CHAPTER 1: INTERNATIONAL ECONOMICS
When countries specialize, they may be EFFECTS OF GOVERNMENT POLICIES ON TRADE
GAINS FROM TRADE
SEVERAL IDEAS UNDERLIE THE GAINS FROM
TRADE
1. When a buyer and seller engage in a
voluntary transaction, both can be made
better off.
• Norwegian consumers import oranges
that they would have a hard time
producing.
• The producer of the oranges receives
income that it can use to buy other
things that it desires
2. How could a country that is the most
(least) efficient producer of everything
gains from trade?
• Countries use finite resources to
produce what they are most productive
at (compared to their other production
choices), then trade those products for
goods and services that they want to
consume.
• Countries can specialize in production,
while consuming many goods and
services through trade.
3. Trade benefits countries by allowing them
to export goods made with relatively
abundant resources and imports goods
made with relatively scarce resources.
4.
more efficient due to larger-scale
• Policy makers affect the amount of trade
production.
through
5. Countries may also gain by trading current
o Tariffs - a tax on imports or exports,
resources for future resources
o Quotas - a quantity restriction on
(international borrowing and lending) and
imports or exports,
due to international migration.
o Export subsidies - a payment to
Trade is predicted to benefit countries as a whole in producers that export, or through other
several ways, but trade may harm particular groups regulations (ex., product specifications)
within a country. that exclude foreign products from the
market, but still allow domestic
• International trade can harm the owners of
products.
resources that are used relatively intensively in
• What are the costs and benefits of these
industries that compete with imports.
policies?
• Trade may therefore affect the distribution of
If a government must restrict trade, which
income within a country.
policy should it use and how much should
PATTERNS OF TRADE it restrict trade?
If a government restricts trade, what are
• Differences in climate and resources can explain
the costs if foreign governments respond
why Brazil exports coffee and Australia exports
likewise?
iron ore.
Trade policies are often chosen to cater to
• But why does Japan export automobiles, while
special interest groups, rather than to
the U.S. exports aircraft?
maximize national welfare.
• Why some countries export certain products
Governments tend to adopt tariffs, then
can stem from differences in:
negotiate them down in exchange for
Labor productivity
reduction in trade barriers of other
Relative supplies of capital, labor and
countries.
land and their use in the production of
International trade focuses on transactions
different goods and services.
involving movement of goods and services
across nations.
 International finance focuses on financial • Top three destinations: Mexico 73B (35%), Larger economies generate more
or monetary transactions across nations Canada 19B (9%), China 10B (5%) in 2010. – income from the goods and services
Texas lags California and US in diversification sold, so they are able to buy more
CHAPTER 2 – WORLD TRADE: AN OVERVIEW
across countries (FRBD 2007). imports.
Who trades with the United States? • Top five industries: Computers and electronic
The Gravity Model
parts 39B, Chemicals 39B, Petroleum and coal
• Five largest trading partners with the U.S in
33B, Machinery except electrical 26B, Other things besides size matter for trade:
2008 were Canada, China, Mexico, Japan,
Transportation equipment 19B in 2010
and Germany (Mexico used to be ahead of 1. Distance between markets influences
• Total Texas imports $202B in 2004. transportation costs and therefore the cost of
China)
• $109B from Mexico imports and exports.
• The total value of imports from and exports to
Canada (trade volume) in 2008 was about $550 • Venezuela, Saudi Arabia and China next with • Distance may also influence personal
billion (up from $500B in 2005) $8-9B each contact and communication, which
• The largest 15 trading partners with the U.S • Canada not in top 10 countries of origin for may influence trade.
accounted for 69% of the value of U.S trade in Texas imports 2. Cultural affinity: if two countries have cultural
2008. Size Matters: The Gravity Model ties, it is likely that they also have strong
economic ties.
Who Trades with Whom? Texas Exports • 3 of the top 10 trading partners with the U.S. are
3. Geography: ocean harbors and a lack of
• Total Texas exports $207B (16% of all US the 3 largest European economies: Germany,
mountain barriers make transportation and
exports), highest of all states (California 143B, U.K., and France.
trade easier.
