International Economics:: Trade Theory and Policy

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
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.
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
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?
Page 5
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
Page 6
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
Page 7
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.
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)

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.
Page 10
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
GDPmarket 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.
Page 11
Fig 1.2: GDP and GNP, 2008 ($ billion)
The dotted line is a 45 line, the axes use a logarithmic scale, and the circles are proportional to the size of GDP .
Page 12
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.

Page 13
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 => implied PPP: ETZS/E
Page 14
PUS 10
PTZS
1
Figure 1.3: Gross domestic product, 2008; top 15, ranked according to PPP
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!).
Page 16
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 $).
In relative terms Brunei is the largest net exporter and
Ethiopia the largest net-importer.
Trade openness is defined as the ratio of exports +imports
to production. For Singapore this ratio is more than 234%.
Page 17
Figure 1.4: Exports and imports of goods and services, 2008 ($ billion)
The dotted line is a 45 line, the axes use a logarithmic scale, and the circles are proportional to the size of exports.
Page 18
Figure 1.5: Relative exports of goods and services, 2008 (% of GDP)
Page 19
Figure 1.6: Taxes on international trade
Page 20
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 Maddisons 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.
Page 21
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
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
4.6
2.5
0.2
0
1870
1900
1930
world
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.
Page 24
Figure 1.9: Foreign capital stocks, assets / world GDP
Foreign capital stocks; assets / world GDP
0.6
0.4
0.2
0
1860
1880
1900
1920
1940
Page 25
1960
1980
2000
Figure 1.10: Relative migration flows, Western Europe and Western Offshoots
Page 26
1.7: Some Stylized Facts for Austria
Page 27
Page 28
Austrias most important trading partners (exports in 2009)
Page 29
Austrias FDI Position
Page 30
Chapter 3
Classical Trade: Technology
Page 31
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 countrys
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)
Page 32
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.
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
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
Kenya
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)
Page 35
Comparative advantage: productivity method

Food
Chemicals
EU
Kenya
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
Page 36
Comparative advantage: opportunity cost method

Food
Chemicals
EU
Kenya
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
Page 37
The ppf is a straight line in the Ricardian model

Food
Chemicals
EU
Kenya
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)
Page 38
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
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
100
Resurce constraint : LEU aCCEU aFFEU
EU ppf
PPF : FEU
LEU
aF
aaCF CEU
Opportunit y costs :
aC
aF
30
Kenya ppf
0
25
Page 40
Chemicals
Production in the EU; pC/pF = relative price of Chemicals

Producer maximizing profits in
Food
this setting is equivalent to

maximizing total revenue, given
PrEU
slop
e=
the final goods price ratio pC/pF

-p
/p
If pC/pF is low, this implies only
production of Food
EU
Chemicals
Page 41

Food

If pC/pF is high, this implies
only production of Chemicals
EU
PrEU
Chemicals
Page 42

Food

If pC/pF is equal to the slope of
the ppf, production can be
anywhere along the ppf (to be
EU
determined by other factors)

Under Autarky it must hold that
pC/pF is equal to the slope of the
ppf.
Chemicals
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
A
Kenya ppf
0
Kenya
budgetline
5 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 = P C/PF.
Wages have to adjust according to productivity in each country .
EU
EU
EU
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.
Page 45
Some empirical evidence

K
e
n
y
a
e
x
p
o
r
t
(
%
)
i
m
p
o
r
t
(
%
)
Figure 3.5 KenyaEU exports and productivity, various sectors
100
food
50
0
0
50
100
150
chemicals
-50
Relative productivity ratio (Kenya/EU); %
Page 46
200
machinery
Some empirical evidence - continued

The Balassa index
A
BI j
Share of industry j in country A exports

Share of industry j in reference country exports
BI j 1 Revealed comparativ e advantage of country A in good j
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.
Page 47

Figure 3.7 Highest Balassa index, selected countries
Page 48

Figure 3.7 Highest Balassa index, selected countries
Page 49
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 countrys
welfare level.
Allowing for more countries and more goods is easy, allowing
for more than one factor of production is not (see neoclassical
model).
Page 50
Chapter 4
Production Structure
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.
Page 52
Paul Samuelson (19152009)

