English summary of the book 'International Economics Theory and Policy', 11th edition, by Krugman, Obstfeld and Melitz. The summary consists of chapters 1 up to and including 10, 12 up to and including 16 and 19. These are the book chapters that have to be read for the course 'International Economi...
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International Economics and Business
International Economics
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Summary book International Economics
International Economics Theory and Policy (11th edition)
Chapter 1 – Introduction:
International economics has never been as important as it is now: international trade has
roughly tripled in importance compared with the economy as a whole. The US, by virtue of its
size and the diversity of its resources, relies less on international trade than almost any other
country.
International economics uses the same fundamental methods of analysis as other branches of
economics because the motives and behaviour of individuals are the same in international trade
as they are in domestic transactions. Yet international economics involves new and different
concerns because international trade and investment occur between independent nations. Seven
themes recur throughout the study of international economics:
1. The gains from trade à the range of circumstances under which international trade is
beneficial is much wider than most people imagine. Although nations generally gain from
international trade, it is quite possible that international trade may hurt particular
groups within nations, in other words, that international trade will have strong effects on
the distribution of income.
2. The pattern of trade à trade patterns are an interaction between the relative supplies of
national resources such as capital, labor, and land on one side and the relative use of
these factors in the production of different goods on the other.
3. Protectionism à how much trade to allow? The single most consistent mission of
international economics has been to analyse the effects of so-called protectionist
policies.
4. The balance of payments à A country’s balance of payments must be placed in the
context of an economic analysis to understand what it means.
5. Exchange rate determination à the relative values of currencies can change over time,
sometimes drastically. The study of exchange rate determination is a relatively new part,
because it is quite new that exchange rate are fixed in the marketplace (instead of by
government action)
6. International policy coordination à One country’s economic policies usually affect other
countries as well.
The international capital market à in any sophisticated economy, there is an extensive capital
market: a set of arrangements by which individuals and firms exchange money now for
promises to pay in the future. There are special risks associated with international capital
markets, for example currency fluctuations.
,Chapter 2 – World trade: An overview
In this chapter the authors describe who trades with home and we will talk about the gravity
model.
There is a strong empirical relationship between the size of a country’s economy and the volume
of both its imports and its exports. With size we mean the value of gross domestic product
(GDP), which measures the total value of all goods and services produced in an economy. Each
country’s share of US trade with Europe was roughly equal to that country’s share of Western
European GDP. The value of trade between any two countries is proportional, other things equal,
to the product of the two countries GDPs and diminishes with the distance between the two
countries. This is known as the gravity model of world trade. Large economies trend to spend
large amounts on imports because they have large incomes. They also tend to attract large
shares of other countries’ spending because they produce a wide range of products. But there
are also factors limiting international trade. Distance is an important one. All estimated gravity
models show a strong negative effect of distance on international trade; typical estimates say
that 1 percent increase in the distance between two countries is associated with a fall of 0.7 to 1
percent in the trade between those countries. Explanation is for example increased costs of
transporting goods and services. Also, trade agreements could be effective to enhance trade.
However, although there is completely free trade, national borders always have a negative effect
on trade.
History of World Trade:
• The world got smaller between 1840 and 1914 (more world trade and globalization)
• Two subsequent world wards, the Great Depression of the 1930s and widespread
protectionism did a great deal to depress world trade.
• It rose again in the fifties, however globalization didn’t return to pre-World War I levels
until the early 1970s.
• Since then, world trade as a share of world production has risen to unprecedented
heights.
What do we trade? If we look at figure 2-6 (page 46) we see that manufacturing goods are the
biggest share. This is interesting, because in the early days it was agricultural goods. And in the
future it may be services, since there is getting more service offshoring / outsourcing à when a
service previously done within a country is shifted to a foreign location.
Chapter 3 – Labour productivity and comparative advantage: The Ricardian Model
Countries engage in international trade for two basic reasons:
• Countries trade because they are different from each other. They can benefit from their
differences by reaching an arrangement in which each does the things it does relatively
well.
• Countries trade to achieve economies of scale in production. It can produce a single good
at a large scale and hence more efficiently than if it tried to produce everything.
Opportunity costs à the number of good X that could have been produced with the resources
used to produce a given number of product Y. Opportunity costs differ between countries. This
difference in opportunity costs offers the possibility of a mutually beneficial rearrangement of
world production.