New York 68B) in 2010 (has been the biggest • These countries have the largest gross domestic 4. Multinational corporations: corporations spread
exporter ever since 2002). product (GDP)in Europe. –GDP measures the across different nations import and export
• Texas exports fell at a slower rate than the US as value of goods and services produced in an many goods between their divisions.
a whole in 2009 and recovered faster in 2010. economy. 5. Borders: crossing borders involves formalities
• If Texas were a nation, would rank among top • Why does the U.S. trade most with these that take time and perhaps monetary costs like
20 exporting countries (FRBD 2007). European countries and no other European tariffs.
countries? •
• Compared to US, Texas exports a larger share These implicit and explicit costs reduce
of its output, depends on exports for more of its • The size of an economy is directly related to the trade.
jobs, sends more sophisticated products volume of imports and exports. • The existence of borders may also
overseas and employs higher skilled workers in Larger economies produce more goods indicate the existence of different
export-related jobs (FRBD 2007). and services, so they have more to sell languages (see 2) or different
in the export market.
 currencies, either of which may impede • The negative effect of distance on trade Services such as shipping, insurance,
trade more. according to the gravity models is significant, legal fees, and spending by tourists
but has grown smaller over time due to modern account for about 20% of the
Distance and Borders
transportation and communication. volume of trade.
• Estimates of the effect of distance from the • Technologies that have increased trade: Mineral products (ex., petroleum, coal,
gravity model predict that a 1% increase in the Wheels, sails, compasses, railroads, copper) and agricultural products are a
distance between countries is associated with a telegraph, steam power, automobiles, relatively small part of trade.
decrease in the volume of trade of 0.7% to 1%. telephones, airplanes, computers, fax • In the past, a large fraction of the volume of
• Besides distance, borders increase the cost and machines, Internet, fiber optics, trade came from agricultural and mineral
time needed to trade. personal digital assistants, GPS products.
• Trade agreements between countries are satellites… In 1910, Britain mainly imported
intended to reduce the formalities and tariffs • Political factors, such as wars, can change trade agricultural and mineral products, although
needed to cross borders, and therefore to patterns much more than innovations in manufactured products still represented
increase trade. transportation and communication. most of the volume of exports.
• The gravity model can assess the effect of trade • World trade grew rapidly from 1870 to 1913. In 1910, the U.S. mainly imported and
agreements on trade: does a trade agreement Then it suffered a sharp decline exported agricultural products and
lead to significantly more trade among its due to the two world wars and the mineral products.
partners than one would otherwise predict Great Depression. In 2002, manufactured products made up
given their GDPs and distances from one It started to recover around 1945 but most of the volume of imports and exports
another? did not recover fully until around 1970. for both countries
• The U.S. signed a free trade agreement with • Since 1970, world trade as a fraction of world • Low-and middle-income countries have also
Mexico and Canada in 1994, the North GDP has achieved unprecedented heights changed the composition of their trade.
American Free Trade Agreement (NAFTA). In 2001, about 65% of exports from
Changing Composition of Trade
• Because of NAFTA and because Mexico and low-and middle-income countries were
Canada are close to the U.S., the amount of • What kinds of products do nations trade now, manufactured products, and only 10%
trade between the U.S. and its northern and and how does this composition compare to of exports were agricultural products.
southern neighbors as a fraction of GDP is trade in the past? In 1960, about 58% of exports from
larger than between the U.S. and European • Today, most (about 55%) of the volume of trade low-and middle-income countries were
countries is in manufactured products such as agricultural products and only 12% of
automobiles, computers, clothing and exports were manufactured products.
Has the World Become “Smaller”?
machinery.
Multinational Corporations and Offshoring
• Before 1945, multinational corporations (firms
with activities in multiple countries) played a
small role world trade.
• Today about one third of all US exports and 42%
of all US imports are sales from one division of
a multinational corporation to another.
Offshoring
• Offshoring (or outsourcing) occurs when a firm
moves its operations to a foreign location. –
Service outsourcing can occur for services that
can be performed and transmitted
electronically.
For example, a firm may move its customer
service centers whose telephone calls can
be transmitted electronically to a foreign
location.
Service outsourcing is currently not a
significant part of trade.
Some jobs are “tradable” and thus have the
potential to be outsourced.
