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International Trade: Summation of terms and properties of
the models.
My goal with this summation is to get the terms and definitions of the models down, therefore
I will ignore most of the algebra which is better described in the book. This is based on
Krugman & Obstfelt, sixth edition. To complete this I would recommend the “Study Guide”
and the notes on the Course web.
Chapter 2: Labour Productivity and Comparative Advantage:
The Ricardian Model.
The Ricardian Model
 Labour is the only factor of production. Countries differ only in productivity of labour
in different industries.
 Comparative advantage in productivity of labour decides which good the country will
export.
 Trade is: A) An indirect method of production. B) Increased consumption possibilities.
Increase in welfare.
 Relative prices derived from relative world supply and demand decide which goods
are produced. Relative prices also implicate relative wage rate.
 Relative wage rate will lie in between the two countries ratios of productivity.
 Myths:
o Free trade is beneficial only if your country is strong enough to stand up to
foreign competition. Not true because of the assumption of comparative rather
than absolute advantage. Gains from trade depends on the productivity relative
to the foreign industry as well as wage rate relative to foreign industry.
o Foreign competition is unfair and hurts other countries when it is based on
low wages. Pauper labour argument. This is false. All that matters is that it is
cheaper for home in terms of it own labour to produce one good instead of
another. Foreign’s lower price of the other good is entirely due to the cheaper
labour in this model.
o Trade exploits a country and makes it worse off if its workers receive much
lower wages than workers in other nations. This is also not true. The question
that answers the question is: What is the alternative? With out trade workers in
the poor countries real wages would drop even further.
 A Multigood model requires us to look at the relative wages rather than demand of
goods. Here it is obvious that transportation costs can create non traded goods.
 The Basic prediction of the recardian model is true: Countries will tend to export
goods in which they have relatively high productivity.
Key Terms;
Absolute advantage – the country with the greater advantage in absolute numbers.
Comparative advantage – the comparatively greater advantage relative to the other countries
resource.
Derived demand – Demand in respect of countries production of goods rather than that of
consumers.
Non traded goods – goods that has to be produced locally due to for instance
transportationcosts.
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Opportunity cost – the cost of the country being able to do something else.
Pauper labour argument – that competition based on foreign’s low wages is unfair and hurts
other countries.
Chapter 3: Specific Factors and Income Distribution
Specific factors model
 International trade affects the distribution of income to a large extent. Trade produces
winners and losers. Reasons: Factors can not be moved instantly and costlessly
between industries, and changes in production mix has differential effects on demand
for different factors.
 Specific factors model: difference in resources create different relative supply curves
and therefore trade. Diminishing returns is assumed because of the specific factor.
 Factors specific to export gain.
 Factors specific to import-competing sectors lose
 Labour can move between the two industries but not between countries. The total
amount of labour is set, and they will either gain or lose.
 Trade produces gains in the way that the ‘gainers’ could compensate the losers for
their losses and remain better off than before, income is redistributed and increased.
 Economists would rather attack the problem with income distribution directly than
meddle with trade flows.
o Income distribution is not specific to international trade.
o It is always better to allow trade and compensate those hurt by it than to
prohibit the trade.
o Those who stand to lose are typically better organized than those who stand to
gain.
Key Terms:
Budget constraint – the limit of the economy. general rule is that a country can’t consume
more than it produces.
Diminishing returns – since one factor is constant, returns from increased amounts of labour
will gradually diminish.
Marginal product of labour (MPL) – the product of one more unit of added labour.
Mobile factor – labour is the mobile factor in this model.
Production function – the function which depends on a specific and a mobile factor and gives
the output given for each amount of input of factors.
Production Possibility Frontier (PPF) – possible ouput of the country given it’s resources.
Specific Factor – the factor which is constant, for instance land or capital which determines
whether the country produces one good or the other.
Chapter 4: Resources and Trade: The Hecksher-Ohlin Model
Hecksher-Ohlin Model
 Two goods, two factors. Good differ in factor intensity. As long as both goods are
produced there is a one to one relationship between the relative price of goods and the
relative price of factors.
 A rise in relative price of the labour-intensive good will distribute income in favour of
labour, the real wage will rise in terms of both goods while the real income of
landowners decline in terms of both goods.
