Chapter 1: The World Economy – Some Stylized Facts

p. 4: „International economics is what international

economists do,…, you will only know about intern-
ational economics, once you have studied it your-
self“.
„…I think that an important distinguishing cha-
racteristic is the general equilibrium nature of this
approach.“
This forces us to be precise and complete in our
explanations.

International Economics Page 1

 Absolute Advantage
• Compare one good across countries.

• Country with greater output per labor hour has an absolute

advantage in that good.

International Economics
 Which Advantage?
• Absolute advantage is a special case.

• Comparative advantage is the general case.

International Economics
 Absolute advantage definition
• Absolute Advantage as a Basis for Trade1
• Country
• A B
• Soybeans 3 Hours 12 Hours
• Textiles 6 Hours 4 Hours
*One more unit to produce.
• Suppose, the fixed input/output ratios for the two industries S
and T in countries A and B are given by the values in the
above Table.
• For instance, it takes 3 hours to produce one more unit of S
in country A and also for country B

International Economics Page 4

• Consider the Table carefully; much can be learned from it.
• First, we see that workers in country A can produce S in less
time than workers in B, while workers in B have an edge in
the ability to produce T.
• Because country A’s workers can produce S in less time than
country B’s workers, A is said to have an absolute advantage
in the production of S.
• By analogous reasoning, in this example B has an absolute
advantage in the production of T.
• Because of less labor is required. A factor of production
advantage.

International Economics Page 5

 To be continued
• Adam Smith argued that the proper international division of
labor would be one where countries specialized in the
production of goods in which they have an absolute
advantage.
• In this case, rather than producing both goods, as they would
do in autarky, country A should concentrate on the production
of S, and country B on the production of T.

International Economics Page 6

 To be continued
• Consider what would happen if each country followed this
principle. The results of such a process are illustrated in next
Table.
• Suppose the output of textiles (T) is reduced by 1 unit in
country A. This would free up 6 hours of labor. Let that worker
move to soybean (S) production. With 6 more hours of labor,
the output of soybeans will rise by 2 units. In similar fashion,
let the output of S in country B fall by 1 unit. In this case, 12
hours of labor are released to the T industry. With 12 more
hours of labor, 3 additional units of textiles can be produced.

International Economics Page 7

• Per Unit Gains from Specialization When Country A Moves to
Specialize in Soybeans (S), and Country B in Textiles (T)
• Per Unit Gain
• In Production of S In Production of T
•
• In A +2 -1

• In B -1 +3

• In world +1 +2

International Economics Page 8

• Now, let’s total the results.
• In A, a transfer of 6 hours of labor from textiles to soybeans
leads to a reduction of T output by 1 unit and to an increase
in S output by 2 units.
• In B, when the output of S falls by 1 unit, the output of T rises
by 3 units.
• For the world as a whole, the output of S rises by 1 unit and
the output of T rises by 2 units. Thus, we see the benefits of
an international division of labor. Without using any new
resources, total world output has risen! This rise has come
about by following the simple rule that each country should
concentrate on the production of those goods it produces
most efficiently.

International Economics Page 9

• The problem still remains as to what is required to persuade
workers in each country to concentrate their efforts along the
lines of absolute advantage. As Smith saw it, the solution to
this problem was simple.
• Market forces would guarantee that this will happen. Recall
that the labor theory of value states that pretrade prices of
goods are determined by their labor content. Given the
existence of perfect competition in each industry (Assumption
5), we can easily establish that the price of a good in autarky
is simply equal to the cost of the labor inputs used in its
production, which, in turn, equals Wi, the wage rate in country
i, times the amount of labor input.

International Economics Page 10

• From Table we can determine, then, the pretrade ratio PS/PT
for each country. In particular,
• in country A,
• PS = WA * hours SA = WA * 3
• PT = WA * hours TA = WA * 6
• Hence,
• PS/PT of A = WA * 3/ WA * 6
• = 3/6
• = 1/2
• Likewise, in country B
• PS = WA * hours SA = WA * 12
• PT = WA * hours TA = WA * 4
• PS/PT in B= (WB *12)/(WB *4
• =12/4
• =3
International Economics Page 11
• What these calculation tell us is that in autarky, S costs 1/2
units of T in A but 3 units of T in B. Once trade is allowed,
consumers in B will want to buy their soybeans from A’s
producers rather than from their own because A’s price is
lower. Thus, the demand for A’s soybeans will rise. How can
production rise to meet this demand? The resources must
come from the textile industry. Will they?

