What Is International Economics About?

1. RIR 212: INTRODUCTION
TO INTERNATIONAL
ECONOMICS
What Is International
Economics About?

2. Highlights
What is Economics
What is international economics about?
Important issues in international trade.
History and present state of world trade flows
History of the development of trade theory
The Ricardian model of trade
Empirical evidence and policy results
http://internationalecon.com/Trade/Tch5/T5-5B.php

3. Difficult to Define
Economists like Pareto, Myrdal and Hutchinson think that
any search for a precise definition of Economics is a
barren enterprise
Many economists thought it is needless to waste words in
defining Economics
However, it is essential for a student to have some
definition in mind as working basis

4. Early Definitions
According to Adam Smith
 Economics is concerned with an enquiry into nature and causes of wealth
Craines in his book said
 Economics deal with the phenomenon of wealth
According to a French economist J.B. Say
 Economics is science which treats of wealth
The American Economist, F.A Walker is of the view that
 Economics is that body of knowledge which relates to wealth
In all these definitions, key position is assigned to WEALTH

5. Major Economic Problems
What is an economic problem?
 In view of the scarcity of means at our disposal
and the multiplicity of ends we seek to achieve
 The economic problem lies in making the best
possible use of our resources so as to get
maximum satisfaction in case of a consumer
and maximum output or profit for a producer

6. Defining Concepts cont.
Economics - The social science that deals with the production,
distribution, and consumption of goods and services and with the
theory and management of economies or economic systems.
Microeconomics - Study of the economic behavior of individual units of
an economy (such as a person, household, firm, or industry) and not of
the aggregate economy (which is the domain of macroeconomics).
The main subjects covered under microeconomics include theory of demand,
theory of the firm, and demand for labor and other factors of production.
Macroeconomics - The study of the overall aspects and workings of a
national economy, such as income, output, and the interrelationship
among diverse economic sectors.

7. Fundamental Problems
What to produce?
 Quantity and range of goods to produce
 Resources are limited, we must choose between different alternative
collection of goods and services that may be produced
How to produce?
 Techniques of production e.g labor intensive, capital intensive
For whom to produce?
 It means that how the national product is distributed i.e. who should get
how much

8. Fundamental Problems
Are the resources economically used?
 No wastage or misutilization of resources since they are limited
Problem to full employment?
 Economy must endeavor to achieve full employment not only of
labor but of all its resources
Problem of growth?
 Economy must expand or develop to maintain conditions of stability

9. Two Main Streams
The study of Economics is divided into two parts
on the basis of looking the system as whole or in
terms of its innumerable decision-making units
 Micro Economics
• It is also called Price Theory
 Macro Economics
• It is also called Income Theory

10. Micro Economics
The word ‘micro’ means a millionth part
In ‘micro economics’ we analyze small part or component of the whole
economy
e.g. individual consumer’s behaviour or firm, price of particular product or
factor of production, employment in firm or industry
In simple, micro-economic theory studies the behaviour of individual
decision making units such as consumers, resource owners and business
firms
The basic assumption in micro economic analysis is full employment in
the economy as whole

11. Macro-economics
Macro economics is concerned with aggregates and averages of the
entire economy
 E.g. national income, aggregate output, total employment, total consumption,
savings and investment, aggregate demand, aggregate supply, general level of
prices etc.
In macro-economics, we study how these aggregates and averages of
the economy as a whole are determined and what causes fluctuations
in them
Macro-economics also analyses the chief determinants of economic
development and the various stages and processes of economic growth

12. Positive or Normative Science
Whether Economics is Positive Science or Normative Science?
 Positive science explains WHAT IS
 Normative science explains WHAT OUGHT TO BE i.e. right or wrong of a thing
 In simple words, positive science ‘describes’ while normative science
‘evaluates’
Some early economists, like J S Mill, Robbins, Craines; were of the view
that Economics is just a positive science
However, Cairnes and Macfie talked about normative character of
Economics

13. Basic Assumptions in Economics
There are three broad assumptions
Behaviour of individuals
i.e. they behave in a rational manner
Consumer needs maximum satisfaction, labour purse for
higher wages and entrepreneur seeks maximum profits
It is called maximization principle
 Consumers tastes remain unchanged for fairly long periods of time
There is a perfect competition in the economy

14. International Economics
 A branch of economics that studies economic interactions among different countries,
including foreign trade (exports and imports), foreign exchange (trading currency),
balance of payments, and balance of trade. The study of interational economics
focusses on two related areas - international trade and international finance
 International economics is about how nations interact through trade of goods and
services, through flows of money and through investment.
 International economics is an old subject, but it continues to grow in importance as
countries become tied to the international economy.
 Nations are more closely linked through trade in goods and services, through flows of
money, and through investment than ever before.