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 An increase of a factor leads to a biased growth of the PPF, an unchanged relative
price gives that the factor which the good is biased towards increase in the production
while the other is decreased.
 A country that is comparatively well endowed in a resource is abundant in that
resource while the other country is scarce.
 Hecksher-Ohlin about trade: Countries tend to export the goods that are intensive in
the factors with which they are abundantly supplied.
 Because the of the effects on relative prices and earnings of resources international
trade has a strong influence on the Income distribution. The owners of abundant factor
gains and scarce factor loses.
 In an idealised model factor prices would equalize, this is not happening because of
protectionism, trade barriers and differences in technology.
 Empirically the H&O-model is doubtful, the differences in technology are considered
a huge reason for trade in the world today. It is good to analyze the effects of income
distribution though.
Key Terms:
Abundant factor – the factor the country is comparatively well endowed in.
Biased expansion of production possibilities – with growth the PPF will expand with a
bias towards the good which uses the factor of growth in its production intensively.
Equalization of factor prices – relative prices of factors is strongly related to the relative
price. Stopler-samuelsson effect.
Factor abundance – factors the country is abundant in
Factor intensity – depends on the factor abundance and decides the ratio of the factor used
in production of the good.
Factor prices – the prices of labour and land. Wage and renatal rate.
Factor-proportions theory – Another name for the Hecksher-Ohlin model.
Heckseher-Olin Theorem – a country will export that good which uses intensively its
abundant factor and import that good which uses intensively its scarce factor.
Leontief-paradox – the fact that US who ‘should’ have been an exporter of capital intense
goods weren’t so. The explanation is that the US spends a lot of money on R&D and then
leave the production of the capital goods up to factories somewhere else. Also that
Leontieff didn’t make a difference in High- and Low-skilled labour while conducting the
empirical investigation.
Rybczynski Theorem – For any given good prices (P/P fixed) and given that both goods
continue to be produced, if the economy’s supply of a factor of production increases then
the output of that good that uses this factor intensively increases and the output of the
other good decreases.
Scarce factor – the factor which the country is not abundant in, relatively less abundant
that is.
Stolper-Samuelsson Theorem – if both goods continue to be produced, an increase in the
relative price of a good will benefit the factor used intensively in its production and hurt
the other factor.
Chapter 5: The Standard Trade Model
The Standard Trade Model
 The standard trade model derives world relative supply from the PPF and the world
relative demand from preferences.
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 Price of exports relative to import is a countries Terms of Trade. The intersection of
RS and RD.
 Economic growth is an outward shift in the PPF and is usually biased. More in one
goods direction than the other. Growth leads to increase in RS for the good which the
growth is bieased towards which gives a Terms of Trade effect.
 Export-biased growth worsens the countries terms of trade.
 Import-biased growth helps the Terms of trade, it is possible that Import-biased
growth abroad hurts the country.
 Income, such as aid, will hurt the country if it spends a higher proportion of it on the
export good than the giver the transfer raises world D and improves terms of trade.
 If the propensity to spend it on the export good at the margin than the donor the
transfer worsens the terms of trade and offsets at least a little of the direct benefits of
the donation.
 In practice most income in a country is spent domestically, usually due to barriers of
trade, natural and artificial, which makes many goods non-traded. If non-traded goods
compete with exports for resources, transfers will usually raise the recipients Terms of
Trade.
 Import tariff will raise the RS of a country’s import good while lowering RD. A tariff
unambiguously improves the country’s ToT at the rest of the worlds expense.
 An export subsidy has the reverse effect. Lowers the RS and reducing RD for the
export good, worsening the ToT. It hurts the subsidizing country and benefit the rest
of the world
 Both tariffs and subsidies has a strong effect on income distribution within countries
and these effects often weigh more heavily on policy than the ToT.
Key terms:
Biased growth – growth that is more inclined towards one of the goods than the other.
Export-biased growth – growth biased towards the sector which produces the sector of the
export good. Hurts the countries Terms of Trade.
Export subsidy – home subsidizes its exports worsening terms of trade. The subsidy increases
the relative price of the export good by the subsidy, consumers will buy more of the import
competing good while producers produce more of export good. World relative price decreases
and Terms of Trade worsen.
