International Economics:
Trade Theory and Policy
WS 2013/14
Christen/Leiter/Pfaffermayr
Lecture:
Mo. 8:30-11:00, HS3
Proseminar:
see Syllabus
International Economics
Page 1
Literature
van Marrewijk, Ch. (2012), International Economics,
Oxford University Press, 2nd ed.
Chapters from Parts I, II and III
Additional material will be covered in the Proseminar
International Economics
Page 2
Exam and Grading
Includes all the material covered in the course (lecture plus
proseminar).
A positive grade in the PS is a necessity.
Course grade is an ECTS-weighted average of exam and PS.
An example of an exam plus some examples of exam
questions are provided in OLAT.
Three final exams per semester.
Lecture: 70.0%
Two short essays. You can choose from three topics.
Proseminar: 30.0%
Three short questions.
International Economics
Page 3
Questions addressed in trade theory and policy I
• Determinants of trade and industry structure of an open
economy in the long run.
• The welfare effects and distributional consequences (factor
incomes) of worldwide globalization and trade liberalization.
• Labor market effects of trade and foreign direct investment.
• Trade Policy:
Instruments and their welfare effects
The impact and the welfare effects of regional trade
agreements
International Economics
Page 4
Questions addressed in trade theory and policy II
• Structural change and trade liberalization: Should European
countries protect e.g. their textile industries?
• ‘Are our wages set in Beijing?’: The impact of trade with low
wage countries on low skilled workers’ wages in Europe.
• Why do trade volumes grow faster than GDP?
• What can we expect from the multilateral trade liberalization
efforts of WTO?
• The impact of a bilateral Trade Agreements, e.g., between EU
and US?
International Economics
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Literature and Resources I
• Study Guide: Stephan Schueller and Daniel Ottens Oxford
University Press
• Krugman, Paul R., Maurice Obstfeld and Marc J. Melitz:
International Economics, Theory and Policy, Pearson, 9th ed.,
2012.
• Feenstra Robert C. and Alan M. Taylor, International
Economics: International Edition, Worth Publishers, 2nd ed.,
2011
• Further literature cited in these two books, especially papers
in the academic journals
International Economics
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Literature and Resources II
FIW: http://www.fiw.ac.at/
WIFO: http://www.wifo.ac.at/
WIIW: http://www.wiiw.ac.at/
WTO: http://www.wto.org/
EU: http://ec.europa.eu/trade/
WITS: http://wits.worldbank.org/wits/
CEPII: http://www.cepii.fr/CEPII/en/bdd_modele/bdd.asp
UNCTAD: http://unctad.org/en/Pages/Statistics.aspx
GTAP: https://www.gtap.agecon.purdue.edu/
Feeenstra: http://cid.econ.ucdavis.edu/data.html
International Economics
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Chapter 1: The World Economy – Some Stylized Facts
p. 4: „International economics is what international
economists do,…, you will only know about international economics, once you have studied it yourself“.
„…I think that an important distinguishing characteristic is the general equilibrium nature of this
approach.“
This forces us to be precise and complete in our
explanations.
International Economics
Page 8
* The portrait was painted by Carla
Rodenburg in 2001. I am grateful to
Angus Maddison for his permission to
use this painting.
 Angus Maddison
Figure 1.1 Angus Maddison (1926 -2010)
International Economics
Page 9
Chap. 1.2 and 1.3:
The economic size (power?) of a nation is best
measured in terms of the total value of goods and
services produced in a certain time period.
Other measures of size such as land area and
population are weakly correlated with economic
size – look at Russia, China, India, Brazil on the
one hand, and on the European Countries on the
other hand.
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A size comparison across open countries needs three steps:
1. Accurate data from the statistical offices in national
currency (Maddison in our case).
2. Decide to look at GNP or GDP
GDP + net receipts of factor income = GNP
GDP…market value of goods and services produced
by labor and property located in a country.
GNP… market value of goods and services produced
by labor and property of the nationals of a country.
3. Use the same currency ($): current US $ or PPP.
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Fig 1.2: GDP and GNP, 2008 ($ billion)
The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of GDP.
