International trade

Outline
1. Why do countries trade? A brief history of models
2. Intra-industry trade
3. Protectionism
4. WTO & the principles of the multilateral system
Outline
1. Why do countries trade? A brief history of models
1. Mercantilism (XVI-XVIII century)
2. Adam Smith: absolute advantage theory
3. David Ricardo: comparative advantage
4. Heckser-Ohlin (H-O) model
5. Economies of scale
6. Gravity model
2. Intra-industry trade
3. Protectionism
4. WTO & the principles of the multilateral system
History: models on trade
1. Mercantilism (XVI-XVIII century)

• The world´s wealth is fixed

• When we import, we “give away” some of that wealth.
• It´s best to export, not import.
• The government should provide the means to favor and protect national
production and foster exports.
History: models on trade
2. Adam Smith: absolute advantage theory

• Which country has absolute advantage?

• That is, which country can produce the good more cheaply (using less
labor)?

Adam wrote in The Wealth of Nations:

“If a foreign country can supply us with a commodity cheaper than we

ourselves can make it, better buy it of them with some part of the
produce of our own industry, employed in a way in which we have
some advantage.” (Adam Smith, The Wealth of Nations, New York: The
Modern Library 1937, p. 424).

• Problem: what happens if a country has absolute advantage in

everything?
History: models on trade
3. David Ricardo: comparative advantage

• Assumptions:
• 2x2x1 model (2 countries, 2 goods, 1 f.o.p)
• The factor of production (L) is not mobile.
• Fixed opportunity cost of goods for both countries
• No transportation or transaction costs

• Technology will determine which country has the highest labor productivity
History: models on trade
3. David Ricardo: comparative advantage

• Each country should specialize in producing (and exporting) the good in

which it has a comparative advantage
• As a result, consumers in both countries will be able to consume more
and be better off
• Problems:
• 1 f.o.p only
• where does the comparative advantage come from?
History: models on trade
4. Heckser-Ohlin (H-O) model
• Assumptions:
• 2x2x1 model (2 countries, 2 goods, 2 f.o.p)
• Countries are endowned with different amounts of f.o.p (K,L).
• K and L are not mobile and are used to produce the 2 goods with constant returns
to scale
• No transportation or transaction costs

• Relative factor endowments will determine comparative advantage

History: models on trade
4. Heckser-Ohlin (H-O) model

• Each countries specializes in the production (and export) of the good

that uses intensively the f.o.p they have an abundance of

• As a result, consumers in both countries will be able to consume more

and be better off

• Note: how is this different from Ricardo?

• In the Ricardian model: it´s the efficiency of the production process that drives trade
• In H-O: it´s the relative abundance of the factors of production that drives trade.
Comparative advantage

Key concept: opportunity cost: next best use for the resources used in the production
of a good

1. A country has comparative advantage if it has a lower opportunity cost than others
when it comes to the production of that particular good

2. NOTE: Comparative advantage ≠ Absolute advantage = lower absolute cost.

Problem: the model still relies on differences across countries. Will there be no trade
amongst very similar countries?
How comparative advantage works

• Example: 2 countries, 2 goods

Amounts (in kgs) produced in an hour

Butter Jam
Country A 2 1
Country B 3 9
How comparative advantage works

1) Calculate the opportunity costs. For example, in country A:

- How much butter do we give up to produce 1 extra kg of jam? 2 kgs of butter
- How much jam do we give up to produce 1 extra kg of butter? 0.5 kgs of jam
Do the same for country B
2) Find the lowest opportunity cost for each product

Opportunity cost per Kg of product

Butter Jam
Country A 1/2 kg of jam 2 kgs of butter
Country B 3 kg of jam 1/3 kg of butter
How comparative advantage works

Kgs of butter
In this case, country B has absolute advantage in
both goods (it can produce more of both)

But it has comparative advantage only at

producing jam because it is relatively better at it
3

2
PPF for country B

PPF for country

A
1 9
Kgs of jam
Comparative advantage and specialization
• If each country specializes in producing the good for which it has a
comparative advantage and exchange it for the other one, both countries
gain.
• To do this, countries agree on a mutually beneficial price (eg 1 kg butter
per 1 kg of jam)
• Country A produces 9kg of jam in an hour, which they can exchange for 9
kg of butter
• Country B produces 2 kgs of butter in an hour, which they can exchange
for 2 kgs of jam

Amounts (in kgs) available in an hour

with trade
Butter Jam
Country A 2 2
Country B 9 9
Comparative advantage: not just theory

The revealed comparative advantage (RCA) index is a measure of a

country’s relative advantage or disadvantage in a specific industry as
evidenced by trade flows.