External price – the price outside of the domestic market. World price.
Immiserizing growth – export biased growth where the loss in the Terms of Trade offsets the
gain in welfare by the growth and the country is worse off after the growth than before.
Import-biased growth – growth biased towards the sector that produces the import good, the
country gains in Terms of Trade.
Import tariff – a tariff on import which helps the country’s Terms of Trade on the rest of the
world’s expense. Due to the tariff home producers will face a lower relative price of one good
and therefore produce less of that and more of the other good. RS shifts right. Consumers
facing a lower relative price will consume more of that good. RD shifts right. World relative
price increases and the world is worse off.
Indifference curves – curves of consumption for an individual that leaves him/her equally well
off.
Internal price – domestic price, charged after a subsidy or tariff on the domestic/internal
market.
Isovalue lines – lines which value of output is constant along.
Marignal propensity to spend – the allocation of a marginal shift in expenditure in proportion
to the other country.
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Metzler paradox – the expected effects of the tariff and subsidy is opposite. A tariff will then
raise the ToT effect so much that the internal relative price in fact falls. The subsidy will
lower the welfare so much that the internal relative price falls.
Terms of trade – The relation between P(export good)/P(import good). Increase, helps the
welfare and a decrease leaves the country worse off.
Transfers of income – for instance, postwar aid, capital given to another country.
Chapter 6: Economies of Scale, imperfect competition and
International trade.
Economies of Scale
 Trade result from increasing returns or economies of scale, lower unit cost per unit of
output. This gives countires incentive to specialise in production.
 Economies of scale usually leads to a breakdown of perfect competition and requires
the use of imperfect competition models. Monopolistic competition model and
Dumping model are the two major models.
 Monopolistic competition: an industry contains a number of firms. Q=S(1/n-b(P-P*)).
Large market will supply a large number of firms, everybody competes as monopolists
but firms will enter until P=AC.
 International trade enlarges the market and makes it possible to produce a large
amount of different products to a lower price.
 Trade is in two kinds
o Two way trade in differentiated products within an industry. Intraindustry
trade. Economies of scale. Does not generate as strong effects on income
distribution.
o Trade that exchanges goods of one industry for another industries goods,
interindustry trade. Comparative advantage. Strong effects on economies of
scale.
Dumping
 Dumping occurs when a monopolistic firm charges a lower price on exports than it
charges domestically. It is a profit maximising strategy.
 MR(domestic)=MR(foreign)=MC (Monopoly profit maximising strategy).
 Reciprocal dumping occurs when two monopolists dumps on the others home market.
Causes international trade.
 External economies of scale that occur at he level of the industry instead of the firm. A
country may, because of external economies of scale maintain a large industry even if
another country could produce the same goods more cheaply. When external economies
are important countries can conceivably loose from trade.
Key terms
Average Cost – C(q)/q  F /q  c Cost/unit including fixed costs.
Dumping – Price discrimination between markets. Monopolist charges a lower price abroad.
Dynamic increasing returns – when cost falls over time rather than due to produced quantity.
For instance due to increased knowledge.
 economies of scale – industries rather than companies gain from being placed in the
External
same spot, knowledge spillovers, labour pooling and specialised suppliers are reasons.
External economies of scale is for instance silicon valley.
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Forward falling supply curve – the larger the industry the lower the price at which firms are
willing to sell in the case of external economies of scale.
Imperfect competition – where there are distortions to the market and it is possible for
producers to set price to some extent.
Infant industry argument – the argument that you should be able to protect new industries in
order to give them time to develop and gain knowledge so that they can compete with other
industries over time.
Inter-industry trade – exchange of different goods between industries.
Internal economies of scale – economies of scale that makes the cost lower as the output rices.
Intraindustry trade – two way trade within a sector.
Knowledge spill-overs – external economies of scale gain from this if firms are placed in the
same area.
Labour market pooling – highly skilled labour gather where the jobs are and if the industry is
in the same place there will be large amounts of highly skilled labour which will make the
production more efficient.
Learning curve – the time it takes to learn the production of a good.
Marginal cost – the cost of production for the last unit. Represented by C’(q)
Marginal revenue - MR  P  Q /B The revenue gained on the last unit.
