November 16, 2021 11:4 Lecture Notes in International Trade . . .

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Chapter 1
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Introduction
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These lectures present and apply the basic models and theorems of
classical trade theory. However, a broader and more important objec-
tive is to improve students’ ability to understand general equilibrium
relations in both open and closed economies. Commodity markets
and factor (e.g. capital and labor) markets are inextricably linked;
the neck bone is connected to the toe bone. General equilibrium
analysis explains these connections. By linking commodity markets
across countries, international trade also links the countries’ factor
markets.
Basic theory at both the graduate and undergraduate level
frequently emphasizes how markets work when they work well. These
notes emphasize the consequence of market failures in a general
equilibrium setting. Basic theory equips students with intuition
about the effects of changes in, for example, technology or policy.
By the end of this course, I hope that students have the tools to
know when they should be skeptical of that intuition, and more
significantly have an idea of how to modify it.
After describing the content of these lecture notes, I address a
number of questions that frequently arose during the years that I
taught the material.
Chapter 2 discusses the Ricardian model, relying primarily on
an example. The chapter explains the meaning of comparative
advantage, emphasizing the difference between comparative and
absolute advantage. It presents a general equilibrium model that

1
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2 Lecture Notes in International Trade Theory

shows the relation between commodity prices and the price of labor,
the sole factor of production. It then introduces the concept of the
real wage, as distinct from the nominal wage, and shows how changes
in commodity prices alter the real wage.
Using (primarily) graphical methods, I ask and answer compara-
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tive statics questions, showing how changes in technology or a move

from autarchy (= no trade) to free trade changes welfare. I use the
general equilibrium relations to construct a country’s export supply
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and import demand functions, emphasizing the differences between

these and familiar partial equilibrium demand and supply functions.
The chapter also reviews intermediate tools, including the indirect
utility function, differentials of functions, and the envelope theorem.
The assumptions about technology are central to the Ricardian
model. Chapter 3 leaves technology in the background, assuming only
that the production possibility frontier is strictly concave. In this
setting, graphical methods make it easy to describe the equilibrium,
and to determine how it changes with a change in policy. I illustrate
the procedure by showing how different taxes (including tariffs), and
different types of redistribution of tax revenue, change production,
consumption, trade, and welfare. I then use these graphical tools to
obtain the import demand and supply functions under trade. The
intersection(s) of these curves give the equilibrium world price(s).
I introduce the concept of stability, imbedding the static model in
a dynamic framework using the fiction of a Walrasian auctioneer. In
an equilibrium problem, the assumption that an equilibrium is stable
plays essentially the same role in conducting comparative static
experiments, as does the second order condition in an optimization
problem. Chapter 3 contains a section that collects technical details,
and also a section that reviews taxes in a partial equilibrium setting.
The next chapter contains three applications of the model
described in Chapter 3. I chose these examples for their intrinsic
interest and for their value in illustrating methods. The first applica-
tion shows a possible pitfall of using trade openness (defined as the
value of imports over the value of national output) as a proxy for the
liberality of trade policy. Many empirical studies have used this proxy
to estimate whether liberal trade policies promote economic growth.
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Introduction 3

The problem is that openness might be either positively or negatively

correlated with the liberality of a trade policy, making its use as a
proxy for trade policy problematic.
The second application considers a famous economic question
known as the Transfer Problem: how does a transfer (e.g. war
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reparations) from one country to another affect the terms of trade

between these two countries? The answer to this question depends
on the magnitude of the trading partners’ marginal propensities
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to consume their respective import goods. We obtain this answer

using comparative statics and the assumption that the pre-transfer
equilibrium is stable. This application therefore illustrates the role
of the stability assumption.
The third application compares a partial and a general equilib-
rium model of leakage, defined as the increase in pollution in a group
of countries due to a decrease in pollution elsewhere. In the partial
equilibrium model, pollution reductions in a group of countries are
at least partly undone by increased pollution elsewhere: leakage is
positive. However, in the general equilibrium setting, where income
effects can be important, leakage might be either positive or negative.
Chapter 5 explains and illustrates the Theory of the Second Best
(TOSB). This emphasis, which is unusual in a short course in applied
microeconomics, reflects my view of the TOSB’s importance, relative
to (most) students’ level of exposure to the ideas underlying it. This
chapter makes extensive use of the graphical approach developed in
Chapter 3 and the mathematical tools presented in several chapters.
The first general equilibrium example shows that trade lib-
eralization in the presence of fixed distortionary domestic taxes
can raise or lower welfare. The second example concerns missing
markets: the creation of an international market (opening up to
trade) might raise or lower welfare when insurance markets are
missing. I then use a rather non-standard definition of “distortion”
to discuss the possibility that growth can be immizerizing. This
stretched definition shows the power of the TOSB to provide a
unified framework for studying a range of economic issues. The final
example shows that achieving an exogenous constraint suboptimally
constitutes a distortion, thereby creating another setting in which
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4 Lecture Notes in International Trade Theory

the TOSB is relevant. This application also provides an opportunity

to introduce the Principle of Targeting.
Chapter 6 presents the Ricardo–Viner model with one mobile
factor, labor, and other factors that are fixed in the two sectors.
I show the relation between output, labor allocation, and factor prices
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as a function of the relative commodity price. As the economy moves

from autarchy to trade, or as the price at which it trade changes,
it is easy to map out the changes in labor allocation and factor
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prices. This material therefore provides practice in working through

