Chapter 1: Introduction
The first realm of the world economy is international trade, this refers to the exchange of
both goods and services between the countries of the world. The output of the exports of
goods and services is measured in the (world) gross domestic product. The expansion of
world trade is one of the main features of globalization.
more reasons for world economy expansion
- transportation
- technology (especially in the form of information and communication technology ICT)
- tariffs
A second important realm of the world economy is international production, this is the
production of products ( and their intermediate inputs) in multiple countries. There are two
modes of international production:
- non-equity contracting
- includes foreign outsourcing, licensing and franchising.
- an arm length relationship across national borders that can be described as
low- commitment/ low control
- equity based foreign direct investment (FDI)
- undertaken by multinational enterprises (MNE's)
- involves firms based in one country, owning at least 10 percent of a firm
producing in another country, and thereby exerting management influence
- a high commitment/ high control option
Both contracting relationships and FDI are configured between countries in what are known
as global value chains (GVC). These are systems of value changes linked together in buyer-
supplier or ownership relationships across countries. GVC's are further held together by
trade relationships in both intermediate and final products. GVCS have been enabled by the
innovations in container shipping and ICT, and their configuration affects the way countries
are included or excluded from evolving patterns of modern globalization.
The contours of industrial competitiveness are now increasingly defined by the outlines of
international production networks rather than the boundaries of nations. This process is
called unbundling, meaning that stages of the production process are moved away from their
original national location
Migration is also an important aspect of globalization, however as barriers for goods and
services have slowly been lowered or disappeared, the boundaries for migration have largely
remained in place.
A third important realm of the world economy is international finance, this refers to the
exchange of assets between these countries. Assets are financial objects characterized by a
monetary value that can change over time. The way in which these prices change in
response to the international transactions, impacts individual countries in important ways. On
an annual basis, global transactions in foreign exchange dwarf global trade transactions.
,However, capital flows can also be volatile and potentially destabilizing, this can be seen in a
capital flight. This involves investors selling a country's assets and reallocating their
portfolios in other countries assets, and is part of the trouble of global finance.
From a public perspective, it is hoped that the three realms mentioned above will contribute
to international development, namely to improve levels of welfare and standards of living.
Development has been defined in a number of ways, the most prominent is as gross
domestic product per capita, the average value of production produced by a citizen of a
country. The limitation of the approach is that GDP has been explicitly developed not to be a
measure of welfare. The main alternative to the GDP, is to use the capabilities approach,
which assesses development outcomes in terms of a range of human capabilities, things
people can actually achieve. This is often assessed using the Human development index.
- per capita income (adjusted for the cost of living)
- average life expectancy
- average levels of education
Too much specialization by focusing on one realm to the exclusion of others can be
counterproductive as well. A few other important subjects to keep in mind are culture, the
environment, politics and technology, also called CEPT
analytical elements
- countries
- are the states of the world economy, their national governments, serving as
home to both firms and residents
- sectors
- are categories of production defined largely in terms of final goods
- tasks
- we are going to need to recognize that production in a particular sector
involves a number of steps or separate tasks
- firms
- production in any sector of a country is undertaken by firms, either purely
local or MNE
- factors of production
- production in any sector of a country undertaken by a firm makes use of
various factors of production
- currencies
- most (not all) countries in the world have a separate currency in which
transaction with other countries take place through foreign exchanges
- financial assets
- both countries and firms issue various types of financial assets, denominated
in a particular currency, which can be bought to be part of wealth
management portfolios by other countries, firms and residents of another
country
Chapter 2: absolute advantage
,The initial explanation for patterns of trade lay with the concept of absolute advantage, later
this concept was replaced by a more powerful concept: comparative advantage. There are
two main explanations of comparative advantage
- The Ricardian model
- the means by which comparative advantage can be determined by
differences in technology between the countries of the world
- Heckscher- Ohlin model
- the means by which comparative advantage can be determined by
differences in resource endowments between the countries of the world
A pattern of absolute advantage implies a potential pattern of trade. Absolute advantage
refers to a country's ability to produce a good or service with fewer real resources or inputs
than another country. This can also be looked at as the inverse, namely the country's ability
to produce more of a good or service with the same real resources or inputs than another
country. It is important to remember that the principle of absolute advantage is a policy
suggestion that countries should import goods from other countries where they are produced
more efficiently. It is also important to remember that the pattern of trade implied by absolute
advantage is one determined by technological considerations. As it turns out however,
patterns of absolute advantage are neither necessary nor sufficient conditions for countries
to either export or import a good or service.