Monopolistic competition – Each firm can differentiate their product and each actor takes the
price charged by its rivals as given, it ignores the impact of its own price on other firms.
Oligopoly – a few firms in the market that can control prices but not to the extent that a pure
monopoly
does.
Price discrimination – when a company charges a higher price to those who are willing to pay
or those who has to buy the good anyway.
Pure monopoly – one firm market, it sets its prices according to it’s own agenda. MR=MC is
the profit maximising function.
Reciprocal dumping – a situation where dumping leads to two-way trade. A country is
shipping its goods alittle cheaper to country B just to get rid of their extra quantities while
anther country does the same thing back.
Specialized suppliers – another efficiency creating effect of external economies of scale.
Chapter 7:International factors movement
International labour mobility
 International factors movement can sometimes substitute trade it is also caused by the
same effects.
 Labour moves from an abundant country to a scarce country. Due to the MPL or MPT
it workers or distributors are better or worse off.
International borrowing and lending
 International borrowing and lending can be viewed as internation trade as well but
involves present and future consumptions on the axis of the PPF.
 Future consumption is the present consumption with the real interest rate added.
 Multi national firms, while often function as vehicles for international borrowing and
lending, primarily is a way of extending control over activities taking place in
different countries. Their reason for existence is:
o A location motive that leads the activities of the firm to be in different
countries. Motives are the same as for international trade (resources and so on)
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o Internalization motive that leads these activities integrated in a single firm.
Motives are transportation of technology or advantages of vertical integration.
Key Terms
Direct foreign investments – foreign companies creates subsidiaries in other countries.
Factor movements – include labour migration and transfer of capital.
Inter-temporal production possibility frontier – The PPF with present and future consumption
on its axis and is used to explain the import/export of inter-temporal trade.
Inter-temporal trade – trade in time, present consumption for future consumption. Future
consumption is defined as present consumption + real interest rate.
Location and internalization motives of multinationals – location moves are the same as trade,
difference in factors. Internalization are transportation of technology and advantages of
vertical integration.
Real interest rate – (1+r) where r is the relative interest rate is what one unit of present
consumption will cost in terms of future consumption. Relative price for present consumption
is therefore 1/(1+r).
Technology transfer – technology defined as any kind of economically used knowledge, is
hard to move sometimes. Therefore moving personnel with this knowledge might be the only
solution and this needs a subsidiary of the company in the target country.
Vertical integration – internalization, in sourcing.
Chapter 8: The Instruments of Trade Policy
 For analysis of trade police partial equilibrium analysis is sufficient.
 A tariff drives a wedge between foreign and domestic prices raising the domestic price
but not as much as the tariff rate. However a small country has to bear the incidence of
the tariff fully.
 Consumer and producer surplus are good tools in order to measure the effects of a tax
relative to social welfare.
o Producers gain because of the higher tariff price.
o Government gains due toe revenue of the tariff and if it is a large country also
Terms of trade gain.
o Consumers however lose because of the tariff price.
 The net effect of a tariff comes down to: big country ambiguous, small country always
loss.
o An efficiency loss which distorts the incentives facing domestic producers and
consumers.
o There is also however (as mentioned) a terms of trade gain for a big country.
These two factors weighed against each other and decide the effect of the
tariff.
 A subsidy creates efficiency losses similar to the tariffs but compounds these losses by
deteriorating the Terms of Trade and cost money to uphold. Welfare always falls.
 Import quotas and VER (voluntary export restraint) gives government revenue, if it is
a quota, from the rents of licences, big country ambiguous, small country falls. A VER
always makes the country worse off since the licence-fees befall foreigners who they
were given too.
Key Terms
Ad valorem tariff – a tariff which is expressed in percent instead of a specific value.
Consumer surplus – the difference between what consumers are ready to pay and the price.
Graphically the area above the price under the demand curve.
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Consumption distortion loss – the loss under the demand curve due to the increase of price
which leads the consumer to consume too little of the good.
Effective rate of protection – example: If a the cost of parts for an automobile was 6000 and
the production in the world cost 2000 then price would be 8000. If a country then imposes a
25% (ad valorem) tariff the price would go up to 8000*1,25=10000. To calculate the effective
rate of production you take the former maximum production cost 2000 and the new one
(10000-6000=4000) and divide the new by the old 4000/2000=2. The Effective rate of
protection is 100%.