15. International Economics cont.
What is different in comparison to “ordinary” economics?
The institutional setting (national policies, currencies etc)
nothing else, really.
International economics typically divided:
 international trade and
 international money.
The study of international trade can be extended to study
international capital, labour flows and diffusion of technology

16. International Trade Theory
What is international trade?
Exchange of raw materials and manufactured goods (and services)
across national borders
Classical trade theories:
explain national economy conditions--country advantages--that
enable such exchange to happen
New trade theories:
explain links among natural country advantages, government action,
and industry characteristics that enable such exchange to happen
Implications for International Business

17. Evolution of Trade Theory
Mercantilism (1500–)
Classical Political Economy
 Price-Specie-Flow Mechanism (Hume, 1752)
 Absolute Advantage (Smith, 1776)
 Comparative Advantage (Ricardo, 1817)
Neo-Classical Economics
 Heckscher-Ohlin Model (1919, 1933) and extensions
Modern Economics
Economies of scale, imperfect competition…

18. Defining mercantilism …
The theory that a country should accumulate financial wealth
by amassing as many inflows of “currency” as possible
Diffuse collection of economic thought
Mostly written by merchants and businessmen
Appears in economics virtually always as a target of critique.
However, the mercantilist mindset has not vanished among
many non-economists
The word mercantilist is still used for a person opposing free
trade based on “traditional arguments”

19. Mercantilism: 16th – late 18th century
 A nation’s wealth depends on accumulated treasure
 Gold and silver are the currency of trade
 Two means of increasing a country’s wealth are colonialism and international trade.
 Prevailed in 1500 - 1800
 Export more to “strangers” than we import to amass treasure, expand kingdom
 Implicit assumption that the economy was operating at less than full employment
 Zero-sum vs positive-sum game view of trade
 Government intervenes to achieve a surplus in exports
 King, exporters, domestic producers: happy
 Subjects: unhappy because domestic goods stay expensive and of limited variety
 Today neo-mercantilists = protectionists: some segments of society shielded short term

20. Mercantilist View of the Economy
Nations wealth = holdings of precious metals
Zero-sum economy
“Favourable balance of trade”
 i.e. exports good, imports bad
Implicit assumption that the economy was
operating at less than full employment
Conclusion: Economic activity should be
regulated

21. Mercantilism – 9-point plan
That every inch of a country's soil be utilized for agriculture, mining or
manufacturing.
That all raw materials found in a country be used in domestic
manufacture, since finished goods have a higher value than raw
materials.
That a large, working population be encouraged.
That all export of gold and silver be prohibited and all domestic money
be kept in circulation.
That all imports of foreign goods be discouraged as much as possible.

22. Mercantilism – 9-point pl
That where certain imports are indispensable they be obtained at first
hand, in exchange for other domestic goods instead of gold and silver.
That as much as possible, imports be confined to raw materials that can
be finished [in the home country].
That opportunities be constantly sought for selling a country's surplus
manufactures to foreigners, so far as necessary, for gold and silver.
That no importation be allowed if such goods are sufficiently and suitably
supplied at home.