International Economics Page 12

• In particular, country A’s autarky price of textiles is 2 units of
soybeans, while B’s price is only 1/3 unit.
• Hence, once the opportunity exists for A’s consumers to buy
from B, their demand for textiles produced in their own
country will fall. Falling demand in A’s textile industry leads to
layoffs. Workers leave that industry for the expanding
soybean industry.
• Of course, exactly the opposite process occurs in B, where
rising demand for textiles leads to an expansion of that
industry, while the soybean industry shrinks.

International Economics Page 13

• Let’s take a moment to summarize our results so far. Adam
Smith’s model of international trade included the following
points:*
• 1. For a variety of reasons, including differences in
technology and climate, countries of the world differ in their
ability to produce various goods.
• 2. World output could be expanded if, rather than closing
borders through mercantilist practices, countries would
specialize in the production of goods in which they enjoy
absolute advantage.
• 3. Such a situation is easy to achieve because it is the natural
outcome of market forces combined with free international
trade. This is because each good is cheapest in the country
that has an absolute advantage in its production.
International Economics Page 14
Chap. 1.2 and 1.3:
The economic size (power?) of a nation is best
measured in terms of the total value of goods and
services produced in a certain time period.
Other measures of size such as land area and
population are weakly correlated with economic
size – look at Russia, China, India, Brazil on the
one hand, and on the European Countries on the
other hand.

International Economics Page 15

A size comparison across open countries needs three steps:

1. Accurate data from the statistical offices in national

currency (Maddison in our case).
2. Decide to look at GNP or GDP
GDP + net receipts of factor income = GNP

GDP…market value of goods and services produced

by labor and property located in a country.

GNP… market value of goods and services produced

by labor and property of the nationals of a country.
3. Use the same currency ($): current US $ or PPP .

International Economics Page 16

Fig 1.2: GDP and GNP, 2008 ($ billion)
The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of GDP .

GDP and GNI, 2008 (billion current $)

100,000

USA
Japan
10,000
Gross National Income, GNI

Germany

China
1,000

100

10
10 100 1,000 10,000 100,000
Gross Domestic Product, GDP

International Economics Page 17

Purchasing Power Parity (PPP)
Comparing income in current $ tends to overestimate
the differences between high and low income
countries
(i) Tradable goods are subject to international competition so that the
prices of such tradable goods tend to be equal when measured in the
same currency.
(ii) Within a country producers of tradable and non-tradable goods
compete for same resources (labor) so that the wage rate in each country
reflects labor productivity.
(iii) Across countries differences in productivity in the non-tradable sectors
tend to be smaller than in the tradable sectors.

In current $, the value of output tends to be under-

estimated in low-income countries.
International Economics Page 18
Purchasing Power Parity (PPP)-continued
Example: based on the current exchange rate
Cost of hair cut in the US: 10$
Cost of hair cut in Tansania: 1$
So the same service is priced differently: the value
of production in US is overestimated by a factor 10!
United Nation income comparison project (ICP)
collects price data on goods and services in all
countries of the world and calculates PPP
comparing prices in local currencies.
PUS 10
P$=PTZS E$/TZS => implied PPP: ETZS/E  
PTZS 1
International Economics Page 19
Figure 1.3: Gross domestic product, 2008; top 15, ranked
according to PPP

International Economics Page 20

1.5 International Trade
Trade flows can readily compared using exchange
rates.
We distinguish merchandise trade and trade in
commercial services.
Stylized facts 2008 (see http://www.fiw.ac.at/ for more
recent evidence):
China has been the largest merchandize trade exporter, followed by
Germany and US.

US share in world exports is just 8.5%.

Many countries have a larger share in world exports than in world

production (country size matters!).
International Economics Page 21
Exports Relative to Imports
The difference between exports and imports (trade balance)
is more pronounced than the difference between GDP and
GNP, but relative to the size of imports and exports the
difference is small.

In 2008 China had the largest trade surplus in goods and

services (349 bn $) followed by Germany (228 bn $).

US has the largest trade deficit (696 bn $).

In relative terms Brunei is the largest net exporter and

Ethiopia the largest net-importer.

Trade openness is defined as the ratio of exports +imports

to production. For Singapore this ratio is more than 234%.
International Economics Page 22
Figure 1.4: Exports and imports of goods and services, 2008 ($ billion)
The dotted line is a 45º line, the axes use a logarithmic scale, and the circles are proportional to the size of exports.

