International Trade and Investment Final Summary
The gravity model 2
The model of Ricardo 3
General information 3
Mechanism 5
Welfare 5
International trade 6
Extension of the model: multi good or N-good model 9
Extension of the model: transportation costs and non traded goods 10
Strong points versus weak points 11
The specific factors model 11
Assumptions / general description 11
Allocation 13
Trade and income redistribution 14
Overall-effect of trade 16
The Heckscher-Ohlin model 18
Assumptions 18
The Heckscher-Ohlin model: A model of a two-factor economy under autarky 18
The Heckscher-Ohlin model: The effects of international trade 23
The international labour mobility (model) 26
The equilibrium in a world without international labor mobility 28
The equilibrium in a world with international labor mobility 28
The standard trade model 29
Gains from trade 29
Changes in the terms of trade 30
Economic growth 30
Transfers (not in book) 32
Import tariffs and export subsidies 35
International borrowing and lending 37
External economies of scale and international trade 41
The importance of established advantage 42
Trade can even bring welfare losses 43
Dynamic external economies of scale 44
Internal economies of scale and international trade 45
The goals of the analysis 45
Internal economies of scale 45
1
, The consequences of the emergence of internal economies of scale 45
Monopolistic competition: 45
Dumping 50
Foreign Direct Investment (FDI) and Outsourcing 52
The instruments of trade policy 53
The most important instruments of trade policy 55
Import tariffs 55
Export subsidies 61
Import quotas 62
Voluntary Export Restraints (VER) 65
Other instruments of trade policy 65
Tariffs and import quotas in the presence of a monopoly 66
The political economy of trade policy 70
The case for free trade 70
The case against free trade 72
Trade policy in developing countries 85
Import substitution 85
Export promotion 87
Activist trade policy in developed countries 87
Background information 87
The two arguments, based on market failures, that can justify activist trade
policy in developed countries: 88
Controversies in trade policy 93
Levels of regional economic integration 95
Free Trade Area 96
Preferential Trade Agreements (PTA) 97
Welfare effects of PTAs 97
Additional, dynamic welfare effects of PTAs 103
PTAs in practice 105
The gravity model
● It is a simple yet successful empirical model.
● It explains the flow of trade between countries.
○ The gravity model allows us to include a multitude of (potential)
explanatory variables.
● The general form is:
○ A model for the flow of trade (T) from country i to country j including
three explanatory variables:
○ Y_i: The economic size of source country Y_i (GDP)
2
, ○ Y_I: The economic size of the destination country Y_j (GDP)
○ A: A constant term
○ D_ij: The distance between the countries
○ T_ij: The value of trade between country i and country j
● The links in the model:
○ The trade flows from country i to country j are positively linked to the
economic size of the source country Y_i
○ The trade flows from country i to country j are positively linked to the
economic size of the destination country Y_j
○ The trade flows from country i to country j are negatively linked to the
geographical distance D_ij
The model of Ricardo
General information
Basic insight: A country will tend to export the product in which it has a
comparative advantage and will tend to import the product in which it has a
comparative disadvantage.
● Factors of production: one factor of production: labour
○ Labour mobility: labour is mobile within countries but not between
countries
● Amount of countries: 2 H and F
● Amount of products: 2 cheese and wine
● Assume perfect competition in the output and factor markets
● Differences in labour productivity lead to:
○ [1] Comparative advantages
○ [2] Specialisation of countries
○ [3] International trade
● The Ricardian model sees comparative/relative advantages as the drivers of
trade.
● In the model of Ricardo technology is specified in terms of constant unit
labour requirements that differ across products and countries.
● Variables:
○ The number of hours of labour required for producing one pound of
cheese in the domestic country.
■ a_LC
○ The number of hours of labour required for producing one pound of
cheese in the foreign market.
■ a_ _*_LC
○ The number of hours of labour required for producing one gallon of
wine in the domestic country.
■ a_LW
○ The number of hours of labour required for producing one gallon of
wine in the foreign country.
■ a_ _*_LW
3
, ● The production possibility frontier: A curve that specifies the maximum
amount of each of the two products that can be produced with the available
labour supply (L) in the country in question. It also illustrates the trade-off
between producing the two goods.
○ Equation:
■ We thus assume that all labour will be used.
○ The absolute value of the slope of the production possibility frontier
equals the opportunity cost of the production of the product on the x-
axis in terms of the product on the y-axis.
○ The formula of the slope:
○
● The level of production is determined by equating marginal returns and
marginal costs.
○ Calculating the production of cheese in the domestic country: At the
point at which the number of pounds of cheese in one hour1/a_LC
times the price of one pound of cheese (P_c) equals the nominal wage
rate (w) per hour, or, (1/a_LC)*P_c = w
■ Siminarly for wine, or (1/a_LW)*P_w=w
● In line with the assumption of perfect competition in output markets the
price is the marginal return and is equal to the marginal costs.
○ P_c =a_LC *w
○ P_w=a_LW*w
● In line with the assumption of perfect competition of in factor markets the
real wage equals the marginal product of labour, i.e. the inverse of unit
labour market requirements.