Most jobs are non-tradable because they
need to be done close to the customer
CHAPTER 3: LABOR PRODUCTIVITY
COMPARATIVE ADVANTAGE: The Ricardian
Model
Theories of why trade occurs:
• Differences across countries in labor, labor
skills, physical capital, natural resources, and
technology
• Economies of scale (larger scale of production
is more efficient)
Sources of differences across countries that lead to
gains from trade:
• The Ricardian model (Chapter 3) examines
differences in the productivity of labor (due to
differences in technology) between countries.
• The Heckscher-Ohlin model (Chapter 4)
examines differences in labor, labor skills,
physical capital, land, or other factors of production
between countries.
Comparative Advantage and Opportunity Cost
• The Ricardian model uses the concepts of
opportunity cost and comparative advantage.
• The opportunity cost of producing something
measures the cost of not being able to produce
something else with the resourced used
• For example, a limited number of workers could
produce either roses or computers.
The opportunity cost of producing
AND computers is the amount of roses not
produced.
The opportunity cost of producing roses is
the amount of computers not produced.
• Suppose that in the U.S. 10 million roses could
be produced with the same resources that could
produce 100,000 computers.
• Suppose that in Colombia 10 million roses could
be produced with the same resources that could
produce 30,000 computers.
• Workers in Columbia would be less productive
than those in the U.S. in manufacturing
computers.
• Colombia has a lower opportunity cost of
producing roses.
Colombia can produce 10 million roses,
compared to 30,000 computers that it
could otherwise produce.
The U.S. can produce 10 million roses,
compared to 100,000 computers that it
could otherwise produce.
• The U.S. has a lower opportunity cost of
producing computers.
Colombia can produce 30,000 computers,
compared to 10 million roses that it could
otherwise produce.
The U.S. can produce 100,000 computers,
compared to 10 million roses that it could
otherwise produce.
The U.S. can produce 30,000 computers,
compared to 3.3 million roses that it could
otherwise produce.
• A country has a comparative advantage in
producing a good if the opportunity cost of
 producing that good is lower in the country than
in other countries.
The U.S. has a comparative advantage in
computer production.
A One-Factor Ricardian Model
Colombia has a comparative advantage in
rose production
• Suppose initially that Colombia produces
computers and the U.S. produces roses, and that
both countries want to consume computers and
roses.
• Can both countries be made better off ?
Comparative Advantage and Trade
• When countries specialize in production in
which they have a comparative advantage, more
goods and services can be produced and
consumed.
Have U.S. stop growing roses and use those
resources to make 100,000 computers
instead. Have Colombia stop making
30,000 computers and grow roses instead.
If produce goods in which have a
comparative advantage (U.S. produces
computers and Colombia roses), they could
still consume the same 10 million roses, but
could consume 100,000 – 30,000 = 70,000
more computers.
• The simple example with roses and computers
explains the intuition behind the Ricardian
model.
• We formalize these ideas by constructing a one-
factor Ricardian model using the following
assumptions:
1. Labor is the only factor of production.
2. Labor productivity varies across countries
due to differences in technology, but labor
productivity in each country is constant.
3. The supply of labor in each country is
constant.
4. Two goods: wine and cheese.
5. Competition allows workers to be paid a
“competitive” wage equal to the value of
what they produce, and allows them to
work in the industry that pays the highest
wage.
6. Two countries: home and foreign.
• A unit labor requirement indicates the
constant number of hours of labor required to
produce one unit of output.
aLC is the unit labor requirement for cheese
in the home country. For example, aLC = 1
means that 1 hour of labor produces one
pound of cheese in the home country.
aLW is the unit labor requirement for wine in
the home country. For example, aLW = 2
means that 2 hours of labor produces one
gallon of wine in the home country.
• A high unit labor requirement means low labor
productivity.
• Labor supply L indicates the total number of
hours worked in the home country (a constant
number).
• Cheese production QC indicates how many
pounds of cheese are produced.
• Wine production QW indicates how many
gallons of wine are produced
Production Possibilities
• shows the maximum amount of a goods that can
be produced for a fixed amount of resources.
• The production possibility frontier of the home
economy is:
aLCQC + aLWQW ≤ L
Where:
aLC = Labor required for each pound of cheese produced
QC = Total pounds of cheese produced
aLW = Labor required for each gallon of wine produced
QW = Total gallons of wine produced
L = Total amount of labor resources

Relative Prices, Wages, and Supply
• Let PC be the price of cheese and PW be the price
of wine.
