International Economics

Chapter 1

What is globalization?

The free movement of goods, services, labors across the national boundaries is defined as Globalization.
It helps in integration of markets and economy of one country to rest of the worlds.

Different phases of Globalization

1st Phase-

It resulted from the Industrial revolution in Europe and the opening of new, resource rich but sparsely
populated lands in North America. These lands received large amount of immigrants and vast amount of
Foreign investments, principally from England to open up new lands for food and raw materials
production for Europe in exchange of manufactured goods. This phase ended with the outbreak of world
war 1 in 1914.

2nd Phase-

Started with the end of world war II in 1945 and extended till 1980, characterized by rapid increase in
international trade as a result of the dismantling of heavy trade protection that had been put in place
while Great Depression.

3rd Phase

Started by 1980, this phase engulfed the whole world by its speed, depth and immediacy with the rapid
improvements in tele communications and transportation sector, massive international capital flows

Challenges put up by Globalization

1. Loss of jobs for one country and Brain drain for another
2. Domestic industries face stiff competition if not properly developed
3. Often financial crises occur which quickly moves to other countries as well
4. Environmental pollution and Climate change

The International Flow of Goods and services, Labor and capital:-

The Gravity model The bilateral trade between two countries is proportional to the product of two
countries GDPs and inversely related to the geographical distance between them.

Usually, movement of goods and services are freer than movement of people. Financial and portfolio
capital moves where the interest rates are higher and FDI moves where the expected profits are higher
leading to more efficient use of capital.

International Economic theories and Policies

Purpose International Economic theories and Policies (to predict and explain) It examines for the
basis for and the gains from trade, the reasons for and the effects of trade restrictions, policies directed
at regulating the flow of international payments and receipts and the effects of these policies on nation
welfare and the welfare of other nations as well. It also examines the effectiveness of macroeconomic
policies under different types of international monetary arrangements and systems

The subject matter of International Economics

1. Deals with the economic and financial interdependence among the nations
2. Analyses the flows of goods, services, payments and monies between a nation and rest of the
world
3. Policies directed at regulating the flows and their effects on nation welfare
4. Overall, deals with international trade theory, international trade policy, the BOP, foreign
exchange market and open economy macroeconomics

Current International Economic Problems and challenges

1. Slow growth and High unemployment in Advanced economies after the The Great recession
2. Trade Protectionism in Advanced countries in a rapidly globalizing world
3. Excessive fluctuations and Misalignment in Exchange Rates and financial Crises
4. Structural imbalances in advanced economies and Insufficient Restructuring in Transition
economies eg. Overvalued dollars in US, inflexible labor market in EU and serious inefficiencies
in the distribution systems of Japan
5. Deep poverty in developing countries
6. Resource scarcity, environmental degradations, climate change and Unsustainable development
The Law of Comparative Advantage
1. What is the basis for trade and what are the gains from trade?
2. What is the pattern of trade?

The Mercantilists views on Trade:- They always maintained that for a nation to become rich it should
export more than what it imports, so that the export surpluses can be utilized to accumulate precious
metals. In early times, the wealth of the nation was measured on the stock of precious metal. Since all
the countries cant have export surpluses at one point of time so one nation grew at the expense of
another. Thus mercantilists preached economic nationalism and advocated strict governmental controls
on all the economic activity of the nation.

In contemporary world, though all the nations claim to be in favor of free trade, most of them continue
to impose many restrictions on international trade. For eg. Industrial nations put restrictions on imports
of agricultural produce, textiles, shoes, steel and many other products. Moreover, they also provide
subsidies to the High tech industries such as computers and telecommunications

Trade based on Absolute Advantage: Adam Smith

Trade between two nations is based on absolute advantage, where one nation is more efficient at
producing one commodity but less efficient at producing other commodity and the two nations trade for
the commodity where they have the absolute advantage thus increasing their output. In this way,
resources are utilized in best way.

Thus Adam Smith strongly advocated for Free trade (lassiez faire ) as opposed to Mercantilists. One
exception was the protection of industries important for national defense. One important thing is that,
both the nations gain but one nation might gain much more than other nation.

Trade based on Comparative Advantage: David Ricardo

According to this law, even if one nation is less efficient than (has absolute disadvantage in both
commodities with respect to another) the other nations in the production of both commodities, there is
still a basis for mutually beneficial trade.
The first nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller and import the commodity in which its absolute disadvantage is greater.

US UK

Wheat (bushels/hour) 6 1

Cloth (yards/hour) 4 2

If US could exchange 6W for 6C with UK then it would gain 2C (or save half labor time) and UK would
gain 6C as it can produce 12C for 6W so there would be no problem in giving up 6C for getting 6W.
Here UK gains more than US. We see that total gain available is 8C for the exchange of 6W.
The case of No Comparative Advantage- If one nation has same level of comparative disadvantage in
both the commodities then there could be no mutual beneficial trade.

Assumptions made by Richardo :-

1. Only two nations and two commodities

2. Free trade
3. Perfect mobility of labour within nation and immobility between the two nations
4. Constants costs of production
5. No transportation costs
6. No technical change
7. The labour theory of value (invalid assumption) under this theory, the value or price of the
commodity depends exclusively on the amount of labour going into the production of the
commodity, this implies (1) either the labor is the only factor of production or the labour is used
in the same fixed proportion in the production of all the commodities and (2) that labour is
homogenous

The Opportunity cost theory:- By Harbeler in 1936

A/C to this theory, the cost of a commodity is the amount of a second commodity that must be given up
to release just enough resources to produce one additional unit of first commodity. No assumptions
related to labour theory of value has been taken here.
We see in the same above example that, US will have to give up 2/3rd amount of C to get 1 extra
wheat production while UK will have to give C for 1W which is lower than the US. Thus US has more
comparative advantage over UK in the production of W, so it should produce W domestically and export
some to UK while UK should produce C and export some to US
The Standard theory of International Trade
The Production frontier with increasing cost : In real world, nation faces increasing opportunity costs
rather than constant opportunity costs. Increasing opportunity costs means that a nation must give up
more and more of the commodity to release just enough resources to produce each additional unit of
one other commodity. This results out in the formation of Concave frontier of production function.

The marginal rate of Transformation: MRT of X for Y refers to the amount of Y a nation must give up to
produce one additional unit of X and is given by slope of production frontier at the point of production

Reasons for increasing Opportunity costs and Different Production Frontiers: Increasing opportunity
costs arise because resources or factor of production
1. Are not homogenous i.e. all units of same factor are not identical or of same quality
2. Are not used in the same fixed proportion or intensity in the production of all commodities

As the nations produce more of a commodity, it has to utilize resources that are less efficient or less
suited for the production of that commodity. Also, the nature of endowments and the technology
employed play an important role in determining the production function

Community indifference curve (tastes and preferences) It shows the various combinations of the two
commodities that yield equal satisfaction to the community or nation. Higher curves means greater
satisfaction and lower curve means lower satisfaction. These curves are convex from origin and they
must not cross to be useful

The Marginal rate of Substitution MRS of X for Y in consumption refers to the amount of Y that a
nation could give up for one extra unit of X and still remain on the same indifference curve. It is given by
absolute slope of the community indifference curve at that point of consumption and declines as the
nation moves down the curve.

The decline is because, as the more of X and less of Y is consumed, the more a unit of Y becomes
valuable to the nation at the margin compared with the unit of X. Declining MRS means curve are
convex from the origin.

Some difficulties in Community Indifference curves - A particular set or map of community indifference
curves refers to the particular income distribution within the nation. A different income distribution
would result in a completely new set of indifference curves which might intersect previous indifference
curves.
This happens when a nation opens up trade or expands its level of trade, where exporters will benefit
while domestic producers competing with import will suffer. There is also differential impact on the
consumers, depending on the consumption orientation towards X or Y. Thus Trade will change the
pattern of distribution of national income and may cause indifference curves to intersect and then we
will not be able to comment whether the opening of trade has benefitted the nation.
One way out of this is Compensation Principle which says that nations would benefit if the gainers
would be better off even after fully compensating the losers for their losses