a simple general equilibrium model with more structure than the
model studied in Chapter 3.
Chapter 6 contains two applications, involving imperfect prop-
erty rights and a minimum wage constraint, both discussed through
the lens of the TOSB. I show how the autarchic equilibrium depends
on the level of property rights and level of the minimum wage in the
two settings, and the effect of opening up to trade in both scenarios.
A final section extends the minimum wage model by considering the
effect of adjustment of the specific factors, holding the trade regime
fixed. As the (erstwhile) sector-specific capital flows to the sector
with higher private returns, social welfare might either increase or
decrease — yet another example of the TOSB.
Chapter 7 presents and explains the four theorems of the
Heckscher–Ohlin–Samuelson (HOS) model. The Factor Price Equal-
ization Theorem provides conditions under which trade in com-
modities results in international equality of factor prices. When
these conditions hold, trade in commodities is a perfect substitute
for trade in factors. The Stolper–Samuelson Theorem establishes
the relation between relative commodity prices and real factor
returns. This theorem provides a clear illustration of the fact that
trade harms some factor owners even when it increases national
income. The Rybczynski Theorem shows how a change in factor
endowments changes output at a given commodity price. The HOS
Theorem establishes the relation between countries’ relative factor
endowments and their comparative advantage.
This chapter provides the final example of immizerizing growth.
It also shows that when a country imposes both a restriction on
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Introduction 5

commodity trade and on trade in factors, liberalization of one of

those two markets has ambiguous welfare effects. This possibility is
another example of the TOSB, which by this point students should
find natural. To the extent that the course is successful, students
have a strong enough command of general equilibrium analysis to
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determine the forces that determine the direction of welfare effect of

liberalizing capital markets under a fixed commodity tariff.
Appendix B collects problem sets and Appendix C provides most
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of the answers. Most of the problems are based on the general

equilibrium material presented in the text, and provide practice using
the methods developed there. However, several problems use partial
equilibrium models. The partial equilibrium models (some of which
are challenging) illustrate the possibility that partial and general
equilibrium models can produce different answers to apparently
similar questions. These differences illustrate the importance of
channels of causation (e.g. income effects) that are present in the
general equilibrium setting, but absent in the partial equilibrium
setting.
I also take this opportunity to address some issues that frequently
arose during the years I taught this material. Many students
are unclear about the distinction between a partial and general
equilibrium model. The former treats all prices except for the price of
the good under consideration as exogenous. For example, the level of
income and the prices of substitutes and complements, which affect
the demand function, are taken as exogenous; and the prices of inputs
which affect the supply function are taken as exogenous. Changes in
the exogenous variables (prices, income, tastes) change the location
of the partial equilibrium supply and/or demand function, changing
the equilibrium price of the commodity in question. A general
equilibrium model has at least two endogenous prices. In most of
the models in this course, the prices of factors of production, such as
capital and labor, and thus the level of income, are jointly determined
with the relative price of commodities.
The choice to use a partial or a general equilibrium model seems
arbitrary to some students. Because partial equilibrium models are
usually simpler, they provide a good place to start most analyses.
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6 Lecture Notes in International Trade Theory

But sometimes indirect effects, such as those operating through

changes in factor prices or changes in income, can be important and
can qualify or even reverse the conclusions from partial equilibrium
models. You do not know until you look. For example, Section 4.4
of Chapter 4 shows that although environmental “leakage” (defined
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above) is always greater than or equal to zero in a partial equilibrium

model, it might be negative once we take into account general
equilibrium effects, e.g. those related to changes in income.
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Many students are sensitive to the lack of realism in the models

presented here. I try to persuade them that a model can be revealing
even if it is not accurate. I like Jorge Luis Borges’ short story
“On exactitude in science” and Alfred Korzybski’s aphorism “the
map is not the territory” for this purpose. The Ricardian model is
absurdly unrealistic, or wonderfully elegant, depending on your point
of view. After Chapter 2, students should ask themselves whether
they have a better understanding of: comparative advantage; the
relation between commodity and factor prices; and how to determine
the welfare-effect of an exogenous change. If the answer to any of
these questions is “yes” it is probably because of model simplicity,
not realism.
The models discussed here use a representative agent. In contexts
where there is a single type of agent, this assumption is innocuous.
In the Ricardian model, labor is the only factor of production. With
nothing to distinguish one worker from another, it seems innocuous to
assume that they all have the same preferences and income and face
the same prices: any worker is literally the representative worker. In
even slightly more complicated models, it is not reasonable to assume
that everyone in the economy has the same income. Often I assume
that agents have identical homothetic preferences, so that differences
in income do not preclude aggregation. I also invoke a social planner
who somehow aggregates the preferences of agents in the economy.
These lectures — with only a few digressions — consist of
applied theory; they rely on graphical and mathematical methods.
As a matter of personal preference, I try to avoid using extended
math in oral lectures: that leads to a race to see who goes to sleep
first. However, the written material provides extensive mathematical
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Introduction 7

derivations; these help students understand the concepts and the

results. The graphs play a much larger part in the oral lectures.
The written material contains most of the graphs; but as soon as a
figure contains more than two or three curves, it becomes difficult to
read. For that reason, it is essential that students gain command
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of the construction presented in Chapter 3, where I explain the

use of three curves: the production possibility frontier, the income
expansion path, and the balance of payments constraint. If students
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understand exactly what these curves mean, and what causes them
to shift, the ensuing material is much more digestible.
Even with this solid background, students should “think with
their fingers”, rebuilding the figures shown. In some places I drop an
important curve, simply because a figure becomes incomprehensibly
cluttered it the curve is included. There, I provide a verbal descrip-
tion of the missing curve and explain its role. Students who master
the construction presented in Chapter 3 will be able to supply the
missing curve. Even though the resulting figure will be cluttered,
the fact that the student has created the clutter means that it is
comprehensible.