 International economics studies the interaction among countries through trade flows of goods,

services and investment.

 The EU accounted for 16.9 % of world exports and 15.1 % of world imports in goods in 2020.
 The EU was the world’s leading exporter of food, drinks and tobacco as well as of chemical
products in 2020 but was highly dependent upon imports of mineral fuels.
 In 2020, the United States remained the principal destination for goods exported from the EU
and China the main source of goods imported into the EU.

 Theory of trade Also called the Heckscher-Ohlin theory; the classical, country-based
international theory states that countries would gain comparative advantage if they produced
and exported goods that required resources or factors that they had in great supply and
therefore were cheaper production factors.

The Gravity Model=> it’s based on observations

 We consider the pattern of world trade that we observe today.

 Core idea: empirical model known as the gravity model.
 Gravity model is based on two observations:
1. Countries tend to trade with nearby economies.
2. Trade is proportional to country size.
 The model is called gravity model (like physics equation that describes the pull of one body to
another as proportional to their size and distance)
 2 countries that are large and closer will trade more than 2 countries that are small and far
 Importance for gravity model: size+distance
 Net exports are a measure of a nation's total trade. The formula for net exports is a simple one:
The value of a nation's total export goods and services minus the value of all the goods and
services it imports equal its net exports

 Geography (distance) and size (GDP) are the most important determinants of bilateral trade
flows.
 Note that the world’s largest economies (after the U.S.) are: Japan, Germany, United Kingdom,
France, and China.

The importance of size:

• Large economies produce more goods and services, so there is more to sell on export markets.

• Large economies generate more income from the sales of goods and services

• Higher income increases demand for all goods –including imported goods

• Therefore, trade is very concentrated among developed countries:

 50% of current world trade is among developed economies (countries in OECD & EU

25).

 12% of current world trade is among developing economies.

• Major US trade partners (2022): Canada, Mexico, China, Japan, Germany.

• 56% of the US trade is realized through the 10 major trade partners

: Canada, Mexico, China, Japan, Germany, South Korea, UK, Taiwan, India, Vietnam

 Tij=Yi*Yj/Dij
Tij= Trade(includes exports+imports; trade is roughly proportional to country size) between
country i and j
Yi=GDPi
Yj=GDPj
Dij=Distance between i and j

 On average doubling the distance between two countries of similar size will halve their bilateral
trade

 GDP= Gross domestic product is a monetary measure of the market value of all the final goods
and services produced and sold in a specific time period by countries

Distance and Borders

• Estimates based on the model of gravity for the effect of distance, indicate that an increase in the
distance separating two countries by 1% restricts their trade between 0.7% to 1%.

• Apart from the distance, bordersincrease the cost of trade in terms time and money.

• International trade agreements intend to facilitate trade by facilitating procedures and duties
required to overcome borders.

 In 1994 the US signed with Mexico and Canada the North American Free Trade Agreement
(NAFTA)
• Due to NAFTA and geographic proximity, the volume of trade between the US and its two
neighbors is higher as a percentage of GDP compared to the volume of trade between the US and
Europe.

Factors that influence trade:

 Distance
 Sizes
 Free trade agreements
 Geography (sea harbours, absence of high mountains that obstruct trade, easier if is sea
between 2 countries)
 Sharing a common language( latino-americans countries)
 Colonnial ties
 Cultural ties
 Law system
 • Multinational companies (firms of the same company trade large volume of commodities with
each other)

Trade Deficits and Surpluses

• The factors that generate trade (how much and what a country trades) are very distinct from the
factors that generate trade deficits or surpluses.

• ... and their consequences are very different too.

• A country that has a trade deficit (surplus) means that this country is borrowing (lending) from the
rest of the world.

• For example, the U.S. is currently running a very large trade deficit (above 5% of

GDP)

• This means that the U.S. is borrowing that amount from the rest of the world…

• ... by selling financial assets (U.S. treasury bonds, stocks, corporate bonds, etc...)

equal in value to the trade deficit.

Classical theory of comparative advantage
• Absolute advantage (A. Smith 1723-1790): The ability of an actor to produce more of a good or
service than a competitor

• Relative advantage (D. Ricardo 1772-1823): The ability of an actor to produce a good or service for
a lower opportunity cost than a competitor.

• Assumptions of the Ricardo theory of comparative advantage:

– Two countries, two goods, one factor of production (labor).

– Free trade, no transaction costs or transportation costs.

– Constant opportunity cost. (Opportunity cost=the value of the next-best alternative when a
decision is made; it’s what is given up, the of other alternative when one alternative is chosen)

– Free mobility of labour within a country.

– No mobility of labour from country to country.

• Production possibility frontier(or transformation curve) is a straight line.

• “Before” trade, both countries produce both goods.

• “After” trade, each country specializes in the production which has the comparative advantage.

• Comparative advantage: lower opportunity cost, or lower relative cost of production, or lower
relative price.