Exports and imports of goods and services, 2008 ($ bn)

10,000
USA

Germany
1,000 China
import value

Russia

100 Saudi Arabia

Ethiopia
10

Brunei

1
1 10 100 1,000 10,000
export value

International Economics Page 23

Figure 1.5: Relative exports of goods and services, 2008 (% of GDP)

Relative exports of goods and services, 2008 (% of GDP)

Singapore 234

Hong Kong 212

Luxembourg 179

Seychelles 131

Malaysia 110

Bahrain 97

Belgium 92

United Arab Emirates 91

Macao 90

Malta 88

0 50 100 150 200 250

International Economics Page 24

Figure 1.6: Taxes on international trade
Taxes on international trade, 2008 (% of revenue)

Lesotho 57

Bahamas, The 52

Namibia 44

Cote d'Ivoire 35

Madagascar 35

Maldives 32

St. Kitts and Nevis 32

Bangladesh 27

Niger 26

Russian Federation 25

0 10 20 30 40 50 60

International Economics Page 25

1.6 Globalization
Globalization defined by Neary (2002): The increased
interdependence of national economies; trend towards greater
integration of goods, labor and capital markets.

Globalization and Income:

Income statistics based on Maddison’s work (in 1990 international
Dollars (corrected for PPP, ensure transitivity, base country invariance
and additivity).

Logarithmic scale (level and growth).

Big increase in GDP per capita in 1820 (industrial revolution).

Two waves of globalization: second half of 19th century and after WW2.

New institutional setting after WW2: income per capita +3% p.a., world
income +5% p.a., world trade flows +8% .p.a.
International Economics Page 26
Figure 1.7: Development of world per capita income over the last 2000
years

World GDP per capita (1990 international $), logarithmic scale

10,000

5,709

1,000

435 667
444

100
0 500 1000 1500 1820 2000

International Economics Page 27

 Figure 1.8: Two waves of globalization in trade
Merchandise exports, % of GDP in 1990 prices

17.2

15
13.4

10 10.1

5
4.6
2.5
0.2
0
1870 1900 1930 1960 1990
world USA Japan

International Economics Page 28

1.6 Globalization (continued)
Globalization and capital:
Two similar waves of globalization in the capital markets. Sharp increase in
capital mobility since the 1960thies.

Globalization and migration:

Two modern waves of migration:

1820-1913: 40 millions migrants mainly form Europe to US, Canada, South

America and Australia, young and mainly low skilled workers.

After WW2 (not yet ended): Since the 1990thies the source countries are
now mainly Asian and Eastern European countries.

Many countries have quotas to restrict inward migration.

Labor markets are less globally integrated than goods and capital markets.
International Economics Page 29
Figure 1.9: Foreign capital stocks, assets / world GDP
Foreign capital stocks; assets / world GDP
0.6

0.4

0.2

0
1860 1880 1900 1920 1940 1960 1980 2000

International Economics Page 30

Figure 1.10: Relative migration flows, Western Europe and Western Offshoots

Relative annual immigration flows, 1870-1998 (per 1000)

6

0
1870-1913 1914-1949 1950-1973 1974-1998
-2
Western Europe Western Offshoots

International Economics Page 31

 Chapter 3
Classical Trade: Technology

International Economics Page 32

Overview Ricardian (classical) model
• Technology differences between countries are the driving
force behind international trade flows
• Relative (or comparative) differences are crucial, not absolute
differences
• Absolute differences are important for determining a country’s
wage rates and welfare level
• The production possibility frontier summarizes the state of
technology and the available factors of production in final
goods space
• Trade flows increase welfare (technology gains from trade)

International Economics Page 33

David Ricardo (1772-1823)
“When a country can either import
a commodity or produce it at
home, it compares the cost of
producing at home with the cost of
procuring from abroad; if the latter
is less than the first, it imports.”

International Economics Page 34

Assumptions of the Ricardian technology model
• General (example)
• Two countries (EU and Kenya)
• Two final goods (Food and Chemicals)
• One factor of production (Labour)
• Constant returns to scale production functions
• Perfect competition
• Labour is mobile between sectors, but not between countries.
• Costless trade in final goods (no impediments to trade)
• Technology as reflected by labor productivity differs between
countries

International Economics Page 35

Technology differences between countries
Production technology is summarized in a productivity table:

Labour units required to produce one unit of output

Food Chemicals
EU 2 8
Kenya 4 24

The EU technology is more productive for both goods

The EU has an absolute advantage in Food production: it
requires less labour (2 units instead of 4)
The EU also has an absolute advantage in Chemicals
production: it requires less labour (8 units instead of 24)

