Chapter 2 World 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  

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

economy.

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 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

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

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.

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.

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Chapter 2 World Trade: An Overview  7

Chapter 2

World Trade: An Overview

.2 n Chapter Organization

Who Trades with Whom?

  Size Matters: The Gravity Model

  Using the Gravity Model: Looking for Anomalies

Summary

.3 n Chapter 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.

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.

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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

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 

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