloth and food.

3. Two factors of production: labor and capital.

4. The mix of labor and capital used varies across goods.

5. The supply of labor and capital in each country is

constant and varies across countries.

6. In the long run, both labor and capital can move across
sectors
Heckscher-Ohlin Model: Assumptions
• Countries (Country A and Country B) that have

• Same tastes

• Same technology

• Different resources

• Country A has a higher ratio of labour to land than

Country B does

• Each country has the same production structure of a

two-factor (Labour and Land) economy.
 Heckscher-Ohlin Theorem

A country will export that commodity which

uses intensively its abundant factor and
import that commodity which uses
intensively its scarce factor
 Example
• An economy can produce two goods, cloth and
food
• The production of these goods requires two
inputs that are in limited supply; labor (L) and
land (T)
• Production of food is land-intensive and
production of cloth is labour-intensive in both
countries
• Perfect competition prevails in all markets
 Factor Endowments
• Factor Abundance
• Country A is labour-abundant compared to Country B
and Country B is land-abundant compared to Country
A if and only if the ratio of the total amount of labour to
the total amount of land available in Country A is
greater than that in Country B
L/T > L*/ T*
• Example: if America has 80 million workers and 200
million acres, while Britain has 20 million workers
and 20 million acres, then Britain is labour-abundant
and America is land-abundant
• In this case, the scarce factor in Britain (Country A) is
land and in America (Country B) is labour
 Pricing Effects
• When Country A and Country B trade with each other,
their relative prices converge
• The relative price of cloth rises in Country A and
declines in Country B
• In Country A, the rise in the relative price of cloth
leads to a rise in the production of cloth and a decline
in domestic consumption, so Country A becomes an
exporter of cloth and an importer of food.
• Conversely, the decline in the relative price of cloth in
Country B leads it to become an importer of cloth and
an exporter of food.
 Trade and the Distribution of Income

• Changes in relative prices can affect the

earnings of labor and capital.
• A rise in the price of cloth raises the
purchasing power of labor in terms of both
goods while lowering the purchasing power of
capital in terms of both goods.
• A rise in the price of food has the reverse
effect.
 Trade and the Distribution of Income

• Thus, international trade can affect the distribution of

income, even in the long run:
• Owners of a country’s abundant factors gain from
trade, but owners of a country’s scarce factors lose.
• Factors of production that are used intensively by the
import-competing industry are hurt by the opening of
trade – regardless of the industry in which they are
employed.
 North-South Trade and Income Inequality
• Over the last 40 years, countries like South Korea,
Mexico, and China have exported to the U.S. and
Europe goods intensive in unskilled labor (ex.,
clothing, shoes, toys, assembled goods).

• At the same time, income inequality has increased

in the U.S. and Europe, as wages of unskilled
workers have grown slowly compared to those of
skilled workers.
 North-South Trade and Income Inequality

• The Heckscher-Ohlin model predicts that owners of

relatively abundant factors will gain from trade and owners
of relatively scarce factors will lose from trade.
• Little evidence supporting this prediction exists.

1. According to the model, a change in the distribution of

income occurs through changes in output prices, but
there is no evidence of a change in the prices of skill-
intensive goods relative to prices of unskilled-intensive
goods.
North-South Trade and Income Inequality

2. According to the model, wages of unskilled workers

should increase in unskilled labor abundant
countries relative to wages of skilled labor, but in
some cases the reverse has occurred:
• Wages of skilled labor have increased more rapidly
in Mexico than wages of unskilled labor.
• But compared to the U.S. and Canada, Mexico is
supposed to be abundant in unskilled workers.
 Factor Price Equalization

• Unlike the Ricardian model, the Heckscher-Ohlin model

predicts that factor prices will be equalized among countries
that trade.
• Free trade equalizes relative output prices.
• Due to the connection between output prices and factor
prices, factor prices are also equalized.
• Trade increases the demand of goods produced by
relatively abundant factors, indirectly increasing the
demand of these factors, raising the prices of the relatively
abundant factors.
 Factor Price Equalization

• In the real world, factor prices are not equal across

countries
• The model assumes that trading countries produce the
same goods, but countries may produce different goods
• The model also assumes that trading countries have the
same technology, but different technologies could affect
the productivities of factors and therefore the wages/rates
paid to these factors.
 International Wage Rates

Hourly Compensation of
Manufacturing Workers 2015
Country (United States = 100)
United States 100
Germany 112
Japan 63
Spain 63
South Korea 60
Brazil 31
Mexico 16
China (2013) 11.3
India (2012) 4.5
Source: The Conference Board, International Labor
Comparisons.
 Empirical Evidence
Empirical evidence on the Heckscher-Ohlin model has
led to the following conclusions:

• It has been less successful at explaining the actual

pattern of international trade.

• Complete factor price equalisation is not observed

• Most economists do not believe that differences in

resources alone can explain the pattern of world trade
or world factor prices
Gravity Theory of International Trade
• Gravity Theory of International trade
first introduced by Jan Tinbergen
(1963), who proposed that the size of
bilateral trade flows between any two
countries can be approximated by
employing the ‘gravity equation
• Inspired by
Newton's theory of gravitation
 Gravity Equation
Bilateral trade between two countries is proportional to
size, measured by GDP, and inversely proportional to
the geographic distance between them
Implications of Gravity Theory for Trade

• Countries of similar size will trade more with

one another, than countries of dissimilar size
• Countries that are closer together will do more
trade than countries further apart
 Krugman New Trade Theory (1979)
• Krugman’s work was inspired by the observation that a
intra-sectoral trade between countries with similar
characteristics was growing faster than inter-sectoral trade
between them (Grubel and Lloyd, 1975).

• Similar goods are also sometimes referred to as varieties of

the same good

• For example, Germany exports cars to Japan and imports

cars from Japan
Krugman New Trade Theory (1979)

Source: Baldwin and Martin, 1999

 Krugman New Trade Theory (1979)

• Similar-similar trade more profitable why?

• Two neglected element of international trade

• Increasing return to scale

• Imperfect competition

• Advantages of specialisation that arise from

increasing returns to scale and concomitant forms of
imperfect competition
 Krugman New Trade Theory (1979)
• Main reason that countries trade: to exploit economies of
scale and network effect

• Industries in specific countries concentrate on specific

niche products, gaining economies of scale in those
niches. Countries then trade these niche products to each
other – each specialising in a particular industry or niche
product.

• Trade allows the countries to benefit from larger

economies of scale and variety
Empirics
 Empirics

Intra and Extra EU trade by member state

Source Eurostat
 Krugman New Trade Theory (1979)

• Krugman proposes that the economy should be

described as a complex system where “chance and order
seem to spontaneously evolve into an unexpected order”
(Krugman 1996, 10).

• Although this geographical approach has its limitations

(Coissard 2007), it has become the precondition for any
study of the spatial localization of activities.
 Krugman New Trade Theory (1979)
• Example: Silicon Valley:

“Silicon Valley is there because it is there: that is, the local

concentration of high technology firms provides markets, a
pool of specialized skills, and technological spillovers that in
turn sustain that concentration. And like most such
agglomerations, Silicon Valley owes its existence to small
historical accidents that, occurring at the right time, set in
motion a cumulative process of self reinforcing growth.”
Krugman 1996
 Review of International Trade

Reference:

International Economics Theory and Policy

Paul R. Krugman and Maurice Obstfeld

 Thank you
silvia.rocchetta@dcu.ie

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