International Trade:
Theory and Policy
Andrzej Cieślik
LECTURE 1
Introductory Remarks
Several reasons why you should study international trade:
 International trade is now more important to any economy than it used
to be in the past due to ongoing globalization of national economies
 There is an increasing perception among the general public that
international trade is a vital subject
 We live in times in which everybody is obsessed with international
competition and “international competitiveness”
Problem:
 The problem is that most of what students are likely to hear or read in
popular press about international trade is nonsense.
Solution:
 Your primary task in this class will be to learn how to detect that
nonsense and to vaccinate your minds against the common
misconceptions about international trade. You should be equipped to
respond intelligently to popular discussions of international trade.
2
“Typical” statement on international trade from popular press:
“We need a new economic paradigm because today our country is a
part of a truly global economy. To increase its standards of living our
country now has to learn to compete in an even tougher world
market place. That’s why high productivity and product quality have
become essential. We need to move our economy into the high
value sectors that will generate jobs for the future. And the only way
we can be competitive in the new global economy is if we forge a
new partnership between government and business”.
Paul Krugman
“What do the undergrads need to know about trade?”,
American Economic Review (May 1993), pp. 23-26.
3
COMMON MISCONCEPTIONS:
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“International competition” - Firms compete, countries do not!
International trade is not about competition but about mutually
beneficial exchange.
Imports and not exports are the purpose of international trade.
(as imports allow us to get what we want)
National economy is not a corporation that can be driven out of
business.
“High productivity”
High productivity is beneficial not because it helps a country to
compete with other countries, but because it lets a country produce
and consume more.
(this is true both in the closed and the open economy)
4
Consider a following thought experiment:
“Imagine a world in which productivity rises by 1 per cent annually in all
countries. What will be the trend in our standards of living?. Does
everybody agree that it will rise by 1 per cent per year? Now, imagine
that while our country continues to raise its productivity by 1 per cent
per year the rest of the world manages to achieve 3 per cent
productivity growth. What is the trend in our standard of living? It is still
1 per cent! (but there might be some terms of trade effects – to be
discussed later in the course”
“High value sectors”
 “High value sectors” is a silly concept! You can take a look at the
simplest version of Ricardian 2x2x1 model (two countries, two goods,
one factor) in which one country is more productive in both industries
than the other. The more productive country will have a higher wage
rate and therefore whatever sector it specializes in will be “high value”,
(i.e. will have a higher value added per worker). Does this mean that
country’s high living standard is the result of being in the right sector?
Or the poorer country will be richer if it tried to emulate the other’s
pattern of specialization? Of course, NOT!
5
“Jobs”
 Employment is a macroeconomic issue, you should study the
determinants of the natural rate of unemployment in the long run (and
the aggregate demand in the short run). Microeconomic policies like
tariffs have little effect on employment! Trade policy should be
debated in terms of its impact on efficiency, not in terms of phony
numbers about jobs created or lost.
“A new partnership”
 Many industries want protection or some other sort of against the
foreign rivals (and actually buy protection from politicians). Always
remember that the real competition takes place WITHIN the country
and between industries where firms compete at factor markets to get
scarce resources of capital, skills and labor. Government support of
one industry may help that industry compete against foreigners but it
also draws resources away from other domestic industries (i.e. it hurts
the rest of the economy). The increased importance of international
trade does not change the fact that the government cannot favor one
domestic industry except at the expense of other industries.
6
USEFUL READINGS:
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Krugman P., 1993, “What do the undergrads need to
know about trade?”, American Economic Review
(May), pp. 23-26.
Krugman P., 1993, “The narrow and broad arguments for
free trade”, American Economic Review 83, pp.
362-366.
Krugman P., 1994, “Does third world growth hurt first
world prosperity?”, Harvard Business Review, pp.
113-121.
Krugman P., 1994, “Competitiveness: A dangerous
obsession”, Foreign Affairs.
7
Approach:
“For the bulk of our economics students, our objective should be to
equip them to respond intelligently to popular discussion of
economic issues. A lot of that discussion will be about international
trade, so international trade should be an important part of the
curriculum. What is crucial, however, is to understand that the level
of public discussion is extremely primitive. Indeed, it has sunk so low
that people who repeat silly clichés often imagine themselves to be
sophisticated. This means that our courses need to drive home as
clearly as possible the basics. Offer curves and Rybczyński effects
are lovely things. What most students need to be prepared for,
however, is a world in which TV “experts”, best-selling authors, and
$ 30,000-a-day consultants do not understand budget constraints,
let alone comparative advantage”.