• Due to competition,
hourly wages of cheese makers equal the
value of the cheese produced in an hour: PC
/aLC
hourly wages of wine makers equal the
value of the wine produced in an hour: PW
/aLW
• Because workers like high wages, they will work
in the industry that pays the higher wage.
Trade in the Ricardian Model
• Suppose the home country is more efficient in
wine and cheese production.
• It has an absolute advantage in all production: its
unit labor requirements for wine and cheese
production are lower than those in the foreign
country:
aLC < a LC and aLW < a LW
* *
• A country can be more efficient in producing
both goods, but it will have a comparative
advantage in only one good.
• Even if a country is the most (or least) efficient
producer of all goods, it still can benefit from
trade.
• Suppose that the home country has a
comparative advantage in cheese production: its
opportunity cost of producing cheese is lower
than in the foreign country.
aLC /aLW < a*LC /a*LW
where “*” notates foreign country variables
• When the home country increases cheese
production, it reduces wine production less than
Gains from Trade
the foreign country would.
• Before any trade occurs, the relative price of
cheese to wine reflects the opportunity cost of
cheese in terms of wine in each country.
• In the absence of any trade, the relative price of
cheese to wine will be higher in Foreign than in
Home if Foreign has the higher opportunity cost
of cheese.
• It will be profitable to ship cheese from Home to
Foreign (and wine from Foreign to Home) –
where does the relative price of cheese to wine
settle?
• To see how all countries can benefit from trade,
need to find relative prices when trade exists.
• First calculate the world relative supply of
cheese: the quantity of cheese supplied by all
countries relative to the quantity of wine
supplied by all countries
RS = (QC + Q*C )/(QW + Q*W)
• Gains from trade come from specializing in the
type of production which uses resources most
efficiently, and using the income generated from
that production to buy the goods and services
that countries desire.
where “using resources most efficiently”
means producing a good in which a country
has a comparative advantage.
• Domestic workers earn a higher income from
cheese production because the relative price of
cheese increases with trade.
• Foreign workers earn a higher income from
wine production because the relative price of
cheese decreases with trade (making cheese
 cheaper) and the relative price of wine increases
with trade.
• Think of trade as an indirect method of
production that converts cheese into wine or
vice versa.
• Without trade, a country has to allocate
resources to produce all of the goods that it
wants to consume.
• With trade, a country can specialize its
production and exchange for the mix of goods
that it wants to consume.
• Consumption possibilities expand beyond the
production possibility frontier when trade is
allowed.
• With trade, consumption in each country is
expanded because world production is
expanded when each country specializes in
producing the good in which it has a
comparative advantage
RELATIVE WAGES
• are the wages of the home country relative to
the wages in the foreign country.
Productivity (technological) differences
determine relative wage differences across
countries.
The home wage relative to the foreign wage
will settle in between the ratio of how much
better Home is at making cheese and how
much better it is at making wine compared
to Foreign.
Relative wages cause Home to have a cost
advantage in only cheese and Foreign to
have a cost advantage in only wine.
Do Wages Reflect Productivity?
• Do relative wages reflect relative productivities
of the two countries?
• Evidence shows that low wages are associated
with low productivity.
Wage of most countries relative to the
U.S. is similar to their productivity
relative to the U.S.
• Other evidence shows that wages rise as
productivity rises.
As recently as 1975, wages in South
Korea were only 5% of those of the
United States.
As South Korea’s labor productivity
rose (to about half of the U.S. level by
2007), so did its wages (which were
more than half of U.S. levels by 2007
Misconceptions About Comparative Advantage
1. Free trade is beneficial only if a country is
more productive than foreign countries.
• But even an unproductive country benefits from
free trade by avoiding the high costs for goods
that it would otherwise have to produce
domestically.
High costs derive from inefficient use of
resources.
The benefits of free trade do not depend on
absolute advantage, rather they depend on
comparative advantage: specializing in
industries that use resources most
efficiently.
2. Free trade with countries that pay low
wages hurts high wage countries.
• While trade may reduce wages for some
workers, thereby affecting the distribution of
income within a country, trade benefits
consumers and other workers.
 Consumers benefit because they can Key Notes Where:
purchase goods more cheaply. 1. Differences in the productivity of labor across QC is the output of cloth
Producers/workers benefit by earning a countries generate comparative advantage.