GDP and GNI, 2008 (billion current $)
100,000
USA
Gross National Income, GNI
Japan
10,000
Germany
China
1,000
100
10
10
100
1,000
Gross Domestic Product, GDP
International Economics
Page 12
10,000
100,000
Purchasing Power Parity (PPP)
Comparing income in current $ tends to overestimate
the differences between high and low income
countries
(i) Tradable goods are subject to international competition so that the
prices of such tradable goods tend to be equal when measured in the
same currency.
(ii) Within a country producers of tradable and non-tradable goods compete
for same resources (labor) so that the wage rate in each country reflects
labor productivity.
(iii) Across countries differences in productivity in the non-tradable sectors
tend to be smaller than in the tradable sectors.
In current $, the value of output tends to be underestimated in low-income countries.
International Economics
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Purchasing Power Parity (PPP)-continued
Example: based on the current exchange rate
Cost of hair cut in the US: 10$
Cost of hair cut in Tansania: 1$
So the same service is priced differently: the value
of production in US is overestimated by a factor 10!
United Nation income comparison project (ICP)
collects price data on goods and services in all
countries of the world and calculates PPP
comparing prices in local currencies.
P$=PTZS E$/TZS
International Economics
P
US 10


=> implied PPP: E
TZS/E
P
TZS 1
Page 14
Figure 1.3: Gross domestic product, 2008; top 15, ranked
according to PPP
International Economics
Page 15
1.5 International Trade
Trade flows can readily compared using exchange
rates.
We distinguish merchandise trade and trade in
commercial services.
Stylized facts 2008 (see http://www.fiw.ac.at/ for more
recent evidence):
China has been the largest merchandize trade exporter, followed by
Germany and US.
US share in world exports is just 8.5%.
Many countries have a larger share in world exports than in world
production (country size matters!).
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Exports Relative to Imports
The difference between exports and imports (trade balance)
is more pronounced than the difference between GDP and
GNP, but relative to the size of imports and exports the
difference is small.
In 2008 China had the largest trade surplus in goods and
services (349 bn $) followed by Germany (228 bn $).
US has the largest trade deficit (696 bn $).
In relative terms Brunei is the largest net exporter and
Ethiopia the largest net-importer.
Trade openness is defined as the ratio of exports +imports
to production. For Singapore this ratio is more than 234%.
International Economics
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Figure 1.4: Exports and imports of goods and services, 2008 ($ billion)
The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of exports.
Exports and imports of goods and services, 2008 ($ bn)
10,000
USA
China
import value
1,000
Germany
Russia
100
Saudi Arabia
Ethiopia
10
Brunei
1
1
10
100
export value
International Economics
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1,000
10,000
Figure 1.5: Relative exports of goods and services, 2008 (% of GDP)
Relative exports of goods and services, 2008 (% of GDP)
234
Singapore
212
Hong Kong
179
Luxembourg
131
Seychelles
110
Malaysia
97
Bahrain
Belgium
92
United Arab Emirates
91
Macao
90
88
Malta
0
International Economics
50
100
Page 19
150
200
250
Figure 1.6: Taxes on international trade
Taxes on international trade, 2008 (% of revenue)
57
Lesotho
52
Bahamas, The
44
Namibia
35
Cote d'Ivoire
35
Madagascar
Maldives
32
St. Kitts and Nevis
32
27
Bangladesh
26
Niger
25
Russian Federation
0
International Economics
10
20
30
Page 20
40
50
60
1.6 Globalization
Globalization defined by Neary (2002): The increased
interdependence of national economies; trend towards greater
integration of goods, labor and capital markets.
Globalization and Income:
Income statistics based on Maddison’s work (in 1990 international
Dollars (corrected for PPP, ensure transitivity, base country invariance
and additivity).
Logarithmic scale (level and growth).
Big increase in GDP per capita in 1820 (industrial revolution).
Two waves of globalization: second half of 19th century and after WW2.
New institutional setting after WW2: income per capita +3% p.a., world
income +5% p.a., world trade flows +8% .p.a.