Paul Krugman
“What do the undergrads need to know about trade?”,
American Economic Review (May 1993), pp. 23-26.
8
Approach:
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For most of you this will be the first and the last course
on international trade, therefore, it is now more important
than ever before that you receive a solid background in
the principles of international trade.
Although the last 30 years have seen “a golden age” of
innovation in international trade theory and policy, this
innovative stuff is NOT a priority for you! You still need to
learn the basic insights of classical economists such as
Ricardo or Hume.
9
Sample issues to be discussed:
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What constitutes the basis for trade?
Why do countries export and import certain products?
At what terms of trade (relative prices) are products
exchanged in the world market?
What are the gains from international trade in terms of
production and consumption?
What are the gains from international flows of capital and
labor in terms of production and consumption?
What are the trade policy instruments?
What are the welfare effects of trade liberalization?
10
Two waves of globalization
Merchandise exports, % of GDP in 1990 prices
17.2
15
13.4
10.1
10
5
4.6
2.5
0.2
0
1870
1900
1930
world
1960
USA
Japan
1990
11
Global output and world trade
Global industrial production and world trade volume
(centred 5-month moving average index, 2000=100)
world trade volume
150
100
global
industrial
production
0
1991
1994
1997
2000
2003
2006
2009-3
2008-3
2001-10
2000-10
50
2009
2012
12
Real world trade flows
Real world trade flows; constant 2000 US dollar, index (2000 = 100)
Global Economic Crisis
20.0%
decline
160
120
7.4%
decline
80
40
0.3%
decline
2.8%
decline
annual monthly
data data
1
0
1970
1975
2
1980
3
1985
1990
1995
2000
4
2005
2010
13
Intra- and Inter-regional merchandise trade flows (% of world total)
Merchandise trade export by region, 2008 (% of total)
41.0
EUR
29.9
27.7
ASIA
13.9
13.0
NAM
6.5
6.5
mEAST
0.8
4.5
CIS
1.0
3.8
SCA
0.9
total
intra-region
3.5
AFR
0.3
0
10
20
30
40
14
Foreign direct investment
Foreign capital stocks; assets / world GDP
0.6
0.4
0.2
0
1860
1880
1900
1920
1940
1960
1980
2000
15
Migration
Relative annual immigration flows, 1870-1998 (per 1000)
6
4
2
0
1870-1913
1914-1949
1950-1973
1974-1998
-2
Western Europe
Western Offshoots
16
Course organization
The course in organized in 2 parts covering both trade theory and trade
policy.
Required Reading:
 Krugman, P.R.; Obstfeld, M., Melitz M. 2012, International
Economics: Theory and Policy, Addison Wesley, Boston.
Recommended Reading:
 Marrewijk, Ch. van 2012, International Economics, Oxford University
Press, Oxford.
 Markusen, J.R.; Melvin, J.R.; Kaempfer, W.H.; Maskus K.E. 1995,
International Trade: Theory and Evidence, McGraw-Hill, Boston.
17
Part 1. Trade theory
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Class 1. Introduction (06.10.2015)
A historical overview of trade theory, the importance of international
trade and investment, contemporary patterns of international trade
and investment, classical trade theory, absolute advantage, gains from
trade.
Required Reading: KOM (2012), ch. 1&2.
Recommended Reading: Markusen et al. (1995), ch. 1.; Marrewijk
(2012), ch. 1&2.
Class 2. Ricardian model (13.10.2015)
Simple Ricardian 2x2x1 model, comparative advantage, excess
demand functions, international equilibrium, the role of wages, gains
from trade, extensions: 3 and more goods.
Required Reading: KOM (2012), ch. 3.
Recommended Reading: Markusen et al. (1995), ch. 7. Marrewijk
(2012), ch. 3.
18
Part 1. Trade theory
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Class 3. Modified Ricardian model (20.10.2015)
2x2x3 factor specific model, pattern of trade, commodity prices and
factor prices, Haberler theorem, endowment changes and outputs,
income distribution, gains from trade.
Required Reading: KOM (2012), ch. 4.
Recommended Reading: Markusen et al. (1995), ch. 9. Marrewijk
(2012), ch. 6.
Classes 4-5. Heckscher-Ohlin model (27.10.2015 and 03.11.2015)
2x2x2 factor abundance model, pattern of trade, Heckscher-Ohlin
theorem, factor price equalization theorem, Stolper-Samuelson
theorem, Rybczyński theorem, Jones magnification effects,
extensions: many goods, many factors.
Required Reading: KOM (2012), ch. 5-6.
