Internation trade and investments
Week 1:
Lecture 1: Introduction to international trade & investments and the Ricardian model
Practice of international trade:
• Trade policy (trade policy = wide array of government policies that are designed to
influence the size of trade flows): tariffs, export subsidies, production subsidies, industrial
policy, etc. -> a set of rules, policies set by a country to govern international trade. It includes
tariffs (taxes on imported goods), subsidies, and other policies.
• Trade policy in developing countries
• Trade policy in developed countries
• Globalisation (and the critiques thereon)
• Regional economic integration
Facts about trade:
1. Globalisation is not a new concept it has been around since before world war 1
2. Trade usually grows faster than global GDP because barriers to international trade
have decreased and because of "vertical disintegration." This means that different
steps in the production process are completed in various countries, allowing for more
efficient and specialized global production.
3. Open countries tend to grow faster than relatively closed countries.
4. Most trade takes place between countries that are similar (see figure on next slide).
5. Foreign Direct Investment has increased spectacularly over the past five decades.
Why is globalisation under attack?
1. Trade wars United States and China -> Us raised taxes because they found that
China stole their products etc. China reacted by doing the same (raising taxes).
2. Reshoring -> Bringing manufacturing and production activities back to their own
country after they outsourced it to another country.
The gravity model:
The gravity model is a very successful empirical model for the explanation of trade flows
between countries. Reason: the gravity model straightforwardly allows to include a
multitude of (potential) explanatory variables.
• positively linked to the economic size of the source country Yi .
• positively linked to the economic size of the destination country Yj .
• negatively linked to the geographical distance between the two countries Dij .
General form: Tij = A Yia Yjb / Dijc where A is a constant term.
Tij: The trade flow from country i to country j
,A: is a constant term
Yi Yj: Are economic sizes of the countries i and j, usually measured in GDP
Dij: Distance between 𝑖 and 𝑗, representing how far apart they are geographically or
economically.
a,b,and c: Are parameters that measure the sensitivity of these trade flows
Other form of the formula:
ln(Tij)= ln(A) + a ln(Yi) + b ln(Yj) - c ln(Dij)
Example questions:
The Ricardian model: Comparative advantages
Comparative, i.e., relative, advantages are the drivers of trade rather than the absolute
advantages that were at the centre of the trade theory of Adam Smith.
4.2. Assumptions
• 2 countries: Home (H) and Foreign (F).
• 2 products: cheese (C) and wine (W).
• 1 factor of production: labour (L), which is mobile within countries but not between
countries (international labour immobility).
• Perfect competition in the output and factor markets.
alc= number of hours of labour required for producing one pound of cheese in the domestic
country
a*lc= number of hours of labour required for producing one pound of cheese in the foreign
country
alw= number of hours of labour required for producing one gallon of wine in the domestic
country
a*lw= number of hours of labour required for producing one gallon of wine in the foreign
country
4.3 Production possibility frontier
Production possibility frontier: is a simple economic model that shows the most of two
different goods a country can produce with the resources it has—in this case, its labor
supply.
Formula: a LC Q C + a LW Q W = L
,Graph of production possibility frontier
The absolute value of the slope of the production possibility frontier shows the opportunity
cost of producing C—that is, how much of W must be given up to make more of C.1 hours of
labour. Each hour of labour could alternatively have produced gallons of wine. The
production of one additional pound of cheese thus requires sacrificing gallons of wine, or the
opportunity costs of cheese in terms of wine is
Formula is - alc / alw
4.4. Production and relative prices under autarky
Autarky = situation without international trade
The level of production is determined by equating marginal returns and marginal costs.
Production of cheese in the domestic country: at the point at which the number of pounds
of cheese produced in one hour times the price of one pound of cheese equals the nominal
wage rate (w) per hour, or (1/alc) x Pc = nominal wage rate (w)
Similarly for wine, (1/alw) x Pw = nominal wage rate (w)
The price is the marginal return and is equal to the marginal costs in line with the
assumption of perfect competition on output markets, i.e., PC = aLC* w and PW = aLW * w
The real wage equals the marginal product of labour, i.e., equals the inverse of the unit
labour requirements, in line with the assumption of also perfect competition on factor
markets, i.e., w / PC = 1 / aLC and w / PW = 1 / aLW
, In simple terms, Ricardo’s model of comparative advantage explains that even if one
country is better at making both products (has an absolute advantage), it can still benefit by
specializing in the product it is relatively better at producing. This is different from Adam
Smith's model, which suggested that if a country is more efficient at producing both goods,
it would export both.
Breaking Down the Example
Suppose we have two products:
● Product 1 and Product 2
● The domestic country can make both products more efficiently than another country.
Let's say the domestic country’s productivity numbers look like this:
● It takes 1 hour to make Product 1.
● It takes 2 hours to make Product 2.
For the foreign country:
● It takes 6 hours to make Product 1.
● It takes 3 hours to make Product 2.
The domestic country has an absolute advantage in both products, meaning it can make
each one with less time and effort than the foreign country.
Ricardo’s Insight: Comparative Advantage
However, Ricardo points out that we should look at comparative advantage, not just
absolute advantage.
● For the domestic country, making Product 1 only takes half the time it takes to make
Product 2.
● For the foreign country, Product 2 only takes half the time it takes to make Product 1.
In this case:
● The domestic country has a comparative advantage in Product 1, where it’s
relatively much more efficient.
● The foreign country has a comparative advantage in Product 2, where it’s less
inefficient.
According to Ricardo, each country benefits by focusing on the product in which it has a
comparative advantage:
● The domestic country should specialize in Product 1 and export it.
● The foreign country should specialize in Product 2 and export it.