Efficiency loss – loss in efficiency because of a trade policy distorting the incentives to
produce and consume.
Export restraint – limitations on quantities of export.
Export subsidy – a payment to a firm or individual that ship a good abroad.
Export supply curve – the excess of what producers supply over what consumers buy.
Import demand curve – the excess of what consumers buy over what producers supply.
Import quota – a maximum level amount of imports.
Local content requirement – a requirement that says that some part of the good has to be
manufactured domestically.
Nontariff barriers – import quotas and export restraints for instance.
Producer surplus – producer surplus is what he was willing to supply the good for minus
what he now gets paid. Graphically between the supply curve and under the price.
Production distortion loss – efficiency loss which leads the domestic producers to produce too
much due to the tariff.
Quota rent – profits received by the holders of the import license holders.
Specific tariff – a tariff which is the same no matter the price of the good.
Terms of trade gain – a gain in welfare due to an increase in the relative export price of the
good the country exports.
Voluntary export restraint (VER) – a quota which is voluntarily imposed by the country in
exchange for something else. It is a quota on the country’s’ exports.
Chapter 9: Political economy of trade policy
 Free trade according to economists is desirable
o Efficiency gains, const benefit analysis of trade policy in reverse.
o Additional gains that goes beyond formal analysis.
o The difficulty of translating complex economic analysis into real policies.
 Terms of trade argument – a deviation from free trade policy can make the country
better off due to terms of trade gains, using the optimum tariff. What is not considered
here is the risk of retaliation and disruption of other agreements due to the
implementation of a new tax.
 Domestic market failure – a country can save a failing market by deviating from the
free trade policy. The theory of second best is applicable here, if you can’t go straight
for the problem then maybe a policy supporting the market is better than nothing. A
tariff may raise the marginal social benefit to production that is not measured in
production surplus.
o Problems with domestic market failure market is: it is always only second best
to treating the problem at the source.
o Problems in analysing the failure and therefore recommending the right policy
is very difficult.
 Trade policy is in practise dominated by the income distribution, no single way of
medeling the politics of trade policy exsits. One theory says that policies implemented
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will be those that appear reasonable to the median voter. This however is hardly true.
The median voter runs into the problem of collective action where a large group
usually does nothing but small groups that are negatively affected by a policy can
change the politicians minds by being loudmouthed.
 International negotiations have brought down tariff levels and is the other (politics)
large reason for free trade.
o It helps broaden constituency for freer trade by giving exporters direct stake.
o Helps governments avoid mutually disadvantageous trade-wars.
 GATT – general agreement on tariffs and trade. A organisation which started the work
for freer trade and created WTO.
 World trade organisation – monitors and enforces the rewritten GATT rules of trade.
In different rounds it has tried to make the world market freer. It also has an organ that
enforces the policies as far as judging in conflicts, the rest is up to each country to do
or not to do.
 In addition there are different kinds of trade agreements except for the multilateral:
o Preferential trade agreements: Lower tariffs with respect to each other but not
towards the rest of the world.
o Customs unions: members set up common external tariffs
o Free trade areas: members don’t charge tariffs between each other but have an
individual tariff towards the outside world.
 Effects of welfare depends.
o If the agreements leads to replacement of high-cost domestic production by
imports – trade creation – country gains.
o If joining leads to replacement of low-cost imports from outside the zone with
higher cost goods from member nations – trade diversion – country loses.
Key Terms
Binding – you bind tariffs when it is bound you cannot change it in any other direction than
downwards, this acroding to the GATT-WTO agreement.
Collective action – when a large mass of people/companies are ‘inactivated’ by the fact that
they are so many which leads to small loudmouthed groups being able to get policies stopped
on the majorities expence.
Domestic market failures – a market of a country is not doing it’s job right (quote).
Efficiency case for free trade – free trade increases the efficiency in the world.
International negotiation – governments agreed to engage in mutual tariff reduction.
Marginal Social Benefit (MSB) – the social benefit is a benefit in welfare that is not captured
by the surplus mechanism.
Median voter – the voter exactly halfway up the line.
Optimum tariff – the tariff which optimises the national welfare.