The reason that international trade produces this increase in world output is that it allows each
country to specialize in producing the good in which it has a comparative advantage. A country
has a comparative advantage in producing a good if the opportunity cost of producing that gooLd
in terms of other goods is lower in that country than it is in other countries. Trade between two
countries can benefit both countries if each country exports the goods in which it has a
comparative advantage.
,Ricardian model à international trade is solely due to international differences in the
productivity of labour.
Ricardian Model:
There is an economy, called Home, that has only one factor of prudction. Home is producing only
two goods: cheese and wine. Unit labor requirement à the number of hours of labor required to
produce a pound of cheese (ALC) or a gallon of wine (ALW). The more cheese or wine a worker can
produce in an hour, the lower the unit labor requirement is.
Production possibility frontier à to produce
more of one good, the economy must sacrifice
some production of another good (you only have
a certain amount of labor). The possibility
frontier shows the maximum amount of wine
that can be produced once the decision has been
made to produce any given amount of cheese,
and vice versa.
Wen the PPF is a straight line, the opportunity
cost of a pound of cheese in terms of wine is
constant.
The PPF illustrates what an economy can
produce. To determine what the economy will actually produce, we need to look at prices. We
need to know the relative price of the economy’s two goods, that is, the price of one good in
terms of the other.
In this one-factor model, there are no profits, so the hourly wage in the cheese sector will equal
to the value of what a worker can produce in an hour: Pc / ALC and PW / PLW.
The economy will specialize in the production of cheese if the relative price of cheese exceeds its
opportunity cost in terms of wine; it will specialize in wine in the relative price of cheese is less
than its opportunity cost in terms of wine.
The ratio of unit labor requirements is equal to the opportunity cost of cheese in terms of wine
and we defined comparative advantage precisely in terms of such opportunity costs.
Absolute advantage à one country can produce a unit of a good with less labor than another
country. However, we cannot determine the pattern of trade from absolute advantage alone.
The relative price before trade would be determined by the relative unit labor requirements.
The relative price of cheese in Home would be ALC / ALW.
The prices of internationally traded goods, like other prices, are determined by supply and
demand. We need a general equilibrium analysis, which takes account of the linkages between
the two markets. We are looking at the relative supply and demand: the number of pounds of
cheese supplied or demanded divided by the number of gallons of wine supplied or demanded.
The world general equilibrium requires that relative supply equal relative demand, and thus the
world price is determined by the intersection of RD and RS.
There will be no supply of cheese if the world price dropped below ALC / ALW. If PC / PW is above
ALC / ALW, home will specialize in the production of cheese. Als long as PC / PW < A*LC / A*LW,
foreign will continue to specialize in producing wine. Finally, for PC / PW > A*LC / A*LW, both will
specialize in cheese production. There will be no wine production, so that the relative supply of
cheese will become infinite.
, The relative demand curve
is given! For example, the
price can be at point 1, but if
the RD decreases, the price
will become 2.
The effect of this
convergence in relative
prices is that each country
specializes in the
production of that good in
which it has the relatively
lower unit labor
requirement.
Both countries derive gains
from trade from this
specialisation (mutual gain).
Relative wage à The amount of country workers that they are paid per hour, compared with
the amount workers in another country are paid per hour.
Three misconceptions of international trade (explanation given by model of comparative
advantage):
1. Free trade is beneficial only if your country is strong enough to stand up to foreign
competition à not true, because gains from trade depend on comparative advantage
rather than absolute advantage. The competitive advantage of an industry depends not
only on its productivity relative to the foreign industry, but also on the domestic wage
rate relative to the foreign wage rate.
2. Foreign competition is unfair and hurts other countries when it is based on low wages
(pauper labor argument) à all that matters to home is that it is cheaper in terms of its
own labor for home to produce cheese and trade it for wine than to produce wine for
itself.
3. Trade exploits a country and makes it worse off if its workers receive much lower wages
than workers in other nations à What is the alternative? If Foreign refused to let itself
be ‘exploited’ by refusing to trade with Home, real wages would be even lower.
Many goods end up being nontraded either because of the absence of strong national cost
advantages or because of high transportation costs.
The basic prediction of the Ricardian model (that countries tend to export those goods in which
their productivity is relatively high) has been strongly confirmed by a number of studies over
the years. Perhaps the most striking demonstration of the continuing usefulness of the Ricardian
theory of comparative advantage is the way it explains the emergence of countries with very low
overall productivity as export powerhouses in some industries. The two implications of the
Ricardian theory seems to be supported by the evidence: that productivity differences play an
important role in international trade and that it is comparative rather than absolute advantage
that matters.
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