International Economics
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Figure 1.7: Development of world per capita income over the last 2000 years
World GDP per capita (1990 international $), logarithmic scale
10,000
5,709
1,000
667
435
444
100
0
International Economics
500
1000
Page 22
1500
1820 2000
Figure 1.8: Two waves of globalization in trade
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
International Economics
1960
USA
Page 23
Japan
1990
1.6 Globalization (continued)
Globalization and capital:
Two similar waves of globalization in the capital markets. Sharp increase in
capital mobility since the 1960thies.
Globalization and migration:
Two modern waves of migration:
1820-1913: 40 millions migrants mainly form Europe to US, Canada, South
America and Australia, young and mainly low skilled workers.
After WW2 (not yet ended): Since the 1990thies the source countries are
now mainly Asian and Eastern European countries.
Many countries have quotas to restrict inward migration.
Labor markets are less globally integrated than goods and capital markets.
International Economics
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Figure 1.9: Foreign capital stocks, assets / world GDP
Foreigncapital stocks; assets / worldGDP
0.6
0.4
0.2
0
1860
International Economics
1880
1900
1920
1940
Page 25
1960
1980
2000
Figure 1.10: Relative migration flows, Western Europe and Western Offshoots
Relative annual immigration flows, 1870-1998 (per 1000)
6
4
2
0
1870-1913
1914-1949
1950-1973
-2
Western Europe
International Economics
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Western Offshoots
1974-1998
1.7: Some Stylized Facts for Austria
International Economics
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1.7: Some Stylized Facts for Austria
International Economics
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1.7: Some Stylized Facts for Austria
Austria‘s most important trading partners (exports in 2009)
International Economics
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1.7: Some Stylized Facts for Austria
Austria‘s FDI Position
International Economics
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Chapter 3
Classical Trade: Technology
International Economics
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Overview Ricardian (classical) model
• Technology differences between countries are the driving
force behind international trade flows
• Relative (or comparative) differences are crucial, not absolute
differences
• Absolute differences are important for determining a country’s
wage rates and welfare level
• The production possibility frontier summarizes the state of
technology and the available factors of production in final
goods space
• Trade flows increase welfare (technology gains from trade)
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David Ricardo (1772-1823)
“When a country can either import
a commodity or produce it at
home, it compares the cost of
producing at home with the cost of
procuring from abroad; if the latter
is less than the first, it imports.”
International Economics
Page 33
Assumptions of the Ricardian technology model
•
•
•
•
•
•
•
•
•
General
(example)
Two countries
(EU and Kenya)
Two final goods
(Food and Chemicals)
One factor of production
(Labour)
Constant returns to scale production functions
Perfect competition
Labour is mobile between sectors, but not between countries.
Costless trade in final goods (no impediments to trade)
Technology as reflected by labor productivity differs between
countries
International Economics
Page 34
Technology differences between countries
Production technology is summarized in a productivity table:
Labour units required to produce one unit of output
Food
Chemicals
EU
2
8
Kenya
4
24
The EU technology is more productive for both goods
The EU has an absolute advantage in Food production: it
requires less labour (2 units instead of 4)
The EU also has an absolute advantage in Chemicals
production: it requires less labour (8 units instead of 24)
International Economics
Page 35
Comparative advantage: productivity method
Labour units required to produce one unit of output
Food
Chemicals
EU
2
8
Kenya
4
24
• The EU is twice as productive in the Food sector (4/2 = 2)
• The EU is three times as productive in the Chemicals sector
(24/8 = 3), so
The EU has a comparative advantage in Chemicals, and
Kenya has a comparative advantage in Food
International Economics
Page 36
Comparative advantage: opportunity cost method
Labour units required to produce one unit of output
Food
Chemicals
EU
2
8
Kenya
4
24
• An extra unit of Chemicals needs 8 units of labor in the EU
• This labor could have made 8/2 = 4 units of Food; the
opportunity cost of Chemicals production in the EU is 4 Food.