K is the capital stock
higher income in the industries that use 2. A country has a comparative advantage in
LC is the labor force employed in cloth
resources more efficiently, allowing them to producing a good when its opportunity cost of
producing that good is lower than in other • The production function for food gives the
earn higher prices and wages
countries. quantity of food that can be produced given any
3. Free trade exploits less productive
input of land and labor:
3. Countries export goods in which they have a
countries.
comparative advantage - high productivity or QF= QF (T, LF)
• While labor standards in some countries are less low wages give countries a cost advantage.
than exemplary compared to Western Where:
4. With trade, the relative price settles in between
standards, they are so with or without trade. what the relative prices were in each country QF is the output of food
• Are high wages and safe labor practices before trade. T is the supply of land
alternatives to trade? Deeper poverty and CHAPTER 4: SPECIFIC FACTORS AND INCOME LF is the labor force employed in food
exploitation (ex., involuntary prostitution) may DISTRIBUTION
Production Possibilities
result without export production. SPECIFIC FACTOR MODEL
• Consumers benefit from free trade by having • How does the economy’s mix of output change
• The specific factors model allows trade to affect
access to cheaply (efficiently) produced goods. income distribution. •Assumptions of the as labor is shifted from one sector to the other?
• Producers/workers benefit from having higher model: –Two goods, cloth and food. –Three • When labor moves from food to cloth, food
factors of production: labor (L), capital (K) and
profits/wages—higher compared to the production falls while output of cloth rises.
land (T for terrain). –Perfect competition
alternative. prevails in all markets • Figure 4-1 illustrates the production function for
• Cloth produced using capital and labor (but not cloth.
land).
• Food produced using land and labor (but not
capital).
• Labor is a mobile factor that can move between
sectors.
• Land and capital are both specific factors used
only in the production of one good

• How much of each good does the economy

produce? •The production function for cloth
gives the quantity of cloth that can be produced
given any input of capital and labor:

QC= QC (K, LC)

 • The shape of the production function reflects
the law of diminishing marginal returns.
Adding one worker to the production
process (without increasing the amount of
capital) means that each worker has less
capital to work with.
Therefore, each additional unit of labor
adds less output than the last.
• Figure 4-2 shows the marginal product of
labor, which is the increase in output that
corresponds to an extra unit of labor.
• For the economy as a whole, the total labor
employed in cloth and food must equal the total
labor supply:
LC + LF = L (4-3)
• Use these equations to derive the production
possibilities frontier of the economy.
Prices, Wages, and Labor Allocation
• How much labor is employed in each sector?
• Need to look at supply and demand in the labor
market.
• Demand for labor:
• In each sector, employers will maximize profits
by demanding labor up to the point where the
value produced by an additional hour equals the
marginal cost of employing a worker for that
hour.
• The two sectors must pay the same wage
because labor can move between sectors.
• If the wage were higher in the cloth sector,
workers would move from making food to
making cloth until the wages become equal.
• Or if the wage were higher in the food sector,
workers would move in the other direction.
• Where the labor demand curves intersect gives
the equilibrium wage and allocation of labor
between the two sectors
• Owners of capital are definitely better off.
• Landowners are definitely worse off.
• Workers: cannot say whether workers are better
or worse off:
• Depends on the relative importance of cloth and
food in workers’ consumption
Income Distribution and the Gains from Trade
• International trade shifts the relative price of
cloth to food, so factor prices change
• Trade benefits the factor that is specific to the
export sector of each country, but hurts the
factor that is specific to the import-competing
sectors
• Trade has ambiguous effects on mobile factors.
• Trade benefits a country by expanding choices.
• Possible to redistribute income so that everyone
gains from trade.
• Those who gain from trade could compensate
those who lose and still be better off themselves.
• That everyone could gain from trade does not
mean that they actually do – redistribution
usually hard to implement
The Political Economy of Trade: A Preliminary
View
• Trade often produces losers as well as winners.
• Optimal trade policy must weigh one group’s
gain against another’s loss.
• Some groups may need special treatment
because they are already relatively poor (e.g.,
shoe and garment workers in the United States).
• Most economists strongly favor free trade
• Income Distribution and Trade Politics
• Typically, those who gain from trade are a much
less concentrated, informed, and organized
group than those who lose.
