Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 2 Lecture Notes

December 18, 2019
Chapter 2World Trade: An Overview  5
Overview of Section I:
International Trade Theory
Section I of the text consists of seven chapters:
Chapter 2 World Trade: An Overview  
Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model  
Chapter 4 Specific Factors and Income Distribution  
Chapter 5 Resources and Trade: The Heckscher-Ohlin Model  
Chapter 6 The Standard Trade Model  
Chapter 7 External Economies of Scale and the International Location of Production  
Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational
.1 nSection I Overview
Section I of the text presents the theory of international trade. The intent of this section is to explore
the motives for and implications of patterns of trade between countries. The presentation proceeds by
introducing successively more general models of trade, where the generality is provided by increasing the
number of factors used in production, by increasing the mobility of factors of production across sectors
of the economy, by introducing more general technologies applied to production, and by examining
different types of market structure. Throughout Section I, policy concerns and current issues are used
to emphasize the relevance of the theory of international trade for interpreting and understanding our
Chapter 2 gives a brief overview of world trade. In particular, it discusses what we know about the quantities
and pattern of world trade today. The chapter uses the empirical relationship known as the gravity model
as a framework to describe trade. This framework describes trade as a function of the size of the economies
involved and their distance. It can then be used to see where countries are trading more or less than expected.
The chapter also notes the growth in world trade over the previous decades and uses the previous era of
globalization (pre-WWI) as a context for today’s experience.
Chapter 3 introduces international trade theory through a framework known as the Ricardian model of
trade. This model addresses the issue of why two countries would want to trade with each other. This
model shows how mutually beneficial trade arises when there are two countries, each with one factor of
production that can be applied toward producing each of two goods. Key concepts are introduced, such as
the production possibilities frontier, comparative advantage versus absolute advantage, gains from trade,
relative prices, and relative wages across countries.
Chapter 4 presents the Specific Factors model in which goods are produced using one factor that is mobile
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6  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
between industries and one factor that is specific to that industry. The advantage of this model over the
simple Ricardian model is that it highlights the distributional effects of trade, with some sectors of society
gaining and other sectors losing even though the net welfare effect of trade is a gain. These distributional
effects of trade highlight the commonly voiced oppositions to free trade, and this chapter examines three
reasons why protectionism is an inefficient method for dealing with the losses from trade. The chapter
concludes with an application of the Specific Factors model to international labor migration, focusing
again on the distributional effects of free trade in labor.
Chapter 5 introduces what is known as the classic Heckscher-Ohlin model of international trade. Using this
framework, you can work through the effects of trade on wages, prices, and output. Many important and
intuitive results are derived in this chapter including: the Rybczynski theorem, the Stolper-Samuelson
theorem, and the Factor Price Equalization theorem. Implications of the Heckscher-Ohlin model for the
pattern of trade among countries are discussed, as are the failures of empirical evidence to confirm the
predictions of the theory. The chapter also introduces questions of political economy in trade. One important
reason for this addition to the model is to consider the effects of trade on income distribution. This approach
shows that while nations generally gain from international trade, it is quite possible that specific groups within
these nations could be harmed by this trade. This discussion, and related questions about protectionism versus
globalization, becomes broader and even more interesting as you work through the models and different
assumptions of subsequent chapters.
Chapter 6 presents a general model of international trade, which admits the models of the previous
chapters as special cases. This “standard trade model” is depicted graphically by a general equilibrium
trade model as applied to a small open economy. Relative demand and relative supply curves are used to
analyze a variety of policy issues, such as the effects of economic growth, the transfer problem, and the
effects of trade tariffs and production subsidies. The Appendix to the chapter develops curve analysis.
While an extremely useful tool, the standard model of trade fails to account for some important aspects
of international trade. Specifically, while the factor-proportions Heckscher-Ohlin theories explain some
trade flows between countries, recent research in international economics has placed an increasing
emphasis on economies of scale in production and imperfect competition among firms.