• An extra unit of Chemicals in Kenya needs 24 labor
• This labor could have made 24/4 = 6 units of Food; the
opportunity cost of Chemicals production in Kenya is 6 Food
The EU has a comparative advantage in Chemicals,
Kenya in Food
International Economics
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The ppf is a straight line in the Ricardian model
Labour units required to produce one unit of output
Food
Chemicals
EU
2
8
Kenya
4
24
• Suppose the EU has 200 units of labour available and Kenya
has 120 units available (remember: it is just an example)
• If all workers in the EU produce only Food, the EU can make
200/2 = 100 Food (and 0 Chemicals)
• If all workers in the EU produce only Chemicals, the EU can
make 200/8 = 25 Chemicals (and 0 Food)
• Similarly, if all workers in Kenya produce Food total output is
120/4 = 30 Food (and 0 Chemicals); if they all produce
Chemicals total output is 120/24 = 5 Chemicals (and 0 Food)
International Economics
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Production possibility frontier (ppf)
Definition: all possible combinations of efficient production
points of final goods, given the available factors of production
and the state of technology;
Note that:
• It is a technical specification: the ppf does not depend on the
type of market competition
• The ppf depends on the available factors of production: if,
e.g., more labour becomes available more goods can be
produced
• The ppf depends on the state of technology: if new
techniques become available, output increases with the same
use of inputs
International Economics
Page 39
Production possibility frontiers
Kenya can produce
The EU can produce
Food
(0 Chemicals, 100 Food) or
(0 Chemicals, 30 Food) or
(20 Chemicals, 0 Food), or
(5 Chemicals, 0 Food), or
any combination in between any combination in between
Resurce
constraint
:L

a
C

a
F
EU
C
EU
F
EU
100
EU ppf
L
a
EU
C
PPF
:F


C
EU
a
a
F
F EU
B
C
Opportunit
y
costs
:a
a
F
D
30
Kenya ppf
E
C
A
0
International Economics
5
25 Chemicals
Page 40
Production in the EU; pC/pF = relative price of Chemicals
• Producer maximizing profits in
Food
this setting is equivalent to
maximizing total revenue, given
the final goods price ratio pC/pF
PrEU
• If pC/pF is low, this implies only
production of Food
EU
Chemicals
International Economics
Page 41
Production in the EU; pC/pF = relative price of Chemicals
• Producer maximizing profits in
Food
this setting is equivalent to
maximizing total revenue, given
the final goods price ratio pC/pF
• If pC/pF is high, this implies
only production of Chemicals
EU
PrEU
Chemicals
International Economics
Page 42
Production in the EU; pC/pF = relative price of Chemicals
• Producer maximizing profits in
Food
this setting is equivalent to
maximizing total revenue, given
the final goods price ratio pC/pF
• If pC/pF is equal to the slope of
the ppf, production can be
EU
anywhere along the ppf (to be
determined by other factors)
•Under Autarky it must hold that
pC/pF is equal to the slope of the
ppf.
Chemicals
International Economics
Page 43
Gains form Trade
Relative to autarky trade increases the rel. price of chemicals in the EU
(exporter) and decrease it in Kenya (importer).
Consumption can be extended in both trading partners (gains form trade).
Food
120
100
EU budgetline
EU ppf
B
30
F
Kenya
budgetline
A
Kenya ppf
0
International Economics
5
G
6.25
25
Page 44
Chemicals
Equilibirum
Value of consumption =Value of production, trade is balanced in
each country.
Product prices are determined at the World market equating
world demand =world supply.
Marginal rate of substitution of consumers = PC/PF.
Wages have to adjust according to productivity in each country .
EU
EU
EU
1
EU
PC w ac
w
PC
ac

 K 
K
K
PF
w
PF 1 EU
w aF
aF
Due to lower wages food producers of Kenya (holding the
comparative advantage) are competitive on the world market.
International Economics
Page 45
Some empirical evidence
Figure 3.5 Kenya–EU exports and productivity, various sectors
100
Kenya export (%) - import (%)
food
50
0
0
50
100
150
200
chemicals
machinery
-50
Relative productivity ratio (Kenya/EU); %
International Economics
Page 46
Some empirical evidence - continued
The Balassa index
Share
of
industry
j
in
country
exports
A
A
BI

j
Share
of
industry
j
in
reference
country
exports
BI
1

Revealed
comparativ
e
advantage
of
country
in
good
j
A
j 
A
Exports of 28 manufacturing sectors for the member of OECD countries
Reference country is the group of all OECD countries
Observe high values for countries with a smaller industrial base such
as Italy and Finland.
Observe the persistence of comparative advantages.
International Economics
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Some empirical evidence - continued
Figure 3.7 Highest Balassa index, selected countries
International Economics
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Some empirical evidence - continued
Figure 3.7 Highest Balassa index, selected countries
c Brazil
d USA
20
5
18
16
4
14
12
3
10
8
2
6
4
2
0
2001
1
Oil seed, oleagic fruits, grain, seed, fruit, etc, nes
Works of art, collectors pieces and antiques
Sugars and sugar confectionery
2002
2003
International Economics
2004
2005
Aircraft, spacecraft, and parts thereof
2006
2007
2008
0
2001
Page 49
2002
2003
2004
2005
2006
2007
2008
Concluding remarks, Ricardian (classical) model
• Technological differences between countries are the classical
driving force for international trade flows.
• Only comparative costs, not absolute costs, are important for
determining the direction of trade flows.
• Absolute costs are important for determining a country’s
welfare level.
• Allowing for more countries and more goods is easy, allowing
for more than one factor of production is not (see neoclassical
model).
International Economics
Page 50
Chapter 4
Production Structure
International Economics
Page 51
Overview Production Structure
• The neoclassical model focuses on differences in relative
factor endowments as a cause for international trade flows.
• The main contributors are Eli Heckscher, Bertil Ohlin, and
Paul Samuelson: it is therefore referred to as the HOS model.
• This chapter reviews the production structure of the model.
• Neoclassical production functions with two inputs and
constant returns to scale.
• Optimizing economic agents, taking prices as given.
• The impact of technology differences is analyzed in Chapter
3, we therefore assume identical technology from now on.
International Economics
Page 52
Paul Samuelson (1915–2009)
“Funeral by funeral,
theory advances”
www.brainyquote.com
International Economics
Page 53
Assumptions of the neoclassical (HOS) model
•
•
•
•
•
•
•
•
•
•
•
•
General
(example)
Two countries
(Austria and Bolivia)
Two final goods
(Food and Manufactures)
Two factors of production
(Capital and Labour)
Constant returns to scale production functions
Perfect competition in all markets
Capital and Labor is mobile between sectors, but not between
countries
Costless trade in final goods (no impediments to trade)
Identical production technology in the two countries
No factor-intensity reversal
Identical homothetic tastes in the two countries
Countries differ in their (relative) factor endowments
International Economics
Page 54
Main results of the neoclassical (HOS) model
The HOS model derives 4 main propositions in Chapters 5-7:
• Factor Price Equalization: Trade in goods (which equalizes
final goods prices) leads to the equalization of factor prices.
• Stolper-Samuelson theorem: An increase in the price of a
final good increases the (real) reward to the factor used
intensively in the production of that good and reduces the
(real) reward to the other factor of production.
• Rybczynski theorem: An increase in the quantity of a factor of
production, at constant final goods prices, leads to an
increase in the production of the good using that factor
intensively and a decreased production of the other good.
• Heckscher-Ohlin theorem: A country will export the final good
which makes relatively intensive use of the relatively
abundant factor of production.
