Models of International Trade: ECO 352 - Spring 2010 No. 3 - Feb. 9

ECO 352 Spring 2010
No. 3 Feb. 9
MODELS OF INTERNATIONAL TRADE

Each model examines one particular issue in greater detail and depth.
No one model captures the whole picture and should not be judged as such.
Each should be used for the insight or intuition it conveys on its focus issue.
A grand all-encompassing model can be built (& solved on computer for applying),
but it would be too complex to understand and learn from.
Next few weeks: traditional models. Their restrictions:
[1] Primary factors produce final goods directly; no disintegration of production.
[2] Factors are not internationally mobile; no migration or capital flows.
This is distinct from mobility of factors across sectors within a country.
Will explore degree of that mobility and implications for distributive conflict.
[3] Goods internationally tradeable, with restrictive policies, but no transport costs.
[4] Perfectly competitive markets: international for goods, domestic for factors.
This requires constant or diminishing returns to scale in production.
Country may be large player in trade but individual producers are small.
Many of the omitted or ignored features will be taken up later in the term.
THE GRAVITY MODEL

Simplest view of how much country i imports from country j:
Mij = Expenditure of country i * Fraction spent on goods of country j
= k Yi * Yj / Yworld
Correct this to reflect impediments to trade, e.g. transport costs, and we have
Trade between i and j proportional to
Product of their GDPs / Function of distance between them
Gravity model!
This holds up well empirically, in fact as well as many models that specify the
structure of production in much greater detail. But structural specification is important
for interpreting the effects of trade and deriving policy implications.
Weak points of the Gravity Model:
[1] does not determine endogenously which country produces which goods,
[2] does not tell us how trade will affect factor incomes,
[3] requires various ad hoc adjustments for fitting to data.
For empirical estimation, the concept of distance must be interpreted not just in
the physical sense but an economic sense. Distance within a country matters much
less than distance across borders, having a common border or not makes a
difference, preferential trade agreements and common currencies matter, etc.
One of the best estimated equation is (Baier and Bergstrand, J Int Econ 2001):
ln X ij =
0.05
2.37
ln(Yi + Y j ) +
0.60
ln( si s j )
(009) (6.29)
(1.74)
3.19
4.49
ln(1 + aij )
ln(1 + tij )
( 4.48)
( 2.71)
0.68
( 2.83)
ln(Y j )
0.25
( 2.69)
ln( Pi / P )
F
C
j
0.08
( 2.62)
ln( P X ij )
with N = 240 and adjusted R = 0.388. The notation is:
X ij = export volume from i to j, Yi , Y j GDPs, si = Yi /(Yi + Y j )

aij transport costs, tij tariff rates, Pi F , PjC prod' n, cons' n price indexes
3
THE EXCHANGE MODEL

This assumes that each country has fixed endowment of finished goods.
Ignores production, specialization induced by trade;
focuses on trade to get preferred consumption mix.
But can be interpreted as a production model where all factors
are specific to their uses; short-run (year or less) view of production.
Method of analysis: Edgeworth Box diagram of intermediate microeconomics,
replacing the two individuals of that model by two countries!
When is it valid to treat a country as one consumer? Need exact aggregation:
Y
demands independent of income distribution.
Commonly used sufficient condition:
all consumers in the country have
C
identical homothetic preferences.
Indifference curves are radial replicas;
MRS constant along a radial line.
D
Individual demands Xi = DX(PX,PY) Ii
A
Incomes Ii differ, function DX same for all.
B
Total demand X = DX(PX,PY) Total I
X
(Welfare judgments still need separate Ii .)
20
15
10
10
15
20
For ease of exposition only, assume 2 countries Red and Blue, 2 goods X and Y
Rectangular box, lengths of sides X, Y equal to
the total world fixed quantities of the two goods
Rs quantities read from origin OR ; Bs from origin OB in the reverse direction
Each point P in the box shows an
allocation of the two goods between
the two countries (4 quantities)
Each move, as from E to T, is a

reallocation or exchange or trade
Qty of X given up by R
and gained by B
T
Qty of Y given up by B
and gained by R
In international trade context, giving up becomes export, gaining is import

(But people's perception of the desirability of these is very different!)
5
MUTUALLY BENEFICIAL AND EFFICIENT TRADES