A country has revealed comparative advantage in a given product when

its ratio of exports of that product to its total exports of all goods exceeds
the same ratio for the world as a whole

An index above 1 indicates that a country’s share of exports in that sector

exceeds the global export share of the same sector. If this is the case, we
infer that the country has a comparative advantage in that sector.
Comparative advantage: not just theory

https://unctadstat.unctad.org/en/RcaRadar.html
History: models on trade
4. Economies of scale
• Large scale production reduces average costs
• Each country concentrates in producing a few goods to achieve large
scale
• This reduces production costs, but not the variety of goods available
because they are still available through trade

Average cost

Average cost

Q
Gravity equation trade model
5. Gravity model
In summary: Why do nations trade?
1. Trade occurs because it is mutually beneficial (win-
win, efficiency)
2. Trade can be seen as a productive technology:
• It allows us to turn resources into products in the
most efficient way.
• We can get goods at a lower price by importing
them, rather than producing them domestically (so
trade allows for the production of more goods with
the same resources)
Outline
1. Why do countries trade? A brief history of models
2. Intra-industry trade
• What is it
• How do we measure it
• Different types
• What causes it (kind of)?
• What are its macro effects?

3. Protectionism
4. WTO & the principles of the multilateral system
Intra-industry trade
• So far, we have talked about inter-industrial trade, where a
country specializes in producing and exporting certain goods
to import others

• There is also intra-industrial (or even intra-firm) trade: where

the same products are exchanged across borders. A country
then acts as a producer, exporter and importer of the same
goods.

• This type of trade cannot be explained with traditional trade

theories.
Measurement of intra-industry trade
• Intra-industry trade is measured using the Grubel – Lloyd
index

(X i  M i )  X i  M i Xi  Mi
GLi   1
(X i  M i ) Xi  Mi
• The higher the index value, the greater the importance of this
trade (values between 0 and 1 or between 0% and 100%)
Measurement of intra-industry trade
The value of the Grubel – Lloyd index depends on how we
define “i” (the product) and the country/ region for which it´s
calculated.

More aggregation results in higher values of the index:

• Aggregation of product: the index will be higher for broader

categories (clothing) than for more narrow categories (coats, wool)

• Aggregation of commercial partners: the index will be higher for

groups of countries (European Union) than for a specific country (a
country)
Types of intraindustrial trade
• Trade in similar goods but with different varieties
Types of intraindustrial trade
• Trade in goods that differ in quality and / or price
Types of intraindustrial trade
• Trade in the same goods at different stages of
production (vertical intra-industrial trade)
Tipos de comercio intraindustrial
Weight of the intraindustrial trade across sectors

• Intraindustrial trade is higher for manufactured goods,

especially in the more sophisticated sectors: chemicals,
electronics, electrical equipment, transportation equipment,…

These sectors:
• have large economies of scale
• include many components, and processes may occur in
places all over the world
Weight of the intraindustrial trade across countries

• It is important in countries where international trade

represents a high percentage of GDP

• It is important in countries that have received a lot of

Foreign Direct Investment

• It is important in countries with lots of multinational

companies

• It is more important in developed countries, but increasing

in developing countries

• It is higher when regional agreements exist

Intraindustrial trade: macro effects

1) It causes a greater relationship between exports and imports,

which could mean less overall impact on GDP (X-M is smaller)

https://www.oecd.org/economy/outlook/2752923.pdf
Intraindustrial trade: macro effects

2) World trade is more sensitive to the economic cycle

https://www.federalreserve.gov/econres/ifdp/files/ifdp1282.pdf
Intraindustrial trade: macro effects

3) Economic shocks are transmitted more quickly

https://edition.cnn.com/2020/02/09/business/china-coronavirus-global-auto-industry-impact/index.html
Outline
1. Why do countries trade? A brief history of models
2. Intra-industry trade
3. Protectionism
• Why does it exist
• What can be done about it
• Protectionist measures: instruments
• Traditional trade policy instruments
• Tariffs, quotas, VERs
• Other types of protectionist instruments
Free trade vs protectionism

If international trade generates benefits for

every part, why is there opposition to free
trade? Why ask for protectionist measures?
Free trade vs protectionism
Because free trade has redistributive effects.