• Gains from trade: specialization, greater production internationally, greater consumption for all
(welfare increases)

Ricardo’s example: labour cost of production (hours needed to produce

one unit of production)

countries 1 unit of cloth (price of cloth) 1 unit of wine (price of wine)

England 100 120
Portugal 90 80

 Labour theory of value: the amount of labour needed to produce one unit of a commodity,
determines its value.
 Portugal has the “absolute” advantage in producing both goods

countries 1 unit of 1 unit of Relative Relative

cloth wine price of price of
(price of (price of cloth wine
cloth) wine)
England 100 120 0,83 1,2
Portugal 90 80 1,125 0,88
 1 unit of 1 unit of Relative Relative Relative Relative
cloth wine price of price of labour cost productivity
cloth with wine with of the of
respect to respect to production wine with
wine cloth of cloth respect
(Pc/Pw) (Pw/Pc) with to cloth
respect to (opportunity
wine cost
of the
production
wine with
respect
to cloth)
England 100 120 0,83 1,2 0,83 1,2
Portugal 90 80 1,125 0,88 1,125 0,88

Comparative advantage

• Each country

– specializes in the sector producing at a lower relative labour cost.

– exports the good of the comparative advantage and imports the other good.

• England specializes in the production of cloth.

• Portugal specializes in the production of wine

Gains from Trade

• Both countries gain if the relative international price of cloth with respect to wine is between the
two relative prices in a state of autarky for the two countries:

• 0,83<Pc/Pw<1,125 (Pc=relative price of cloth; Pw=relative price of wine)

England will export cloth to Portugal at any relative price greater than 0,83

Portugal will be willing to import cloth at any price smaller than 1,125

• And for the relative price of wine

• 0,88<Pw/Pc<1,2

Portugal will export wine to England at any relative price greater than 0,88
 England will be willing to import wine at any price smaller than 1,2

General case: labour cost of production

Countries 1 unit of 1 unit of

cloth wine
Ι αLC αLW
II α*LC α*LW

Labour cost of production

Countries 1 unit of 1 unit of Opportunity cost Relative price of

cloth wine of the production cloth with respect
of cloth with to wine (or relative
respect to wine labour cost )
I αLC αLW αLC / αLW αLC / αLW
II α*LC α*LW α*LC / α*LW α*LC / α*LW

if (αLC / αLW) < (α*LC / α*LW )

• then Country, I, has the comparative advantage in the production of cloth.

• country ΙΙ has the comparative advantage in the production of wine. ⇒

• Country Ι exports cloth, imports wine.

• ⇒ Country IΙ exports wine, imports cloth.

Labour theory of value

• Ρc/Ρw = αLc/αLw
• The relative cost of production in terms of hours needed to produce good C, relative to the
production of W, determines the relative price of the good C with respect to W.

• This holds for the case of a closed economy (no international trade)

Equation (Ρc/Ρw = αLc/αLw) holds for the case of a closed economy

• For the case of two countries:

• Suppose that (before international trade) it is true that:

• (αLc / αLw) < (α*Lc / α*Lw ) ⇒

• ⇒( Ρc / Ρw) < ( Ρ*c / Ρ*w )

• ⇒Country, I, exports cloth and imports wine.

• And country, II exports wine and imports cloth.

As soon as free trade starts between the two countries:

• (Ρc/Ρw) < (Ρc/Ρw )i < ( Ρ*c /Ρ*w ) (7)

• The relative international price of cloth,(Ρc/Ρw )i

– is the same in both countries and

– is between the two relative prices that correspond to a state of autarky.

It is also true that

• (αLc /αLw)< (Ρc/Ρw )i< (α*Lc /α*Lw)

• hence, after international trade has started the labor theory of value does not hold.

The relation between productivity and labour cost of production

• Labour cost to produce one unit of cloth: αLc

• Labour cost to produce one unit of wine : αLw

• Productivity of labour in the cloth industry:1/ αLc

• Productivity of labour in the wine industry :1/ αLw

• Hence, the ratio αLc /αLw represents

– the relative labour cost of the production of cloth and

– the relative productivity of wine with respect to cloth.

What determines which good will be exported?

• Conditions that have to do with production:

– The relative productivity of labour, that is the relative labor cost, determines the structure of

trade.

– Country I, which has a relatively greater productivity of labour in the production of cloth,

will export cloth and import wine.

• Which means that in case

• (αLc / αLw) < (α*Lc / α*Lw )

• This inequality can be read in two ways:

• The relative labour cost of cloth with respect to wine is smaller in country I.

• The relative productivity of labour is higher in cloth with respect to wine, in country I.

Example: labour cost of production

1 unit of T 1 unit of V Relative price of Hours of labour

T with respect to that each
V country
possesses
Spain 2 1 2 100
India 5 10 1/2 1000
 1 unit of 1 Relative Relative Opportunity Relative
(Τ) Unit of price of T price of V cost of T productivity
(V) with with with of
respect to respect to respect labour in V
V T to V with
respect to T
Spain 2 1 2 1/2 2 2
India 5 10 1/2 2 1/2 1/2
The higher we are=> more satisfied