International Economics
Page 55
Neoclassical production functions
Characteristics of our neoclassical production functions
• Two inputs: capital (K) and labour (L)
• Substitutability: a given output level can be produced using
different combinations of inputs, i.e. the use of one input can
be substituted for the use of another input
• Positive marginal product: if more capital or more labour is
used output increases
• Diminishing marginal product: given the use of capital, an
increase in the use of labour leads to ever smaller increases
in output (similarly for capital)
• Constant returns to scale: an increase in the use of both
inputs by z% also leads to an increase in output of z%
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Page 56
Structure of the equilibrium
delivery of manufactures
(spending m on manufactures)
capital services
capital owners
(rental income)
production
manufactures
producers
consumers
labourers
labour services
production
food
(wage income)
delivery of food
(spending (1-m) on food)
direction of goods and services flows
(direction of money flows)
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Page 57
Production functions: substitutability and isoquant
• Let M be the output of
Capital
Manufactures, Km the input of
capital, Lm the input of labour
and m a capital intensity
parameter (0 < m < 1); this is a
possible production function:
m 1m
MK
mL
m
• The figure on the left depicts
isoquant
an isoquant for this function;
note the substitutability
between capital and labour
Labour
International Economics
Page 58
Production is constant returns to scale (CRS)
Capital
• At point A1 production M = 1
M=1
• Reducing inputs by 30%
leads to point A2
• CRS implies at point A2
B1
production M = 0.7
• Similarly for points B1 and B2
B2
• Conclusion:
A1
isoquant M = 0.7 is a radial
A2
blow-up of isoquant M = 1
M=0.7
D
Labour
International Economics
Page 59
Profit maximization: two-step procedure
Producer profits = revenue – production costs
Maximizing profits is a two-step procedure
• First, given how much you want to produce: minimize
production costs
• Second: determine the optimal output level
International Economics
Page 60
Cost minimization
Capital
• Suppose you want to
M=1
produce M=1 at minimum cost
taking wage rate w and rental
rate r as given
• Total cost = wLm + rKm , a
straight line in (labour, capital)
K
space with slope = - w/r
A
• Minimum costs are achieved
at a point of tangency
between the isocost line and
the isoquant; point A, using K
L
International Economics
Labour
Page 61
capital and L labour
Constant returns to scale and production costs
Under constant returns to scale (CRS) the isoquants are radial
blow-ups of one another
Minimizing production costs is now simple:
• First, we determine the cost-minimizing input combination for
producing one unit of output, say K and L
• Second, determine the output level, say z units.
Proportionally adjust the unit inputs to produce z output, so
using: zK and zL
• Under CRS: total cost = (per unit cost)  output
International Economics
Page 62
Profit maximization, CRS, and perfect competition
Profits = [price – (per unit cost)]  output
There are three possibilities
• price < unit cost:  optimal output level = 0, no profit
• price = unit cost:  optimal output level undetermined (can
be determined by other factors); profit level = 0
• price > unit cost:  optimal output level = infinite, profit level
is infinite  not possible in economic equilibrium
Conclusion: CRS + perfect competition implies:
• price  unit cost
• output > 0
price = unit costs
International Economics
Page 63
Impact of a fall in the wage rate
Capital
The figure shows the costM=1
minimizing input combination
at point A for the ratio w0/r
Suppose the wage rate falls to
w1; rotates the isocost line
A
Minimum costs are now
B
achieved at point B with a
lower capital/labor ratio
Labour
International Economics
Page 64
Food production with lower capital intensity
Capital
• The figure shows the costM=1
minimizing input combination
F=1
at point A for M=1 and w/r
• Suppose Food production
has a lower capital-intensity
parameter: F < M
A
• For the same w/r minimum
costs for Food production are
at point B with a lower
B
capital/labour ratio
Labour
International Economics
Page 65
Empirical Evidence
Figure 4.4 Capital stock per worker×1000 $; 1990 in 1985 $
80
70
S w itz erland
60
50
W . G erm any
40
Japan
US A
30
UK
20
10
India
0
International Economics
Page 66
Empirical Evidence – continued
Primary products exports (% of country's manufacturing exports), 2008
Saudi Arabia
Japan
Korea South
Taipei
Nigeria
Hong Kong
Singapore
Un Arab Em
Rus s ia
China
Switzerland
Banglades h
Norway
Germ any
Mexico
Un Kingdom
Aus tria
Sweden
Italy
World
Philippines
Belgium
USA
Poland
Malays ia
Canada
France
Thailand
India
Spain
Netherlands
Pakis tan
Vietnam
Indones ia
Aus tralia
Brazil
Ethiopia
0
International Economics
10
20
30
40
Page 67
50
60
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Concluding remarks Production Structure
• The neoclassical (HOS) model explains trade flows based on
differences in relative factor abundance
• The HOS model derives 4 main propositions
• Production uses 2 inputs (substitution between inputs) under
constant returns to scale (CRS)
• The cost-minimizing input combination depends on:
– The capital-intensity parameter
()
– The wage-rental ratio
(w/r)
• With CRS and perfect competition:
– if a good is produced price = unit production costs
International Economics
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