23. Mercantilism: Flaws
impaired economic growth
Ignores living standards
Ignores human development

24. Adam Smith and the Attack
on Mercantilism and Economic Nationalism
In 1776, Adam Smith published the first modern statement of
economic theory, An Inquiry into the Nature and Causes of the Wealth
of Nations
 The Wealth of Nations attacked mercantilism—the system of
which dominated economic thought in the 1700s
 Smith proved wrong the belief that trade was a zero sum game—
that the gain of one nation from trade was the loss of another
 On the other hand… Voluntary exchange (trade) is a positive sum
game —both nations can gain

25. Adam Smith
“... He generally, indeed, neither intends to promote the public interest,
nor knows how much he is promoting it [...] he intends only his own
gain, and he is in this, as in many other cases, led by an invisible hand
to promote an end which was no part of his intention.” Smith
(1776)
“Somehow all of the activities seem to get coordinated. There’s a taxi to
get you to the airport. There’s butter and cheese for lunch on the
airplane. There are refineries to make the airplane fuel and trucks to
transport it, cement for the runways, electricity for the escalators, and
most important of all, passengers who want to fly where the airplanes
are going. […] if you are in a mood to be amazed, it can amaze you
that the system works at all.” Schelling (1978)

26. Smith’s View of the Economic System
Nations wealth = Production capacity
Positive-sum economy
Self-interest combined with competition serves
public interest
Division of labour increases productivity
Conclusion: Policy of laissez faire promotes
economic growth

27. Labour theory of value
The amount of labour required to produce a good determines its’
value
 Let’s assume that it takes two hours to produce A and an hour to
produce B
→ A is two times more valuable than B
The prevailing value theory until 1870s
 Main problem: Does not consider utility
 Other problems: measurement, differing skills, how to deal with
capital, land and profits

28. Theory of absolute advantage
Adam Smith ideas based on…
The capability of one country to produce
more of a product with the same amount of
input than another country
(same thing) The ability of a country to
produce a good using fewer resources than
another country (lower opportunity cost)

29. Theory of absolute advantage
Adam Smith argued:
A country should produce only goods
where it is most efficient …. and trade
for those goods where it is not efficient
Trade between countries is, therefore,
beneficial

30. Trade Based on
Absolute Advantage
Consider this “simple” example involving the EU and India
Only two products are produced, machines and cloth
Labor is fixed, homogeneous within a country, the only
factor of production, and is fully utilized
Technology and production costs are constant
Transportation costs are zero and the countries barter
(trade) for goods

31. Trade Based on Absolute advantage
One Person Per Day of Labor Produces
Country Machines Cloth
EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth

32. The Production Possibilities Frontier and Constant Costs
The Production Possibilities Frontier (PPF) is a curve
showing the various combinations of two goods that a country
can produce when all of a country’s resources are fully employed
and used in their most efficient manner
One Person Per Day of Labor Produces
Country Machines Cloth
EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth

34. Production Possibilities Curves for the United States and India
One Person Per Day of Labor Produces
Country Machines Cloth
EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth
Machines
Cloth
2
15
10
5

35. India
Cloth Mach
15 0
7.5 1
0 2
EU
Cloth Mach
10 0
8 1
6 2
4 3
2 4
India - Opportunity Costs
Machine = 7.5 cloth
Cloth = 0.133 machine
EU - Opportunity Costs
Machine = 2 cloth
Cloth = 0.5 machine
“Opportunity Cost” also known as “Relative Price”

36. Machines
Cloth
2
15
10
5
What Determines the Slope of the PPC?
Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
Same graph, drawn more to scale!
EU: Slope = Opportunity Cost = -0.5
India: Slope = Opportunity Cost = -0.133
This slope is also known as the … Marginal Rate of Transformation

37. EU workers are more productive in producing
machines
The EU has an absolute advantage in
machine production
Indian workers are more productive in
producing cloth
India has an absolute advantage in cloth
production
Absolute Advantage: Production Conditions When
Each Country Is More Efficient in the Production of One Commodity

38. Absolute Advantage: Rationale for Trade
If international trade is allowed
England wants to buy wine if it costs less
than 4 yard of cloth per barrel of wine
Portugal wants to sell wine if it gets more
than 1,5 yard of cloth per barrel of wine
→Both are willing to trade for any price
between 1,5 - 4 yard per barrel

39. TRADE BASED ON
ABSOLUTE ADVANTAGE …
Yes, maybe that was obvious to you from the beginning…
One Person Per Day of Labor Produces
Country Machines Cloth
EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth
What does this mean?