International Economics Page 36

Comparative advantage: productivity method
Labor units required to produce one unit of output
Food Chemicals
EU 2 8
Kenya 4 24

• The EU is twice as productive in the Food sector (4/2 = 2)

• The EU is three times as productive in the Chemicals sector
(24/8 = 3), so
The EU has a comparative advantage in Chemicals, and
Kenya has a comparative advantage in Food

International Economics Page 37

Comparative advantage: opportunity cost method
Labour units required to produce one unit of output
Food Chemicals
EU 2 8
Kenya 4 24
• An extra unit of Chemicals needs 8 units of labor in the EU
• This labor could have made 8/2 = 4 units of Food; the
opportunity cost of Chemicals production in the EU is 4 Food.
• An extra unit of Chemicals in Kenya needs 24 labor
• This labor could have made 24/4 = 6 units of Food; the
opportunity cost of Chemicals production in Kenya is 6 Food
The EU has a comparative advantage in Chemicals,
Kenya in Food
International Economics Page 38
The ppf is a straight line in the Ricardian model
Labour units required to produce one unit of output
Food Chemicals
EU 2 8
Kenya 4 24
• Suppose the EU has 200 units of labour available and Kenya
has 120 units available (remember: it is just an example)
• If all workers in the EU produce only Food, the EU can make
200/2 = 100 Food (and 0 Chemicals)
• If all workers in the EU produce only Chemicals, the EU can
make 200/8 = 25 Chemicals (and 0 Food)
• Similarly, if all workers in Kenya produce Food total output is
120/4 = 30 Food (and 0 Chemicals); if they all produce
Chemicals total output is 120/24 = 5 Chemicals (and 0 Food)
International Economics Page 39
Production possibility frontier (ppf)
Definition: all possible combinations of efficient production
points of final goods, given the available factors of production
and the state of technology;

Note that:
•It is a technical specification: the ppf does not depend on the
type of market competition
•The ppf depends on the available factors of production: if, e.g.,
more labour becomes available more goods can be produced
•The ppf depends on the state of technology: if new techniques
become available, output increases with the same use of inputs

International Economics Page 40

Production possibility frontiers
The EU can produce Kenya can produce
(0 Chemicals, 100 Food) or (0 Chemicals, 30 Food) or
Food
(20 Chemicals, 0 Food), or (5 Chemicals, 0 Food), or
any combination in between any combination in between

100 Resurce constraint : LEU aCCEU  aFFEU

EU ppf PPF : FEU  LaEUF  aC
CEU
aF
aC
Opportunit y costs : aF
B

30 Kenya ppf E
C
A

0 5 25 Chemicals

International Economics Page 41

Production in the EU; pC/pF = relative price of Chemicals
Food • Producer maximizing profits in
this setting is equivalent to
maximizing total revenue, given
PrEU the final goods price ratio pC/pF
slop
e=
-p
C /p
F
• If pC/pF is low, this implies only
production of Food
EU

Chemicals

International Economics Page 42

Production in the EU; pC/pF = relative price of Chemicals
Food • Producer maximizing profits in
this setting is equivalent to
maximizing total revenue, given
the final goods price ratio pC/pF

• If pC/pF is high, this implies

only production of Chemicals
EU

PrEU
Chemicals

International Economics Page 43

Production in the EU; pC/pF = relative price of Chemicals
Food • Producer maximizing profits in
this setting is equivalent to
maximizing total revenue, given
the final goods price ratio pC/pF

• If pC/pF is equal to the slope of

the ppf, production can be
EU
anywhere along the ppf (to be
determined by other factors)
•Under Autarky it must hold that
pC/pF is equal to the slope of the
Chemicals ppf.
International Economics Page 44
Gains form Trade
Relative to autarky trade increases the rel. price of chemicals in the EU
(exporter) and decrease it in Kenya (importer).

Consumption can be extended in both trading partners (gains form trade).

Food
120

100 EU budgetline

EU ppf
B

F
30

A Kenya
budgetline
Kenya ppf G
0 5 6.25 25 Chemicals

International Economics Page 45

Equilibirum
Value of consumption =Value of production, trade is balanced in
each country.

Product prices are determined at the World market equating

world demand =world supply.

Marginal rate of substitution of consumers = PC/PF.

Wages have to adjust according to productivity in each country .