Recommended Reading: Markusen et al. (1995), ch. 8. Marrewijk
(2012), ch. 7.
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Part 1. Trade theory
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Class 6. New trade theories (10.11.2015)
External versus internal economies of scale, Marshallian externalities,
market structure and increasing returns, monopolistic competition
versus oligopoly, trade as a competition policy instrument, Dixit-Stiglitz
preference for variety, intra-industry trade, demand similarity and
Burenstam-Linder hypothesis, life cycle theories of international trade.
Required Reading: KOM (2012), ch. 7.
Recommended Reading: Markusen et al. (1995), ch. 11-13. Marrewijk
(2012), ch. 9-10.
Classes 7-8. International factor flows (17.11.2015 and 24.11.2015)
Multinational corporations, foreign direct investment, Dunning OLI
eclectic framework, knowledge capital model, FDI in developed and
developing economies, international fragmentation of production,
international labor migration, gains from FDI and labor flows.
Required Reading: KOM (2012), ch. 8.
Recommended Reading: Markusen et al. (1995), ch. 21-22. Marrewijk
(2012), ch. 15&17.
20
Part 2. Trade policy
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Class 9. Instruments of trade policy (01.12.2015)
Import tariffs, import quotas, quotas versus tariffs, optimum tariff, nontariff barriers, effective protection, export taxes, export subsidies,
voluntary export restraints, effects of trade liberalization.
Required Reading: KOM (2012), ch. 9.
Recommended Reading: Markusen et al. (1995), ch. 15-16. Marrewijk
(2012), ch. 8.
Class 10. Strategic trade policy (08.12.2015)
Import protection as export promotion, export rivalry, quotas and VERs
as facilitating practices, evaluation of strategic trade policy.
Required Reading: KOM (2012), ch. 12.
Recommended Reading: Markusen et al. (1995), ch. 17. Marrewijk
(2012), ch. 11.
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Part 2. Trade policy
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Class 11. Political economy of trade policy (15.12.2015)
Free trade and efficiency, political arguments for free trade, income
distribution and trade policy, protection for sale, median voter model,
empirical evidence.
Required Reading: KOM (2012), ch. 10.
Recommended Reading: Markusen et al. (1995), ch. 19.
Class 12. Preferential trading agreements (12.01.2016)
Neoclassical theory of economic integration, types of regional
economic integration, trade creation versus trade diversion,
European integration, regionalism and the new trade theory.
Required Reading: Markusen et al. (1995), ch. 18.
Recommended Reading: Marrewijk (2012), ch. 13.
22
Part 2. Trade policy
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Class 14. International trade organizations (19.01.2016)
International institutions and rules, bilateralism versus multi
multilateralism, GATT/WTO, United Nations and UNCTAD, OECD,
administered protection, safeguards, trade policy and environmental
regulations.
Required Reading: Markusen et al. (1995), ch. 20.
Recommended Reading: Marrewijk (2012), ch. 12.
23
METHODOLOGY & TOOLS – OPEN ECONOMY MICROECONOMICS?
International trade theory is an extension and application
of microeconomic theories of production and exchange
to study economic transactions between agents in
different countries.
Therefore, we will use profit and utility maximization
paradigm to explain why countries trade, what goods
they import and export, how trade affects allocation of
resources within and between nations, and whether a
country benefits from international trade.
Two main characteristics distinguish theoretical analyses
of international trade from those of microeconomics:
- The use of general equilibrium (macro view)
- The focus on the country as a whole (macro view)
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Historical background: Early developments in trade theory
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The modern theory of international trade and trade policy
is the product of an evolution of ideas in economic
thought. Now, we will review briefly the development of the
theory from the seventeenth century through the first part
of the twentieth century.
The historical approach is useful not because we are
interested in the history of economic thought as such but
because it is a convenient way of introducing the concepts
and theories of international trade from the simplest (and
not very realistic) to the most complete (and more
realistic). As new knowledge builds on old knowledge you
need to become acquainted with the classic concepts and
theories.
In particular, the writings of the mercantilists, and later
those of Adam Smith and David Ricardo have been
instrumental in providing the framework of the modern
theory of international trade.
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Mercantilism versus classical trade theory
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The ideas of classical trade theorists such as Smith and
Ricardo can be best understood if they are regarded as
reactions to mercantilist views on trade and the role of
government.
Therefore, we begin with a brief review of the economic
doctrine known as mercantilism that prevailed in most
European countries during the seventeenth and eighteenth
centuries.