40. Absolute Advantage: Relative Prices in Autarky
Autarky price of wine in terms of cloth
England: 1 bbl. wine = 4 yd. cloth
Portugal: 1 bbl. wine = 1,5 yd. cloth
• Autarky price of cloth in terms of wine
England: 1 yd. cloth = 0,25 bbl. wine
Portugal: 1 yd. cloth = 0,67 bbl. wine
→England has absolute advantage in cloth,
Portugal in wine

41. TRADE BASED ON
ABSOLUTE ADVANTAGE
Change in the Production of
Country Machines Cloth
EU +5 machines –10 yards of cloth
India –2 machines +15 yards of cloth
Change in World Output +3 machines +5 yards of cloth
.
So there has obviously been an increase in World Output!!

42. Introduction: The Gains from Trade
• The improvement in national welfare (for both countries) is known
as the gains from trade

43. Implications of Adam Smith’s Theory
• Access to foreign markets helps create wealth
• If no nation imports, every company will be limited by the size of its
home country market
• Imports enable a country to obtain goods that it cannot make itself
or can make only at very high costs
• Trade barriers decrease the size of the potential market,
hampering the prospects of specialization, technological progress,
mutually beneficial exchange, and, ultimately, wealth creation

44. Adam Smith and Trade Barriers
Smith was highly critical of trade barriers (Tariffs,
Quotas, Subsidies…)
Trade barriers decrease
Specialization
Technological progress
Wealth creation
The modern view of trade shares Smith’s dislike for trade
barriers

45. TRADE BASED ON ABSOLUTE ADVANTAGE
• Labor Theory of Value
• Assumes that labor is the only relevant factor of production
• This implies that the pre-trade price of a good is determined by the amount of labor it
took to produce it.

46. One country has Absolute Advantage in BOTH
goods
• In this scenario, there is obviously no opportunity to trade…
especially not for U.S.
• NO… No … No!!! This is not correct. We need to introduce
the concept of:
Comparative Advantage
One Person Per Day of Labor Produces
Country Machines Cloth
U.S. 5 machines 15 yards of cloth
India 1 machine 5 yards of cloth

47. Comparative Advantage
David Ricardo: Principles of Political Economy, 1817
• Extended free trade argument
• Should import even if the country is more efficient in the product’s production than
country from which it is buying.
• Look to see how much more efficient. If only comparatively efficient, then import.
Absolute Advantage is a special case of
Comparative Advantage

48. TRADE BASED ON
COMPARATIVE ADVANTAGE
• Why would trade occur if one country had an absolute
advantage in both goods?
• Comparative Advantage is the ability of a country to produce a
good at a lower opportunity cost than another country
• We compare the degree of absolute advantage or disadvantage
in the production of goods

49. India - Opportunity Costs
1 Machine = 5 cloth
1 Cloth = 0.2 machine
US - Opportunity Costs
1 Machine = 3 cloth
1 Cloth = 0.33 machine
One Person Per Day of Labor
Produces
Country Machines Cloth
U.S. 5 machines 15 yards of cloth
India 1 machine 5 yards of cloth
Comparative Advantage: U.S. More Efficient in the
Production of Both Commodities
U.S. has bigger Absolute Advantage in production of Machines

50. TRADE BASED ON
COMPARATIVE ADVANTAGE
• The U.S. has a greater absolute advantage in producing
machines than is does in producing cloth (5x more efficient
in machines … only 3x more efficient in cloth)
• India’s absolute disadvantage is smaller in producing cloth
than in producing machines
• Thus the U.S. has a comparative advantage in machines
and India has a comparative advantage in cloth

51. TRADE BASED ON
OPPORTUNITY COSTS
• Even though U.S. has an absolute advantage in both goods,
India has a comparative advantage in cloth production
• Even if U.S. has an absolute advantage in both goods,
beneficial trade is possible
• If both countries specialize according to their comparative
advantage, they both can gain from this specialization and
trade

52. One person Per Day of Labor Produces
Country Machines Cloth
U.S. 5 machines 15 yards of cloth
India 1 machine 5 yards of cloth
Since we are dealing with Opp. Costs, we
will compare across 15 yards of cloth
.
(per)
One Person Per Day of Labor Produces
Country Machines Cloth
U.S. 5 machines -15 yards of cloth
India (3 days) -3 machines 15 yards of cloth
World Output +2 machines 0 cloth
Let us allow India to produce cloth up to the level that the U.S. can…