When no trade is involved, countries operate in a state of autarky. This is a situation in which
a country has no economic relationships with other countries. However when trade happens,
and there is an absolute advantage, the exporting country will see an increase in supply
(when the market price is higher than the domestic) and a decrease in demand. The amount
by which quantity supplied exceeds quantity demanded constitutes of the exports. The
importing country (without absolute advantage) will see a decrease in supply and increase in
demand if the world price is lower than the market price. The amount by which quantity
demanded exceeds the quantity supplied constitutes the imports.
Moving from autarky to either importing or exporting based on absolute advantage involves a
net increase in welfare for the country involved. This is also known as the gains from trade.
Not only is it possible to give up autarky in favor of importing and exporting but it makes
sense to do so in most instances from the standpoint of overall welfare. Although there are
instances in which trade can be a win-lose proposition, this is definitely not the general case,
as trade can be mutually beneficial for the countries involved, both exporting and importing.
There are however limitations as well, the concept of absolute advantage suggests that
possibility that a country might not have an absolute advantage in anything, and therefore
would have nothing to export, this is in reality very unlikely. The notion of the gains from
trade has limitations as well, it correctly suggests that countries as a whole can mutually gain
from trade. It does not suggest however, that everyone within a country will gain from trade.
Further these two notions do not apply to all sorts of trade, some forms of trade can in no
way be beneficial for the development of human welfare, for example arms and drugs. This
is also called illicit trade
Chapter 3: Ricardian model of comparative advantage
, This model makes use of the concept of production possibilities frontier. These are economy
wide resource constraints that reflect available resources and technology. It depicts the
combinations of output of two goods that the economy can produce given it's available
resources and technology. This is decided based on opportunity costs, that is what must be
forgone when a particular decision is made. The slopes of the PPFs are negative, meaning
that the slope goes down and that there are indeed opportunity costs (see the book for more
explanation in case of having to do calculations). The lower the steep, the lower the
opportunity costs, and the higher the steep the higher the opportunity costs.
The country with lower opportunity costs for one good compared to another good has a
comparative advantage in the first good. With full employment (which puts the economies on
rather than inside the PPF), profit maximization and perfect competition, opportunity costs of
production are fully reflected in relative prices. Thus the constant slopes of the PFFs where
the demand diagonal crosses it are the relative prices.
Differences in economy wide supply conditions cause differences in relative autarky prices
and thereby a pattern of comparative advantage. It is these differences that enable trade. A
country can because of these differences have a comparative advantage in a good in which
it has an absolute advantage.
when autarky is abandoned, the world relative price of good 1 will be somewhere in between
the two autarky ratios. The country who sees an increase in the relative price for good 1, will
have an increased incentive to produce good 1. The country that sees a decrease in the
relative price of good 1, is more likely to produce good 2 since that makes more money.
ONe thing that characterizes a Ricardian model is that the movement from autarky to trade
involves complete specialization. THis is a result of the fact that the opportunity costs of
production are constant. In a normal PPF however, specialization leads to increased
opportunity costs, acting as a brake on complete specialization.
Both consumption and production must respect world prices, meaning that these points must
always be on the world price lines. Comparative advantage is perhaps the most central
concept in international economics. However, like all economic models, it employs a set of
assumptions → full employment, perfect competition, full employment, one recourse that
cannot move from one country to another. And the gains from trade occur for the country as
a whole, not for every individual group. Besides that, not all goods that are traded contribute
to increased welfare.
Formulas:
in a Ricardian model, all the terms a (labour requirements per unit of output) are constant
total amount of factors of production ( in the book the example of labour is used=
amount of labour required to produce good 1 x quantity produced of good 1 + amount of
labour required to produce good 2 x quantity of good 2
maximum quantity good 1:
total amount of factors of production / amount of factor of production needed
slope of the PPF