• Example: Consumers and producers in the U.S.
sugar industry, respectively
• Governments usually provide a “safety net” of
income support to cushion the losses to groups
hurt by trade (or other changes).
International Labor Mobility
• Why does labor migrate and what effects does
labor migration cause?
• Workers migrate to wherever wages are highest.
• Consider movement of labor across countries
instead of across sectors
• Suppose two countries produce one non-traded
good (food) using two factors of production
• Land cannot move across countries but labor
can
 • When the economy devotes more resources
towards production of one good, the marginal
productivity of those resources tends to be low
so that the opportunity cost is highF is no longer
a straight line.
CHAPTER 4: RESOURCES AND TRADE: THE
HECKSCHER-OHLIN MODEL
Production Possibilities
• Production possibilities are influenced by both
Rybczynski theorem
capital and labor:
• If a factor of production increases, then the
Akc Qc+ Akf Qf ≤ K
supply of the good that uses this factor relatively
Where: intensively increases and the supply of the other
good decreases.
Akc = Capital used for each yard of cloth production
• The economy produces at the point that
Qc = Total yards of cloth production
maximizes the value of production, V.
Akf = Capital used for each pound of food production
• An isovalue line is a line representing a
Qf = Total pounds of food production constant value of production, V.
K = Total amount of capital V = PC QC + PF QF
• Given the relative price of cloth, the economy
produces at the point Q that touches the highest
possible isovalue line
• At that point, the relative price of cloth equals
the slope of the PPF, which equals the
opportunity cost of producing cloth
• Producers may choose different amounts of
factors of production used to make cloth or food
• Their choice depends on the wage, w, paid to
labor and the rental rate, r, paid when renting
capital
• As the wage w increases relative to the rental
rate r, producers use less labor and more capital
in the production of both food and cloth
Trade in the Heckscher-Ohlin Model
• Like the Ricardian model, the Heckscher-Ohlin
model predicts a convergence of relative prices
with trade
• With trade, the relative price of cloth rises in the
relatively labor abundant (home) country and

Where: falls in the relatively labor scarce (foreign)

AlcQc + AlfQf ≤ L
Where : country
PC and PF are the prices of cloth and food.
Alc = Labor used for each yard of cloth • Relative prices and the pattern of trade: In
production slope of isovalue line is – (PC /PF)
Home, the rise in the relative price of cloth leads
Alf = Labor required for each pound of food
production to a rise in the relative production of cloth and a

L = Total amount of labor fall in relative consumption of cloth

• The decline in the relative price of cloth in
Production Possibilities
foreign leads it to become an importer of cloth
• With more than one factor of production, the
opportunity cost is no longer constant and the and an exporter of food.
PP
Heckscher-Ohlin theorem
• An economy has a comparative advantage in
producing, and thus will export, goods that are
relatively intensive in using its relatively
abundant factors of production
and will import goods that are relatively
intensive in using its relatively scarce
factors of production.
• Under competition, the price of a good equals
the cost of production
• Cost of production depends on the wage paid to
labor and the rent paid to capital
as well as how many units of labor and
capital are used
Cloth pricing: AlcW + AkrR = Pc
Food pricing: AlfW + AkfR = Pf
Stolper-Samuelson theorem
• If the relative price of a good increases, then the
real wage or rental rate of the factor used
intensively in the production of that good
increases, while the real wage or rental rate of
the other factor decreases
• Any change in the relative price of goods alters
the distribution of income
• Unlike the Ricardian model, the Heckscher-
Ohlin model predicts that factor prices will be
equalized among countries that trade
• Free trade equalizes relative output prices
• Due to the connection between output prices
and factor prices, factor prices are also
equalized
• Trade increases the demand of goods produced
by relatively abundant factors, indirectly
increasing the demand of these factors, raising
the prices of the relatively abundant factors.
Factor Price Equalization
• In the real world, factor prices are not equal
across countries
• The model assumes that trading countries
produce the same goods, but countries may
produce different goods if their factor ratios
radically differ
• The model also assumes that trading countries
have the same technology, but different
technologies could affect the productivities of
factors and therefore the wages/rates paid to
these factors.
• The model also ignores trade barriers and
transportation costs, which may prevent output
prices and thus factor prices from equalizing.