53. Change in World Output Resulting from Specialization According to Comparative
Advantage
TRADE BASED ON
COMPARATIVE ADVANTAGE
Change in the Production of
Country Machines Cloth
U.S. +5 machines –15 yards of cloth
India –3 machines +15 yards of cloth
Change in World Output +2 machines 0 yards of cloth

54. Trade in the Ricardian Model (cont.)
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.

55. Trade Based on
Opportunity Costs
Unit Labor Costs in 24 Developing Economies for Selected Sectors,
2000 (Ratios relative to the U.S.)
Country
Food
Products Textiles Clothing
Electrical
Machinery
Transport
Equipment
Argentina 1.95 1.28 0.64 2.11 1.78
Bolivia 0.61 0.76 0.65 1.00 1.34
Brazil 0.74 0.65 0.47 0.81 0.53
Chile 0.80 0.89 0.51 0.90 0.74
Columbia 0.62 0.66 0.47 1.01 0.97
Cote d’Ivoire 1.50 1.06 1.02 1.34 1.69
Ecuador 0.88 0.30 0.34 1.20 0.55
Egypt 1.45 1.21 0.38 1.10 0.71
Ghana 0.82 0.96 0.60 0.39 1.63
India 1.29 1.57 0.47 0.98 1.43
Indonesia 1.71 0.42 0.45 0.62 0.26
Kenya 1.31 2.20 0.96 0.74 3.34

56. Trade Based on
Opportunity Costs
Unit Labor Costs in 24 Developing Economies for Selected Sectors,
2000 (Ratios relative to the U.S.)
Country
Food
Products Textiles Clothing
Electrical
Machinery
Transport
Equipment
Malaysia 1.08 0.59 0.84 1.01 0.69
Mexico 0.90 0.88 0.64 1.06 0.43
Morocco 1.61 1.38 1.05 1.49 0.92
Nigeria 0.29 0.80 0.11 0.56 0.04
Peru 1.02 0.62 0.46 0.95 0.50
Philippines 0.65 0.67 0.59 0.80 0..40
Korea 0.73 0.63 0.62 0.56 0.71
Taiwan 1.93 1.45 0.80 1.81 1.17
Thailand 0.92 0.87 1.07 0.65 0.41
Turkey 1.09 0.96 0.43 0.97 0.65
Uruguay 1.64 0.74 0.69 1.52 1.22
Venezuela 0.93 0.72 0.49 0.68 0.17

57. Dynamic Gains from International Trade
Static Gains from trade are gains in
world output that result from
specialization and trade
Dynamic gains from trade are gains
from trade over time that occur because
trade induces greater efficiency in the
use of existing resources

58. Assumptions and limitations
Driven only by maximization of production and
consumption
Only 2 countries engaged in production and
consumption of just 2 goods?
What about the transportation costs?
Only resource – labor (that too, non-
transferable)
No consideration for ‘learning theory’

59. Absolute and Comparative
Productivity Advantage Contrasted
Absolute productivity advantage: Held by a
country that produces more of a certain good per hour
worked than another
Comparative productivity advantage (or
comparative advantage): Held by a country that has
lower opportunity costs of producing a good than its
trading partners do
Comparative advantage allows a country that
lacks absolute advantage to sell its products
abroad

60. One more time for practice…
Output per hour of “team”
Country Cars Steel (tons)
Japan 2 2
Malaysia 0.5 1
Japan - Opportunity Costs
1 car = 1 steel
1steel = 1 car
Malaysia - Opportunity Costs
1 car = 2 steel
1steel = 0.5 car
Do you see any Absolute Advantages?
Do you see any Comparative Advantages?