Chapter 7 is the first of two chapters to reflect these developments in international trade theory. With external
economies of scale, average costs in an industry fall as industrial production rises (though not necessarily
the production of any one firm in that industry). As a result, when two countries trade, it makes sense to
concentrate production in one country as this will lead to lower costs than splitting production across two
countries. As with the trade models presented in previous chapters, countries with the lowest production
costs will be exporters, but in this case, the source of low costs is not driven by differences in technology
or factor endowments. Rather, a country with an established industry will be more competitive than one
in which the industry has to start from scratch. This is true even if the established country would not be
the lowest-cost producer if both countries started off at the same level of production. This suggests that a
country could be made better off by closing off from trade, though such cases are difficult to identify and
this form of protectionism may lead to unintended consequences such as retaliatory tariffs.
Chapter 8 examines how trade can be driven by internal economies of scale and monopolistic competition.
An internal economy of scale exists when a firm’s average costs decline as that firm increases its production.
Such a situation leads to a model of imperfect competition (there are a few large firms rather than many
small firms), and it can be used to explain the high degree of intra-industry trade in the world. The chapter
concludes with a discussion of foreign direct investment. The decision by a multinational to serve a
foreign market through a foreign affiliate or to break up its production chain is driven by a
proximity-concentration trade-off in which it must balance economies of scale (producing everything in
one place) with trade costs and differences in factor prices. This subject matter is important because it
shows how gains from trade may arise in ways that are not suggested by the standard models of
international trade.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 2World Trade: An Overview  7
Chapter 2
World Trade: An Overview
.2 nChapter Organization
Who Trades with Whom?
  Size Matters: The Gravity Model
  Using the Gravity Model: Looking for Anomalies
  Impediments to Trade: Distance, Barriers, and Borders
The Changing Pattern of World Trade
Has the World Gotten Smaller?
  What Do We Trade?
  Service Offshoring
Do Old Rules Still Apply?
.3 nChapter Overview
Before entering into a series of theoretical models that explain why countries trade across borders and the
benefits of this trade (Chapters 3–11), Chapter 2 considers the pattern of world trade which we observe today.
The core idea of the chapter is the empirical model known as the gravity model. The gravity model is based
on the observations that (1) countries tend to trade with nearby economies and (2) trade is proportional to
country size. The model is called the gravity model, as it is similar in form to the physics equation that
describes the pull of one body on another as proportional to their size and distance.
The basic form of the gravity equation is Tij A Yi Yj/Dij. The logic supporting this equation is that large
countries have large incomes to spend on imports and produce a large quantity of goods to sell as exports.
This means that the larger that either trade partner is, the larger the volume of trade between them. At the
same time, the distance between two trade partners can substitute for the transport costs that they face as
well as proxy for more intangible aspects of a trading relationship such as the ease of contact for firms. This
model can be used to estimate the predicted trade between two countries and look for anomalies in trade
patterns. The text shows an example where the gravity model can be used to demonstrate the importance
of national borders in determining trade flows. According to many estimates, the border between the
United States and Canada has the impact on trade equivalent to roughly 2,000 miles of distance. Other
factors such as tariffs, trade agreements, and common language can all affect trade and can be incorporated
into the gravity model.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
8  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
The chapter also considers the way trade has evolved over time. While people often feel that globalization
in the modern era is unprecedented, in fact, we are in the midst of the second great wave of globalization.
From the end of the 19th century to World War I, the economies of different countries were quite connected,
with trade as a share of GDP higher in 1910 than in 1960. Only recently have trade levels surpassed
pre–World War I trade. The nature of trade has changed, though. The majority of trade is in manufactured
goods with agriculture and mineral products making up less than 20 percent of world trade. Even
developing countries now primarily export manufactures. A century ago, more trade was in primary products
as nations tended to trade for things that literally could not be grown or found at home. Today,
the motivations for trade are varied and the products we trade are increasing in diversity. Despite increased
complexity in modern international trade, the fundamental principles explaining trade at the dawn of the
global era still apply today. The chapter concludes by focusing on one particular expansion of what is
“tradable”—the increase in services trade. Modern information technology has greatly expanded what
can be traded as the person staffing a call center, doing your accounting, or reading your X-ray can literally
be halfway around the world. While service outsourcing is still relatively rare, the potential for a large
increase in service outsourcing is an important part of how trade will evolve in the coming decades.
The next few chapters will explain the theory of why nations trade.
.4 n
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley