International Economics

Financial Management MBA

University of Coburg
2020, Alba Patozi
International trade outline: Introduction
• World trade: an overview
• Who trades with whom?
• The gravity model of trade
• Trade costs
• Have trade costs become smaller?
• A historical perspective to international trade
• What do countries trade?

Required reading: Krugman, Obstfeld and Melitz, chapters 1 and 2.

 World trade: An Overview
• Statistics:
üIn 2018, the world as a whole produced goods and services worth about $81
trillion.
üAbout 50% was sold across national borders, (i.e., around $41 trillion).
üComparison: Germany’s GDP is roughly $3.95 trillion.
• Key questions:
üWho trades with whom? (today)
üWhat is traded? (today)
üWhy do countries trade?
üWhat’s the role of policies and institutions?
Who trades with whom? Germany’s export destinations

Source: OEC
The top export destinations of Germany are the United States, France, the UK, China and the Netherlands.
 Who trades with whom? Germany import origins

Source: OEC
The top import origins of Germany are China, the Netherlands, France, the US and Italy
Thoughts…
• Size clearly is important
• Distance is an impediment, neighbours are big trading partners.
• Thus, small remote countries (e.g Angola or Nepal) do not show up in
the table.
The gravity model of trade
Consider the so-called ‘gravity equation’ of international trade:
"
$!
𝑇!" = 𝐴 ∗ 𝑌!# ∗ $ or,
%#!
ln 𝑇!" = ln 𝐴 + 𝛼 ln 𝑌! + 𝛽 ln 𝑌" − 𝛾ln(𝐷!" )

Bilateral trade shares 𝑇!" /𝑌! depend on the economic size of the
destination country, 𝑌" , and inversely on bilateral distance 𝐷!" .
The Gravity Model of International Trade
• Analogous to Newton’s (1687) Law of Universal Gravitation.
• Gravity model works well with data (often 𝑅 & > 0.8)
• Parameter estimates for 𝛼, 𝛽, 𝛾 are typically close to 1.

References:
• Anderson, J., 2011. The Gravity Model. Annual Review of Economics 3(1),
pp. 133-160
• Head, K., Mayer, T., 2014. Gravity Equations: Workhorse, Toolkit, and
Cookbook. Chapter in Handbook of International Economics Vol. 4 (eds.
Gopinath, Helpman, Rogo)
Trade costs

Sometimes trade observations do not fit the standard gravity equation

well even when distance is taken into account. Why?
Answer: Trade costs
• Geographical : distance, landlocked, being isolated by mountains or
deserts
• Historical/cultural: lack of colonial history, dissimilar language etc)
• Political: tariffs, no free trade agreements/customs unions, exchange
rate volatility, capital controls, general political uncertainty
• Border effects: Informational costs, nationalism
Have trade costs become smaller?
• Answer: Generally yes, but they are still substantial.
• No ‘’death of distance’. The distance barrier is well and alive for trade
in goods and services. The world has seen an increase in regional
integration ( i.e. relatively more trade with nearby countries).
The world’s ships are a major source of 𝐂𝐎𝟐 emissions
In 2012, these ships ended up emitting 796 millions tons of carbon dioxide.

Source: Vox
Trade from a historical perspective
• The first globalisation wave
• The second globalisation wave
• The third globalisation wave
• Changing trade patterns
Intercontinental trade per capita, selected countries
Before the early modern period, transoceanic flows of goods between
empires and colonies accounted for an important part of international
trade.
The first wave of globalisation 1870-1914
• Marked by the rise and collapse of intra European trade
• In the period 1830-1900 intra-European exports went from 1% of GDP to
10% of GDP
• Capital moved relatively freely between countries.
• Important drivers were both the new technology of the era that could
bridge long geographical distances and the fact that many countries began
to embrace liberal trade policy after years of protectionism.
• Great Britain was the world’s leading economy. The basis for the European
free trade system was the 1860 free trade pact between GB and France.
Many other European countries subsequently aligned themselves with this
free trade system.
The second wave of globalisation, 1944-1971
Largely driven by reductions in transaction costs stemming from technological advances, such as the
development of commercial civil aviation, the improvement of productivity in the merchant marines and the
decentralization of the telephone as the main mode of communication.
The third wave of globalisation, 1989 - present
• Emergence of global information economies and the increasing
dominance of the Information Technologies.
• The eclipsing of manufacturing and manufacturing goods by
knowledge-production and information-processing as the primary
economic activity.
• Birth of the WTO on 1 January 1995, which boosted trade growth
through agreements that covered trade in goods, services and
intellectual property.
The rise of emerging economies in global trade
• Source: The Rise of Middle Kingdoms: Emerging Economies in Global Trade by
Gordon Hanson (2012), Journal of Economic Perspectives 26(2)
• Led by China and India, the share of developing economies in global exports
more than doubled between 1994 and 2008. [...] The result of China’s and
India’s openings has been an immense global export supply shock. Between
1992 and 2008, average annual growth in exports was 18 %. in China and in
India 14 %. These two are not the only significant new players in global trade.
• Consider the next 15 middle-income countries, which (in order of market size)
are Brazil, Korea, Mexico, Russia, Argentina, Turkey, Indonesia, Poland, South
Africa, Thailand, Egypt, Colombia, Malaysia, the Philippines, and Chile. In
2008, they each had a GDP above $100 billion; as a group, their collective
GDP is 1.4 times China’s and India’s combined total. From 1992-2008, these
15 countries had average annual export growth of 8 %. During this period,
low-and middle-income countries overall saw their share of global exports
more than double, from 21 to 43%.
The rise of emerging economies in global trade
From the 1950s to the 1980s, trade was dominated by flows between high-
income countries both because they accounted for most of global GDP and
because many developing countries maintained high barriers to imports.
In the international economics literature, the exchange of goods between
the United States, Canada, the nations of western Europe, and Japan is often
referred to as North-North trade.
However, we are moving toward a world in which South-South commerce
(trade between developing countries) and North-South commerce (trade
between developed and developing countries) are overtaking North-North
flows. Whereas high-income economies accounted for four-fifths of global
trade in 1985, they will account for less than half by the middle of this
decade.
 China’s top export products

Source: Vox
World Export Map
 What do countries trade?

Source: OEC
Trade in services in on the rise
Trade patterns Example 1
• For the UK and other rich countries over time, the percentage of
manufacturing trade flows (as a fraction of GDP) has increased, the
percentage of primary products/raw materials trade flows (as a
fraction of GDP) has decreased
• Explanation: In colonial times, the UK used to import mostly primary
products and export manufactured goods. Today, manufactured
goods dominate both UK imports and UK exports
• This reflects the rise of intra industry trade, vertical specialisation,
outsourcing and multinational companies
Trade patterns Example 2
• China today is the world’s manufacturing workshop (with many
intermediate parts imported from all over the world for assembly in
China).
“How the iPhone Widens the
United States Trade Deficit with
the Peoples Republic of China”
Xing and Detert (2010)
Trade flow accounting: Xing and Detert (2010)
• The international production chain for iPhone
• In 2009 iPhone sold in the U.S. for about $500 in retail stores. It is
assembled in China and then shipped to the U.S. But the value of the
iPhone when it leaves China is in the range of $180. The difference is
essentially distribution costs within the U.S. and essentially Apple’s
mark up.
• The international production chain is spread over various countries:
parts of the iPhone are made in Germany, Korea, Japan. For example,
the German company Infeneon contributes components worth $29,
the Korean company Samsung contributes components worth $23. In
total, the input costs are worth about $172.50.
Trade Flow Accounting: Xing and Detert (2010)

• Then the parts are assembled in China. But the value-added of

manufacturing in China is only $180-$172.50 =$7.50. (i.e, just a bit more
than 1% of the retail value in the U.S.)
• But the iPhone enters the US-China trade balance at $180 per piece,
whereas really it should only enter at $7.50 per piece. The iPhone alone
accounts for roughly $1.9 billion or about 1% of the total China-US trade
deficit (over 11 million iPhones shipped to the U.S, in 2009), but that deficit
appears grossly exaggerated.
• Bottom line: Measuring the value of trade flows is complicated. Ideally we
would like all trade flows to be reported as value-added (as in GDP- for
example, excluding the costs of inputs). But trade flows are typically
reported as total value (i.e. including costs of inputs)
Outsourcing: The Barbie doll example

Source: Feenstra, Robert C., 1998.

Integration of Trade and Disintegration of
Production in the Global Economy.
Journal of Economic Perspectives 12(4),
pp. 31-50. The Barbie doll story is based
on a 1996 newspaper story by Rone
Tempest in the Los Angeles Times.
Outsourcing:
“The raw materials for the doll (plastic and hair) are obtained from Taiwan and
Japan. Assembly used to be done in those countries as well as the Philippines but it
has now migrated to lower-cost locations in Indonesia, Malaysia and China. The
molds themselves come from the US, as do additional paints used in decorating the
dolls.
Other than labour, China supplies only the cotton cloth used for dresses. Of the $2
export value for the dolls when they leave Hong Kong for the US, about 35 cents
covers Chinese labour, 65 cents covers the cots of materials and the remainder
covers transportation and overhead, including profits earned in Hong Kong.
The dolls sell for about $10 in the US, of which Mattel earns at least $1, and the
rest covers transportation marketing, wholesaling and retailing in the US. The
majority of the value added is therefore from US activity. The dolls sell worldwide
at the rate of two dolls every second, and this product alone accounted for $1.4
billion in sales for Mattel in 1995.”
A flow chart for the Barbie doll production

Source: Feenstra/Taylor (1998)

More generally, stories abound now of companies ‘repatriating’
manufacturing processes to Western counties (also known as
‘inshoring’ as opposed to ‘offshoring’).
Important reasons are rising wages and production costs in countries
like China as well as problems with the protection of intellectual
property, political instability etc