Economics + Politics = Decision making

Free trade vs protectionism
• Openness to trade generates costs and benefits

• In net terms, this openness tends to be positive

• Efficiency gains

• Estimulates competition

• Access to capital, technology, knowledge

• But the costs show through more unemployment and

falling production in some sectors (and cities/
regions!)
Free trade vs protectionism
• It is necessary to facilitate the adjustment process to
improve the cost/benefits ratio in those places where
it is negative

• Flexible operation of the economy

• Establish appropriate safety nets

• Proceed gradually in trade liberalization

• Rely on international agreements

Protectionist measures: instruments of trade policy

Instruments of trade
policy

For trade contraction For trade expansion

Via price Via quantity Via price Via quantity

-Import quota
- Tariff (taxes on
- Voluntary export - Import subsidy Voluntary import
imports)
restraint/restriction - Export subsidy expansion (VIE)
- Export tax
(VER)
Instruments of trade policy: tariffs

• Two main types of tariffs:

• A specific tariff is levied as a fixed charge for each
unit of imported goods.
• For example, $1 per kg of cheese

• An ad valorem tariff is levied as a fraction of the

value of imported goods.
• For example, 25% tariff on the value of imported cars.

• A compound duty (tariff) is a combination of an ad

valorem and a specific tariff.
Instruments of trade policy: welfare effects of tariffs

• What are the welfare effects of a tariff (costs and benefits)?

• The price of the good in the importing country increases:
• Domestic producers are better off
• Domestic consumers are worse off

• The government gets some revenue from the tariff

• For a small country, the losses will always be greater than the gains because
price is not affected.
• For a large country the effects are ambiguous because the imposition of a
tariff may cause a decrease in demand large enough to reduce the world price
of the good
Instruments of trade policy: tariffs (in a small country)

The following graph illustrates the small country case (a country is “small” if it
´s not able to change the world price of a product by changing its demand (the
country is a price-taker)).

• The effect of the tariff is an increase in the price it pays for the good

p S

Domestic price without trade

World price after tariff

World price with free trade

D
QS FT QS T QD T QD FT
Q
Instruments of trade policy: quotas

• An import quota is a restriction on the quantity of a good that may be

imported.

• This restriction is usually enforced by issuing licenses to domestic firms

that import, or in some cases to foreign governments of exporting
countries.

• Unlike the tariff case, the government receives no revenue from a quota.
Instead, the revenue from selling imports at high prices goes to quota
license holders. These extra revenues are called quota rents.
• Another problem: how licenses are distributed?
Instruments of trade policy: VERs

• A voluntary export restraint is a limit imposed by the government

of the exporting country restricting the amount of a good that may be
exported to a specific country during a certain period of time.
• It works like an import quota, except that the VER is imposed by the
exporting country rather than the importing country.
• However, these restraints are usually requested by the importing
country.
• After the Uruguay Round (1994), WTO member countries agreed not
to impose any more VERs and phase out the existing ones
Protectionist mesures: other instruments of trade policy

• Domestic content requirements: regulations that require a

specified fraction of a final good to be produced
domestically.

• Red tape: bureaucratic and administrative barriers

• Environmental, health regulations… imposed as an

“excuse” can act as a form of protection.

• Public procurement requirements: Government agencies

are obligated to purchase from domestic suppliers, even
when they charge higher prices (or have inferior quality)
compared to foreign suppliers
Outline
1. Why do countries trade? A brief history of models
2. Intra-industry trade
3. Protectionism
4. WTO & the principles of the multilateral system
The role of the WTO
• The World Trade Organization (WTO) was born in 1995, but includes the
trading system (the rules of international trade) developed since 1948 in
the GATT (General Agreement on Tariffs and Trade)

• The WTO is a multilateral organization

• A negotiating forum for trade liberalization
• A body of rules governing international trade
• A system for resolving disputes

• The WTO considers free trade as an engine for development and

increased welfare
The principles of the multilateral system

• Non-discriminatory system
• Most favored nation: equal treatment for all members
• National treaty: equal treatment for domestic and foreign producers
• Exemption: regional trade agreements
• Promote free trade
• Progressive reduction of trade barriers
• Provide stability and predictability through legal certainty

• Encourage fair competition

• Encourage development and economic reform