• The model predicts outcomes for the long run,
but after an economy liberalizes trade, factors of
production may not quickly move to the
industries that intensively use abundant factors
• In the short run, the productivity of factors will
be determined by their use in their current
industry, so that their wage/rental rate may vary
across countries
Does Trade Increase Income Inequality?
• Over the last 40 years, countries like South
Korea, Mexico, and China have exported to the
U.S. goods intensive in unskilled labor (ex.,
clothing, shoes, toys, assembled goods)
• At the same time, income inequality has
increased in the U.S., as wages of unskilled
workers have grown slowly compared to those
of skilled workers.
Trade and Income Distribution
• Changes in income distribution occur with
every economic change, not only international
trade.
Changes in technology, changes in
consumer preferences, exhaustion of
resources and discovery of new ones all
affect income distribution
Economists put most of the blame on
technological change and the resulting
premium paid on education as the major
cause of increasing income inequality in
the US.
CHAPTER 6: STANDARD TRADE MODEL
The Welfare Effects of Changes in the Terms of
Trade
Terms of trade
• refers to the price of exports relative to the price
of imports.
When a country exports cloth and the
relative
price of cloth increases, the terms of trade
rise.
Because a higher relative price for exports
means that the country can afford to buy
 more imports, an increase in the terms of
trade increases a country’s welfare.
A decline in the terms of trade decreases a
country’s welfare
The Effects of Economic Growth
• Export-biased growth is growth that expands
a country’s production possibilities dispro-
portionately in that country’s export sector.
Biased growth in the food industry in the
foreign country is export-biased growth for
the foreign country
• Import-biased growth is growth that expands
a country’s production possibilities dispro-
portionately in that country’s import sector.
Biased growth in cloth production in the
foreign country is import-biased growth for
the foreign country.
Has Growth in Asia Reduced
the Welfare of High-Income Countries?
• The standard trade model predicts that import-
biased growth in China reduces the U.S. terms
of trade and the standard of living in the U.S
Import-biased growth for China would
occur in sectors that compete with U.S.
exports.
• But this prediction is not supported by data:
there should be negative changes in the terms
of trade for the U.S. and other high-income
countries.
In fact, changes in the terms of trade for
high-income countries have been positive
and negative for developing Asian
countries.
Import Tariffs and Export Subsidies: Simultaneous
Shifts in RS and RD
• Import tariffs are taxes levied on imports.
• Export subsidies are payments given to
domestic producers that export.
• Both policies influence the terms of trade and
therefore national welfare.
• Import tariffs and export subsidies drive a
wedge between prices in world markets and
prices in domestic markets.
Relative Price and Supply Effects of a Tariff
• If the home country imposes a tariff on food
imports, the price of food relative to the price of
cloth rises for domestic consumers.
Likewise, the price of cloth relative to the
price of food falls for domestic consumers.
Domestic producers will receive a lower
relative price of cloth, and therefore will be
more willing to switch to food production:
relative supply of cloth will decrease.
Domestic consumers will pay a lower
relative price for cloth, and therefore will be
more willing to switch to cloth
consumption: relative demand for cloth will
increase.
Effects of an Export Subsidy
• If the home country imposes a subsidy on cloth
exports, the price of cloth relative to the price of
food rises for domestic consumers.
Domestic producers will receive a higher
relative price of cloth when they export, and
therefore will be more willing to switch to
cloth production: relative supply of cloth
will increase.
Domestic consumers must pay a higher
relative price of cloth to producers, and
therefore will be more willing to switch to
food consumption: relative demand for
cloth will decrease.
International Borrowing and Lending
• The standard trade model can be modified to
analyze international borrowing and lending.
Two goods are current and future
consumption (same good at different
times), rather than different goods at the
same time.
• Countries usually have different opportunities to
invest to become able to produce more in the
future.
• A special kind of production possibility frontier,
an intertemporal production possibility
frontier, depicts different possible
combinations of current output and future
output.
• If you borrow 1 unit of output, you must repay
principal + interest = 1 + r in the future, where r
is the real interest rate.
• The price of future consumption relative to
current consumption is 1/(1+r).
1 unit of current consumption is worth 1 +
r of future consumption,
so 1 unit of future consumption is worth
1/(1 + r) units of current consumption.