○ w/P_c =1/a_LC
○ w/P_w =1/A_LW
4
The gravity model 2
The model of Ricardo 3
General information 3
Mechanism 5
Welfare 5
International trade 6
Extension of the model: multi good or N-good model 9
Extension of the model: transportation costs and non traded goods 10
Strong points versus weak points 11
The specific factors model 11
Assumptions / general description 11
Allocation 13
Trade and income redistribution 14
Overall-effect of trade 16
The Heckscher-Ohlin model 18
Assumptions 18
The Heckscher-Ohlin model: A model of a two-factor economy under autarky 18
The Heckscher-Ohlin model: The effects of international trade 23
The international labour mobility (model) 26
The equilibrium in a world without international labor mobility 28
The equilibrium in a world with international labor mobility 28
The standard trade model 29
Gains from trade 29
Changes in the terms of trade 30
Economic growth 30
Transfers (not in book) 32
Import tariffs and export subsidies 35
International borrowing and lending 37
External economies of scale and international trade 41
The importance of established advantage 42
Trade can even bring welfare losses 43
Dynamic external economies of scale 44
Internal economies of scale and international trade 45
The goals of the analysis 45
Internal economies of scale 45
1
, The consequences of the emergence of internal economies of scale 45
Monopolistic competition: 45
Dumping 50
Foreign Direct Investment (FDI) and Outsourcing 52
The instruments of trade policy 53
The most important instruments of trade policy 55
Import tariffs 55
Export subsidies 61
Import quotas 62
Voluntary Export Restraints (VER) 65
Other instruments of trade policy 65
Tariffs and import quotas in the presence of a monopoly 66
The political economy of trade policy 70
The case for free trade 70
The case against free trade 72
Trade policy in developing countries 85
Import substitution 85
Export promotion 87
Activist trade policy in developed countries 87
Background information 87
The two arguments, based on market failures, that can justify activist trade
policy in developed countries: 88
Controversies in trade policy 93
Levels of regional economic integration 95
Free Trade Area 96
Preferential Trade Agreements (PTA) 97
Welfare effects of PTAs 97
Additional, dynamic welfare effects of PTAs 103
PTAs in practice 105
The gravity model
● It is a simple yet successful empirical model.
● It explains the flow of trade between countries.
○ The gravity model allows us to include a multitude of (potential)
explanatory variables.
● The general form is:
○ A model for the flow of trade (T) from country i to country j including
three explanatory variables:
○ Y_i: The economic size of source country Y_i (GDP)
2
, ○ Y_I: The economic size of the destination country Y_j (GDP)
○ A: A constant term
○ D_ij: The distance between the countries
○ T_ij: The value of trade between country i and country j
● The links in the model:
○ The trade flows from country i to country j are positively linked to the
economic size of the source country Y_i
○ The trade flows from country i to country j are positively linked to the
economic size of the destination country Y_j
○ The trade flows from country i to country j are negatively linked to the
geographical distance D_ij
The model of Ricardo
General information
Basic insight: A country will tend to export the product in which it has a
comparative advantage and will tend to import the product in which it has a
comparative disadvantage.
● Factors of production: one factor of production: labour
○ Labour mobility: labour is mobile within countries but not between
countries
● Amount of countries: 2 H and F
● Amount of products: 2 cheese and wine
● Assume perfect competition in the output and factor markets
● Differences in labour productivity lead to:
○ [1] Comparative advantages
○ [2] Specialisation of countries
○ [3] International trade
● The Ricardian model sees comparative/relative advantages as the drivers of
trade.
● In the model of Ricardo technology is specified in terms of constant unit
labour requirements that differ across products and countries.
● Variables:
○ The number of hours of labour required for producing one pound of
cheese in the domestic country.
■ a_LC
○ The number of hours of labour required for producing one pound of
cheese in the foreign market.
■ a_ _*_LC
○ The number of hours of labour required for producing one gallon of
wine in the domestic country.
■ a_LW
○ The number of hours of labour required for producing one gallon of
wine in the foreign country.
■ a_ _*_LW
3
, ● The production possibility frontier: A curve that specifies the maximum
amount of each of the two products that can be produced with the available
labour supply (L) in the country in question. It also illustrates the trade-off
between producing the two goods.
○ Equation:
■ We thus assume that all labour will be used.
○ The absolute value of the slope of the production possibility frontier
equals the opportunity cost of the production of the product on the x-
axis in terms of the product on the y-axis.
○ The formula of the slope:
○
● The level of production is determined by equating marginal returns and
marginal costs.
○ Calculating the production of cheese in the domestic country: At the
point at which the number of pounds of cheese in one hour1/a_LC
times the price of one pound of cheese (P_c) equals the nominal wage
rate (w) per hour, or, (1/a_LC)*P_c = w
■ Siminarly for wine, or (1/a_LW)*P_w=w
● In line with the assumption of perfect competition in output markets the
price is the marginal return and is equal to the marginal costs.
○ P_c =a_LC *w
○ P_w=a_LW*w
● In line with the assumption of perfect competition of in factor markets the
real wage equals the marginal product of labour, i.e. the inverse of unit
labour market requirements.
○ w/P_c =1/a_LC
○ w/P_w =1/A_LW
4