Political argument for free trade – may be a good political commitment even though there
may be better policies in principle. Deviation from free trade is expensive. There are other
benefits for free trade that is not seen in policies. Any attempt to pursue more complicated
policies will be subverted by the political process.
Preferential trading agreement – the rates of tariffs are lower on goods from countries in the
agreement than from countries outside. GATT prohibits this type of agreements in general
Prisoner’s dilemma – se Perloff
Tariff binding – se binding.
Terms of trade argument for tariff – the argument that the optimum tariff will increase the
terms of trade and the welfare. This might be a half-truth because of other effects (retaliation)
in the real world.
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Theory of second best – when the first best isn’t possible it might be better to protect than to
just let be.
Trade creation – joining an agreement which replaces high-cost domestic industries,
efficiency and welfare gains.
Trade diversion – joining a trade agreement which replaces low-cost imports of foreign
industries from outside with expensive goods from other members.
Trade round – the process of a bunch of countries negotiating reductions in tariffs and other
measures to liberalize trade.
Trade war – policies and retaliation and so and so on, none of the countries gain instead
everybody loses.
Chapter 10:Trade Policy in Developing Countries
 In contrast to developed countries the developing countries are concerned with two
objectives:
o Promoting industrialization
o Coping with uneven deployment with domestic economy
 Infant industry argument: have justified the protection of new (infant) industries, the
argument is only valid if it can be cast as a market failure.
o Imperfect capital markets
o Problems with appropriability of knowledge generated by pioneering firms.
 The argument have lead to import-substitution industrialisation in which domestic
production is created under protection. These policies have promoted manufacturing
but the gains in welfare and growth have not happened. The argument against is that it
has in fact created a high-cost, inefficient production.
 Dualism is also a common problem: High-wage capital-intensive manufacturing sector
and a low-wage traditional sector. Urban unemployment is also a big problem.
 Wage differential case for protection is protection in order to try and avoid the
difference in wage through policy. It has little credibility among economists though
who predict rural-urban migration which worsens the unemployment problem and
may worsen the wage problem as well.
 The High performance Asian Economies (HPAE) have industrialised through exports
and manufactured goods. The reason is highly disputed though.
o The countries do not practise free trade, but do have lower protectionism than
most developing countries.
o Industrial policies are considered key to others roots of success may lie in
domestic causes especially high savings and rapid improvements in education.
Key Terms
Appropriability – the firms of a infant market generate SB for which they are not
compensated for instance start-up costs.
Developing countries – se p255 in book.
Dual economy – an economy suffering by economic dualism.
Economic dualism – an economy divided into one high-wage capital intensive manufacturing
sector and one traditional low-wage sector.
Imperfect capital markets – a developing country does not have functioning capital
institutions such as stock market or banks which means there is no one to invest in the new
industries why they need support.
Import-substitution industrialization – the strategy of encouraging domestic manufacturers by
limiting foreign imports.
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Wage differentials argument – can be stated in market failure terms. Due to dualism the
promoting the manufacturing business will be good for the country. Economists are sceptical
though (se above).
Chapter 11: Controversies in Trade Policy.
 Strategic trade policy offered reason why countries might gain from promoting
particular industries. Critic of globalisation and what it did to workers in developing
countries emerge in the 1990s.
 Activist trade policy arguments on two ideas.
o Industries which contain technological externalities should be promoted.
o Brander-Spencer analysis says that strategic intervention enables nations to
capture excess returns. This is however, according to economists, a too subtle
and to information-demanding analysis to ever be successful in real life.
 New concern of the manufactures of developing countries for the workers wages have
risen. The answer by economists is that they earn very little money but at least it is
more than they otherwise would and therefore it is justified.
 It is hard to discuss globalisation from a moral perspective. The main argument of
activists is labour standards which is feared by developing countries which believe
they will be used as protectionist devices.
 Even more difficult problems arise over issues as cultural homogenization and
environmental standards.
Key Terms
Beggar-thy-neighbour policies – policies that increase our welfare at other counties’ expense.
Brander-Spencer analysis – se p 279 and forward in the book.
Excess returns – firms will make profits above what equally risky investments, in other parts
of the economy, does.
Externalities – benefits that accrue to parties other than the firms that produce them
Strategic trade policy – se book p 276.
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