Then we go to discuss the ABSOLUTE advantage. It was,
however, David Ricardo, who explained the pattern and
the gains from trade with his law of COMPARATIVE
advantage.
The law of comparative advantage is one of the most
important laws in economics and applies both to nations
and individuals (later on we illustrate it with some concrete
examples).
26
Mercantilism versus classical trade theory
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During the period 1500-1800 a group of “political writers” (from
various backgrounds such as merchants, bankers, philosophers,
government officials) wrote pamphlets on international trade that
advocated an economic philosophy known as mercantilism.
You need to remember about the historical context in which these
pamphlets were created! This was a time when many countries were
transforming themselves from the city states into modern national
states and these writers were concerned with the process of nation
building.
According to the mercantilists the key question was how a nation
could regulate its domestic and international affairs as to promote its
own interests, i.e. “NATIONAL” interest (which is practice often
means an interest of a specific group of people who do lobbying).
According to them the solution lays in the “strong” foreign trade
sector.
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Mercantilism versus classical trade theory
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Mercantilists maintained that the way for a nation to become rich
and powerful was to export more than to import. The resulting export
surplus would then be offset by an inflow of precious metals (gold
and silver) into the country. The more gold and silver the country
had the more powerful it was.
Mercantilists used to measure the wealth of a nation by the stock of
precious metals it possessed. How do we measure nation’s wealth
today? By the stock of factors of production, such as the stock of
human, physical (man-made) capital, natural resources and
knowledge available for producing goods and services to satisfy
human wants (potential GDP).
Remember that mercantilists were writing their pamphlets mainly for
autocratic rulers with the aim of enhancing their military power. With
more gold and silver, these rulers could maintain bigger and better
armies and consolidate their power. Improved armies and navies
made it possible for them to conquer their neighbors and/or to
acquire more colonies and increase their tax base. The increased
tax base would allow maintaining even bigger and better armies and
so on.
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Mercantilism versus classical trade theory
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To promote a trade surplus the mercantilists advocated
government regulation of trade.
The government had to do all in its power to stimulate
exports and restrict imports, i.e. to follow the export
promotion and import restriction policy.
Tariffs, quotas and other trade barriers were proposed to
minimize imports and to promote domestic production
(Import substitution development strategy).
Since all nations could not simultaneously have an export
surplus and the amounts of gold and silver were fixed (in a
given moment) one nation could gain only at the expense
of other nations, i.e. international trade was seen as the
WIN-LOSE (zero-sum) game.
Mercantilists were preaching ECONOMIC NATIONALISM
as they believed that “national interests” were basically in
conflict.
29
THOMAS MUNN (1571-1641) – a “representative” mercantilist, the
author of “England’s Treasure by Foreign Trade”- wrote:
“Although a kingdom may be enriched by gifts received, or purchase
taken from other nations, yet these things are uncertain and of small
consideration when they happen. The ordinary means to increase
our wealth and treasure is by foreign trade, wherein we must ever
observe this rule; to sell more to the strangers yearly than we
consume of theirs in value. For … that part of our stock (exports)
which is not returned to us in wares (imports) must necessarily be
brought home in treasure (bullion) … We may … diminish our
importations, if we would soberly refrain from excessive
consumption of foreign wares in our diet and raiment … In our
exportations we must not only regard our superfluities, but also we
must consider our neighbors necessities, that so … we may … gain
so much of the manufacture as we can, and also endeavor to sell
them, dear so far forth as the high price cause not a less rent in the
quantity (of our exports). But superfluity of our commodities which
strangers use, and may also have the same from other nations, or
may abate their vent by the use of some such like wares from other
places, and with little inconvenience; we must in this case strive to
sell as cheap as possible we can, rather than to lose the utterance
of such wares”.
30
Critique of mercantilist arguments
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Mercantilists claimed that one nation’s gains from trade came at the
expense of its trading partners, i.e. not all nations could
simultaneously enjoy the benefits of international trade.
They were attacked for their static view of the world economy. This
view was challenged with the publication of Adam Smith’s (17231790) “An Inquiry into the Nature and Causes of the Wealth of
Nations”.
Smith started with the simple observation that for two nations to
trade with each other voluntarily, both nations must gain! If one
nation gained nothing or lost it would simply refuse to trade.
Smith argued that international trade permits nations to take
advantage of specialization and division of labor, which increase the
general level of productivity within a country and thus increase world
output (i.e. there are PRODUCTIVITY gains from international
SPECIALIZATION in production).
The dynamic view of international trade advocated by Smith
suggested that both trading partners could simultaneously enjoy
higher level of production and consumption with free trade.