EU
1 EU
EU EU
PC w ac w PC ac
 K K  
PF w aF w K
PF 1 EU
aF

Due to lower wages food producers of Kenya (holding the

comparative advantage) are competitive on the world market.
International Economics Page 46
Concluding remarks, Ricardian (classical) model
• Technological differences between countries are the classical
driving force for international trade flows.
• Only comparative costs, not absolute costs, are important for
determining the direction of trade flows.
• Absolute costs are important for determining a country’s
welfare level.
• Allowing for more countries and more goods is easy, allowing
for more than one factor of production is not (see neoclassical
model).

International Economics Page 47

Overview Production Structure
• The neoclassical model focuses on differences in relative
factor endowments as a cause for international trade flows.
• The main contributors are Eli Heckscher, Bertil Ohlin, and
Paul Samuelson: it is therefore referred to as the HOS model.
• This chapter reviews the production structure of the model.
• Neoclassical production functions with two inputs and
constant returns to scale.
• Optimizing economic agents, taking prices as given.
• The impact of technology differences is analyzed in Chapter
3, we therefore assume identical technology from now on.

International Economics Page 48

Paul Samuelson (1915–2009)
“Funeral by funeral,
theory advances”

www.brainyquote.com

International Economics Page 49

Assumptions of the neoclassical (HOS) model
• General (example)
• Two countries (Austria and Bolivia)
• Two final goods (Food and Manufactures)
• Two factors of production (Capital and Labour)
• Constant returns to scale production functions
• Perfect competition in all markets
• Capital and Labor is mobile between sectors, but not between
countries
• Costless trade in final goods (no impediments to trade)
• Identical production technology in the two countries
• No factor-intensity reversal
• Identical homothetic tastes in the two countries
• Countries differ in their (relative) factor endowments

International Economics Page 50

Main results of the neoclassical (HOS) model
The HOS model derives 4 main propositions in Chapters 5-7:
• Factor Price Equalization: Trade in goods (which equalizes
final goods prices) leads to the equalization of factor prices.
• Stolper-Samuelson theorem: An increase in the price of a
final good increases the (real) reward to the factor used
intensively in the production of that good and reduces the
(real) reward to the other factor of production.
• Rybczynski theorem: An increase in the quantity of a factor of
production, at constant final goods prices, leads to an
increase in the production of the good using that factor
intensively and a decreased production of the other good.
• Heckscher-Ohlin theorem: A country will export the final good
which makes relatively intensive use of the relatively
abundant factor of production.
International Economics Page 51
Neoclassical production functions
Characteristics of our neoclassical production functions
• Two inputs: capital (K) and labour (L)
• Substitutability: a given output level can be produced using
different combinations of inputs, i.e. the use of one input can
be substituted for the use of another input
• Positive marginal product: if more capital or more labour is
used output increases
• Diminishing marginal product: given the use of capital, an
increase in the use of labour leads to ever smaller increases
in output (similarly for capital)
• Constant returns to scale: an increase in the use of both
inputs by z% also leads to an increase in output of z%

International Economics Page 52

Structure of the equilibrium
delivery of manufactures (spending m on manufactures)
capital services
(rental income) production
capital owners
manufactures

consumers producers

production
labourers
labour services food
(wage income)

delivery of food (spending (1-m) on food)

direction of goods and services flows

(direction of money flows)
International Economics Page 53
 Production functions: substitutability and isoquant
Capital • Let M be the output of
Manufactures, Km the input of

capital, Lm the input of labour

and m a capital intensity

parameter (0 < m < 1); this is a

possible production
 1  function:
M K m m Lm m

isoquant • The figure on the left depicts

an isoquant for this function;
note the substitutability
between capital and labour
Labour

International Economics Page 54

 Production is constant returns to scale (CRS)
Capital • At point A1 production M = 1
M=1
• Reducing inputs by 30%
leads to point A2

• CRS implies at point A2

B1
production M = 0.7
• Similarly for points B1 and B2
B2

A1 • Conclusion:
D
0.3 isoquant M = 0.7 is a radial
A2
D
blow-up of isoquant M = 1
D M=0.7
0.7

Labour

International Economics Page 55

Profit maximization: two-step procedure
Producer profits = revenue – production costs
Maximizing profits is a two-step procedure
• First, given how much you want to produce: minimize
production costs
• Second: determine the optimal output level

International Economics Page 56

 Cost minimization
Capital • Suppose you want to
M=1
produce M=1 at minimum cost
taking wage rate w and rental
rate r as given
slo
pe

• Total cost = wLm + rKm , a

=
-w
/r

straight line in (labour, capital)

K
A
space with slope = - w/r
• Minimum costs are achieved
at a point of tangency
between the isocost line and
the isoquant; point A, using K
L Labour capital and L labour
International Economics Page 57