Week 1:
Lecture 1: Introduction to international trade & investments and the Ricardian model
Practice of international trade:
• Trade policy (trade policy = wide array of government policies that are designed to
influence the size of trade flows): tariffs, export subsidies, production subsidies, industrial
policy, etc. -> a set of rules, policies set by a country to govern international trade. It includes
tariffs (taxes on imported goods), subsidies, and other policies.
• Trade policy in developing countries
• Trade policy in developed countries
• Globalisation (and the critiques thereon)
• Regional economic integration
Facts about trade:
1. Globalisation is not a new concept it has been around since before world war 1
2. Trade usually grows faster than global GDP because barriers to international trade
have decreased and because of "vertical disintegration." This means that different
steps in the production process are completed in various countries, allowing for more
efficient and specialized global production.
3. Open countries tend to grow faster than relatively closed countries.
4. Most trade takes place between countries that are similar (see figure on next slide).
5. Foreign Direct Investment has increased spectacularly over the past five decades.
Why is globalisation under attack?
1. Trade wars United States and China -> Us raised taxes because they found that
China stole their products etc. China reacted by doing the same (raising taxes).
2. Reshoring -> Bringing manufacturing and production activities back to their own
country after they outsourced it to another country.
The gravity model:
The gravity model is a very successful empirical model for the explanation of trade flows
between countries. Reason: the gravity model straightforwardly allows to include a
multitude of (potential) explanatory variables.
• positively linked to the economic size of the source country Yi .
• positively linked to the economic size of the destination country Yj .
• negatively linked to the geographical distance between the two countries Dij .
General form: Tij = A Yia Yjb / Dijc where A is a constant term.
Tij: The trade flow from country i to country j
,A: is a constant term
Yi Yj: Are economic sizes of the countries i and j, usually measured in GDP
Dij: Distance between 𝑖 and 𝑗, representing how far apart they are geographically or
economically.
a,b,and c: Are parameters that measure the sensitivity of these trade flows
Other form of the formula:
ln(Tij)= ln(A) + a ln(Yi) + b ln(Yj) - c ln(Dij)
Example questions:
The Ricardian model: Comparative advantages
Comparative, i.e., relative, advantages are the drivers of trade rather than the absolute
advantages that were at the centre of the trade theory of Adam Smith.
4.2. Assumptions
• 2 countries: Home (H) and Foreign (F).
• 2 products: cheese (C) and wine (W).
• 1 factor of production: labour (L), which is mobile within countries but not between
countries (international labour immobility).
• Perfect competition in the output and factor markets.
alc= number of hours of labour required for producing one pound of cheese in the domestic
country
a*lc= number of hours of labour required for producing one pound of cheese in the foreign
country
alw= number of hours of labour required for producing one gallon of wine in the domestic
country
a*lw= number of hours of labour required for producing one gallon of wine in the foreign
country
4.3 Production possibility frontier
Production possibility frontier: is a simple economic model that shows the most of two
different goods a country can produce with the resources it has—in this case, its labor
supply.
Formula: a LC Q C + a LW Q W = L
,Graph of production possibility frontier
The absolute value of the slope of the production possibility frontier shows the opportunity
cost of producing C—that is, how much of W must be given up to make more of C.1 hours of
labour. Each hour of labour could alternatively have produced gallons of wine. The
production of one additional pound of cheese thus requires sacrificing gallons of wine, or the
opportunity costs of cheese in terms of wine is
Formula is - alc / alw
4.4. Production and relative prices under autarky
Autarky = situation without international trade
The level of production is determined by equating marginal returns and marginal costs.
Production of cheese in the domestic country: at the point at which the number of pounds
of cheese produced in one hour times the price of one pound of cheese equals the nominal
wage rate (w) per hour, or (1/alc) x Pc = nominal wage rate (w)
Similarly for wine, (1/alw) x Pw = nominal wage rate (w)
The price is the marginal return and is equal to the marginal costs in line with the
assumption of perfect competition on output markets, i.e., PC = aLC* w and PW = aLW * w
The real wage equals the marginal product of labour, i.e., equals the inverse of the unit
labour requirements, in line with the assumption of also perfect competition on factor
markets, i.e., w / PC = 1 / aLC and w / PW = 1 / aLW
, In simple terms, Ricardo’s model of comparative advantage explains that even if one
country is better at making both products (has an absolute advantage), it can still benefit by
specializing in the product it is relatively better at producing. This is different from Adam
Smith's model, which suggested that if a country is more efficient at producing both goods,
it would export both.
Breaking Down the Example
Suppose we have two products:
● Product 1 and Product 2
● The domestic country can make both products more efficiently than another country.
Let's say the domestic country’s productivity numbers look like this:
● It takes 1 hour to make Product 1.
● It takes 2 hours to make Product 2.
For the foreign country:
● It takes 6 hours to make Product 1.
● It takes 3 hours to make Product 2.
The domestic country has an absolute advantage in both products, meaning it can make
each one with less time and effort than the foreign country.
Ricardo’s Insight: Comparative Advantage
However, Ricardo points out that we should look at comparative advantage, not just
absolute advantage.
● For the domestic country, making Product 1 only takes half the time it takes to make
Product 2.
● For the foreign country, Product 2 only takes half the time it takes to make Product 1.
In this case:
● The domestic country has a comparative advantage in Product 1, where it’s
relatively much more efficient.
● The foreign country has a comparative advantage in Product 2, where it’s less
inefficient.
According to Ricardo, each country benefits by focusing on the product in which it has a
comparative advantage:
● The domestic country should specialize in Product 1 and export it.
● The foreign country should specialize in Product 2 and export it.