61. Evaluation of the Classical Model
The model does not explain why differences in productivity levels between
countries exist.
It makes extreme and unrealistic predictions such as countries will
completely specialize in the production of exportables only.
It maintains that the gains from trade are greater between countries of
dissimilar production technologies (despite the fact that most trade occurs
between DCs with similar technology and income levels).
The classical model is a useful tool because:
 It provides a motive for trade between developed and developing countries
 It explains why high-wage countries may still benefit from trade even when faced
with low-wage competing countries

62. Summary of the
Comparative Advantage Model
It is not necessary for a country to possess absolute
advantage in order to participate in trade. What is
required is comparative advantage in production.
A country will specialize in and export that good in
which its has comparative advantage, i.e., has a lower
pre-trade relative price than in the other country.
The terms of trade or world price will settle between
the autarky prices of the two countries and is
determined by reciprocal demand.

63. Heckscher (1919)-Ohlin (1933)
Differences in factor endowments not on differences in productivity
determine patterns of trade
Absolute amounts of factor endowments matter
Leontief paradox:
 US has relatively more abundant capital yet imports goods
more capital intensive than those it exports
 Explanation(?):
 US has special advantage on producing new products
made with innovative technologies
 These may be less capital intensive till they reach
mass-production state

64. Theory of Relative Factor Endowments
(Heckscher-Ohlin)
Factor endowments vary among countries
Products differ according to the types of factors that they
need as inputs
A country has a comparative advantage in producing products
that intensively use factors of production (resources) it has in
abundance
Factors of production: labor, capital, land, human resources,
technology

65. International Product Life-Cycle (Vernon)
Most new products conceived / produced in the US in 20th century
US firms kept production close to their market initially
• Aid decisions; minimize risk of new product introductions
• Demand not based on price; low product cost not an issue
Limited initial demand in other advanced countries initially
• Exports more attractive than overseas production
When demand increases in advanced countries, production follows
With demand expansion in secondary markets
• Product becomes standardized
• production moves to low production cost areas
• Product now imported to US and to advanced countries

67. Classic Theory Conclusion
Free Trade expands the world “pie” for goods/services
Theory Limitations:
Simple world (two countries, two products)
no transportation costs
no price differences in resources
resources immobile across countries
constant returns to scale
each country has a fixed stock of resources and no efficiency
gains in resource use from trade
full employment

68. New Trade Theories
Increasing returns of specialization due to economies of scale (unit costs
of production decrease)
First mover advantages (economies of scale such that barrier to entry
crated for second or third company)
Luck... first mover may be simply lucky.
Government intervention: strategic trade policy

69. National Competitive Advantage
(Porter, 1990)
Factor endowments
• land, labor, capital, workforce, infrastructure
(some factors can be created...)
Demand conditions
• large, sophisticated domestic consumer base: offers an
innovation friendly environment and a testing ground
Related and supporting industries
• local suppliers cluster around producers and add to
innovation
Firm strategy, structure, rivalry
• competition good, national governments can create
conditions which facilitate and nurture such conditions

70. Porter’s Diamond

71. “So What” for business?
First mover implications
Location Implications
Foreign Investment Decisions
Government Policy implications

72. References
 Gibbard & Varian (1978): Economic models. Journal of Philosophy 75:664–677
 Bourguignon & Morrisson (2002): Inequality Among World Citizens: 1820-1992. American Economic Review. Vol. 92, No.
4
 Heckscher (1919): The Effect of Foreign Trade on the Distribution of Income, Ekonomisk Tidskrift.
 Hume (1752): Of the Balance of Trade. Availabe at www.utilitarian.net/hume/
 Kay (2003): The Truth about Markets. Allan Lane. Published in the U.S. as “Culture and Prosperity“ by HarperBusiness.
 Keynes (1936): The General Theory of Employment, Interest, and Money.
 Krugman (1993): What Do Undergrads Need to Know About Trade? The American Economic Review. Vol. 83(2): 23–26
 Krugman (1996): Pop Internationalism. MIT Press.
 Landreth & Colander (2002): History of Economic Thought. Houghton Mifflin Company.
 Lucas (1980): Methods and Problems in Business Cycle Theory. Journal of Money, Credit and Banking 12: 696-715
 Ohlin (1933): Interregional and International Trade.
 Ricardo (1817): On the Priciples of Political Economy.
 Schelling (1978): Micromotives and macrobehavior. W. W. Norton
 Smith, A. (1776): An Inquiry into the Nature and Causes of the Wealth of Nations.
 Smith, J. (2006): Immigrants and the Labor Market. Journal of Labor Economics 24(2)