E is initial allocation (endowment, ownership)
Move to F is mutually beneficial lies above the indifference curve
through E for both R and B
(Remember Bs quantities are measured
from OB in reverse direction, so Bs utility
increases toward the south-west and
Bs indifference curves are rotated 180O)
Trade from E to any point in shaded area
is also mutually beneficial
Move to F still leaves open the possibility
of further mutually beneficial trades in
similar smaller double-shaded area
Now consider G. If a further trade from F to G (or a direct trade from E to G) is made,
then there remains no possibility for further mutual benefit
Any further reallocation that R prefers makes B worse off, and vice versa
This is just the definition of Pareto efficiency, so G is Pareto efficient
Key test of the possibility or otherwise of trade: inequality or equality of MRS

At F, the MRS for the two countries are unequal
Therefore there exists scope for mutually beneficial trade
Country with the lower MRS of X to Y
values X relatively less than does B
So gives up (exports) some X
in return for relatively more valued Y
Numerical example: At F,
MRS = for R, 3 for B.
R exports 1 of X and imports 1.5 of Y
R would be happy with
1 * = 0.5 of Y;
B willing to give up 1.5 of Y in
exchange for only 1.5/3 = 0.5 of X
Both do better than that.
G
Unequal
MRS at F
F
E
At G, MRS between X and Y equal for R and B: no more mutually beneficial trades
Can say that at F, R has COMPARATIVE ADVANTAGE in X
Basis of this: lower MRS, or lower relative price of X, at F
More importantly, this will later arise because lower marginal cost of production.
7
CONTRACT CURVE: All Pareto efficient allocations in the exchange Edgeworth box
ignoring initial ownership / endowment ,
E = initial endowment, ORHCKOB = contract curve
as if the government can seize and
HK = core, C = equilibrium
redistribute goods among people
Contract curve extends from OR to OB
Equilibrium, MRS = p / p
X
CORE: Respect initial ownership.

E-Indifference curves of R, B
intersect the contract curve
at H, K, respectively
So only portion HK becomes relevant
Core of the exchange:
trades that are voluntary and efficient
C
E
In the core, there must be at least

one point C such that the line of
R and Bs common MRS between X and Y at C passes through E
This gives a way of achieving the allocation C as a competitive market equilibrium
Set the relative price of X in terms of Y equal to the slope of this line.
Line passes through the point E showing the endowments of both countries
It becomes the common budget line for the two; optimum choice C for both
OFFER CURVES (Price-Consumption curves):

general equilibrium analogs of supply/demand curves to construct equilibrium
Consider just one consumer/country
Take budget lines of different slopes
all through endowment point E
Connect up all their tangencies
with indifference curves
This is the locus of all trades
that are optimal when facing
all possible different relative prices
Normal case: steeper budget line
(higher relative price of X) causes
the consumer / country to keep
less X (export more).
This is substitution effect
Price-consumption Curve
(Offer curve)
Y
Endowment point
X
But offer curve can bend back

due to income effects: when PX /PY very high, can get a lot of Y by giving up
very little X, and so consume more of both X and Y than at a lower price
Now put the two countries offer curves together in the exchange Edgeworth box
Where they intersect is equilibrium
Must be on contract curve, because the two countries indifference curves
are tangent to the same budget line
Rs offer curve
Bs
offer
curve
C
E
Will develop these ideas differently, and will unpack country into individuals.
10

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Models of International Trade: ECO 352 - Spring 2010 No. 3 - Feb. 9

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ECO 352 Spring 2010

MODELS OF INTERNATIONAL TRADE

THE GRAVITY MODEL

with N = 240 and adjusted R = 0.388. The notation is:

X ij = export volume from i to j, Yi , Y j GDPs, si = Yi /(Yi + Y j )

THE EXCHANGE MODEL

Each move, as from E to T, is a

In international trade context, giving up becomes export, gaining is import

MUTUALLY BENEFICIAL AND EFFICIENT TRADES

Key test of the possibility or otherwise of trade: inequality or equality of MRS

CORE: Respect initial ownership.

In the core, there must be at least

OFFER CURVES (Price-Consumption curves):

But offer curve can bend back

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