Chapter 2
World Trade: An Overview
■ Chapter 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?
Summary
■ Chapter Overview
Before entering into a series of theoretical models that explain why countries trade across borders and the
benefits of this trade (Chapters 3–12), Chapter 2 considers the pattern of world trade that 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
4 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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 1,500–
2,500 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.
The chapter also considers the way trade has evolved over time. Although 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% 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 increasingly diverse. 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 expanded greatly 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. Although 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.
■ Answers to Textbook Problems
1. We saw that not only is GDP important in explaining how much two countries trade, but also,
Chapter 2 World Trade: An Overview 5
economy (the United States) and Australia is not near any other major economy, it makes sense that
Canada would be more open and Australia more self-reliant.
2. Mexico is quite close to the United States, but it is far from the European Union (EU), so it makes
3. No, if every country’s GDP were to double, world trade would not quadruple. Consider a simple
example with only two countries: A and B. Let country A have a GDP of $6 trillion and B have a
GDP of $4 trillion. Furthermore, the share of world spending on each country’s production is
4. As the share of world GDP that belongs to East Asian economies grows, then in every trade
6 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
meaning that their markets were too small to import a substantial amount. As they became wealthier
and the consumption demands of their populace rose, they were each able to import more. Thus,
while they previously had focused their exports to other rich nations, over time they became part of
the rich nation club and thus were targets for one another’s exports. Again, using the gravity model,
when South Korea and Taiwan were both small, the product of their GDPs was quite small, meaning
that despite their proximity, there was little trade between them. Now that they have both grown
considerably, their GDPs predict a considerable amount of trade.
5. As the chapter discusses, a century ago much of world trade was in commodities, which were in
many ways climate or geography determined. Thus, the United Kingdom imported goods that it could