Funeral by funeral,
theory advances
www.brainyquote.com
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
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.
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%
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)
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 K
m
m
1 m
m
The figure on the left depicts
isoquant
an isoquant for this function;

note the substitutability
between capital and labour
Labour
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
A2
D
0.3
Conclusion:
A1
isoquant M = 0.7 is a radial

blow-up of isoquant M = 1
D
D
0.7
M=0.7
Labour
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
Page 60
Cost minimization
Capital
Suppose you want to

M=1
produce M=1 at minimum cost

taking wage rate w and rental
pe
slo
rate r as given
Total cost = wLm + rKm , a
/r
-w
straight line in (labour, capital)

space with slope = - w/r
Minimum costs are achieved

at a point of tangency
between the isocost line and
the isoquant; point A, using K
L
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
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
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
slop
e
= -w
w1; rotates the isocost line

/r
Minimum costs are now
B
K/L
achieved at point B with a
pe
slo
=
/r
0
-w
L1
K/
lower capital/labor ratio
Labour
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
For the same w/r minimum
K/L
costs for Food production are

at point B with a lower
B
slo
capital/labour ratio
pe
=
/r
-w
K/L F
Labour
Page 65
Empirical Evidence
Figure 4.4 Capital stock per worker1000 $; 1990 in 1985 $
80
70
Switzerland
60
50
W. Germany
40
Japan
USA
30
UK
20
10
India
0
Page 66
Empirical Evidence continued
Page 67
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
Page 68

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International Economics:: Trade Theory and Policy

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International Economics:

Trade Theory and Policy

Exam and Grading

Includes all the material covered in the course (lecture plus

Questions addressed in trade theory and policy I

Determinants of trade and industry structure of an open

Questions addressed in trade theory and policy II

Structural change and trade liberalization: Should European

Literature and Resources I

Study Guide: Stephan Schueller and Daniel Ottens Oxford

Literature and Resources II

Chapter 1: The World Economy Some Stylized Facts

p. 4: International economics is what international

* The portrait was painted by Carla

Figure 1.1 Angus Maddison (1926 -2010)

Chap. 1.2 and 1.3:

The economic size (power?) of a nation is best

A size comparison across open countries needs three steps:

1. Accurate data from the statistical offices in national

Fig 1.2: GDP and GNP, 2008 ($ billion)

Purchasing Power Parity (PPP)

Comparing income in current $ tends to overestimate

In current $, the value of output tends to be underestimated in low-income countries.

Purchasing Power Parity (PPP)-continued

Example: based on the current exchange rate

1.5 International Trade

Trade flows can readily compared using exchange

Exports Relative to Imports

The difference between exports and imports (trade balance)

Figure 1.5: Relative exports of goods and services, 2008 (% of GDP)

Figure 1.6: Taxes on international trade

Globalization defined by Neary (2002):

Globalization and Income:

World GDP per capita (1990 international $), logarithmic scale

Figure 1.8: Two waves of globalization in trade

1.6 Globalization (continued)

Globalization and capital:

Globalization and migration:

Figure 1.9: Foreign capital stocks, assets / world GDP

Foreign capital stocks; assets / world GDP

1.7: Some Stylized Facts for Austria

1.7: Some Stylized Facts for Austria

1.7: Some Stylized Facts for Austria

Austrias most important trading partners (exports in 2009)

1.7: Some Stylized Facts for Austria

Austrias FDI Position

Overview Ricardian (classical) model

David Ricardo (1772-1823)

Assumptions of the Ricardian technology model

Technology differences between countries

The EU technology is more productive for both goods

Comparative advantage: productivity method

The EU is twice as productive in the Food sector (4/2 = 2)

Comparative advantage: opportunity cost method

An extra unit of Chemicals needs 8 units of labor in the EU

The ppf is a straight line in the Ricardian model

Suppose the EU has 200 units of labour available and Kenya

Production possibility frontier (ppf)

Production possibility frontiers

The EU can produce

(0 Chemicals, 100 Food) or

(20 Chemicals, 0 Food), or

any combination in between any combination in between