31
ADAM SMITH (1723-1790) – a classical economist, the
author of “An Inquiry into the Nature and Causes of the
Wealth of Nations (1776)”- wrote:
“The importation of gold and silver is not the principal, much less the
sole benefit which a nation derives from its foreign trade. Between
whatever places foreign trade is carried on, they all of them derive
two distinct benefits from it. It carries out that surplus part of the
produce of their land and labor for which there is no demand among
them, and it brings back in turn for it something else for which there
is a demand. It gives a value to their superfluities, by exchanging
them for something else, which may satisfy a part of their wants, and
increase their enjoyments. By means of it, the narrowness of the
home market does not hinder the division of labor in any particular
branch of art or manufacture from being carried to the highest
perfection. By opening a more extensive market for whatever part of
the produce of their labor may exceed the home consumption, it
encourages them to improve its productive powers, and to augment
its annual produce to the utmost, and thereby to increase the real
revenue and wealth of the society.” (Smith, 1776, p. 326)
32
PRINCIPLE OF ABSOLUTE ADVANTAGE
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Smith argued that trade between nations is based on the principle of
ABSOLUTE advantage.
When one nation is more efficient in the production of one commodity but
less efficient than the other nation in production of another commodity, then
both nations can gain by each specializing in the production of the
commodity of its absolute advantage. By this process world resources are
utilized in the most efficient way and the output of both commodities will
rise.
The increase in the output of both commodities measures the gains from
specialization in production available to be divided between two nations
through trade (i.e. the GAINS from TRADE).
Where do the productivity differences across countries come from?
• Natural advantages can be related to climate, soil, mineral wealth, etc.
• Acquired advantages include skills, capital and technology.
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EXAMPLE. Trade in agricultural goods (wheat and bananas)
Because of differences in climatic conditions Canada is efficient in
growing wheat but inefficient in growing bananas (greenhouses
would have to be used). On the other hand, Nicaragua is efficient in
growing bananas but inefficient in growing wheat. Thus Canada has
a natural absolute advantage over Nicaragua in growing wheat but a
natural absolute disadvantage in growing bananas while the reverse
holds for Nicaragua. Therefore, under these circumstances both
nations would benefit if each specialized in the production of the
commodity of its absolute advantage and then traded with other
nation. In this situation Canada would specialize in production of
wheat (i.e. produce more than needed for domestic consumption)
and exchange some of it for (additional) bananas grown in
Nicaragua. As a result both more wheat and more bananas would
be grown and consumed and both Canada and Nicaragua would
gain from specialization in production and trade.
34
Trade between England and Portugal in cloth and wine
Numerical Example.
England
Portugal
Total
Labor hours necessary to produce
1 unit of Cloth (industrial good)
1
2
Labor hours necessary to produce
1 unit of Wine (agricultural good)
2
1
Potential output of cloth given total labor
endowment – 24 hours
24
12
24
Potential output of wine given total
labor endowment – 24 hours
12
24
24
Actual preferences concerning allocation of
time to the production of cloth- 8 hours
8
4
12
Actual preferences concerning allocation of
time to the production of wine - 16 hours
8
16
24
Trade in cloth
10
10
England gains 6,
Portugal gains 6
Trade in wine
8
8
No gains 35
Executive summary of Smith’s arguments and policy recommendations
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While mercantilists believed that one nation could gain only at the
expense of other nations and advocated a strict government control
of all economic activity and trade Smith and his followers believed
that all nations would gain from free trade and strongly advocated a
policy of “laissez-faire” (i.e. as little government interference with the
economic system as possible). Free trade would cause the world
resources to be utilized most efficiently and would maximize world
welfare.
According to Smith a nation behaves no differently from an
individual who does not attempt to produce all commodities he/she
needs. Rather he/she produces one that commodity that he/she can
produce most efficiently and then exchanges a part of his/her output
for other commodities he/she needs. In this way, total output in the
society and welfare of all individuals are maximized.
36
Trade policy in contemporary world
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Aside from England during the period 1815-1914 no
Western nation has ever been completely free of
mercantilist ideas. In particular, this historically applied to
big European (mostly continental) nations such as
Germany or France and presently to the European Union
(eg. The Common Agricultural Policy), as well as the
United States (eg. The Sugar Lobby).
Trade restrictions are advocated by some well organized
industries who form powerful lobbying groups and are
often rationalized in terms of national welfare (“national
interest”, “national security”, “strategic industries”, etc.).
Always remember that trade restrictions benefit the
few at the expense of the many!
37