Economia internazionale

Economia internazionale (International economics I)

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Professoressa Luppi

Libro di testo: International economics theory and politics “Krugman, Obstfeld, M, Melitz”

International economics 9th McGraw Hill international student edition

Main topics

• International trade: trade patterns, data analysis, the gravity model
• Trade models
• Firm on international markets: economies of scale and FDIs
• Economic performance on international markets
• Trade policy instruments

International trade

The exchange of both goods (merchandise) and services among the countries of the world.

Trade in services accounts for approximately one fifth of global trade.

The two are often intertwined.

Gravity model and the world trade

The gravity model of international trade in international economics is a model that, in its traditional form, predicts bilateral trade flows based on the economic sizes and the distance between two units.

Research shows that there is overwhelming evidence that trade tends to fall with distance.

The basic model for trade between two countries takes the form of

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In this formula, G is a constant, F stands for trade flow, D stands for the distance and M stands for the economic dimension of the countries that are being measured. The equation can be changed into a linear form. The model has been used by economists to analyze the determinants of bilateral trade flows such as common borders, common languages, common legal systems, common currencies, common colonial legacies, and it has been used to test the effectiveness of trade agreements and organizations such as the NAFTA and the North American Free Trade Agreement World Trade Organization (WTO).

The model has been an empirical success in that it accurately predicts trade flows between countries for many goods and services. A gravity relationship can arise in almost any trade model that includes trade costs that increase with distance. It estimates the pattern of international trade.

Economic size is prized by the GDP measurement and distance refers to geographical distance (KM) (GDP: gross domestic production). The major hypotheses behind the gravity model are that economic (not physical) size of countries is what matters and it affects the model positively. Other factors playing an important role in the model are cultural ties, multinational companies’ presence etc.

The gravity model assumes that size and distance are important for trade in the following way:

Tij is the value of trade between country I and country j, A is a constant, Yi the GDP of country I, Yj the GDP of country j and Dij the distance between the two countries.

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The countries that are located nearby are the most reached and interested countries considering importing and exporting for a particular nation, due to distance and better and more common international relations.

The sign of a wealthy economy is measured with the percentage of imports and exports and the so called commercial balance. Usually, in a good economy the percentage of imported goods is bigger than the percentage of exported goods and services, and we can take U.S. as an example of this (meaning that the citizens have more economic power, they have more income to spend on foreign goods). But this doesn’t mean that an economy, a government that is mostly concentrated in exporting goods isn’t wealthy as well (e.g. China, probably the country that exports the most and gets the most amount of money from it all over the world).

Does Gravity Model fit trade data?

Look at the U.S. Trade Data (are our assumptions based on the data verified?)

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3 of the top 10 trading partners with the US in 2012 were also the 3 largest European economies, Germany, the UK and France. Why does the US states trade more with these European countries than with others? Because these countries have the largest GDP, economy size, the value of goods and services produced in an economy, in Europe. Each European country’s share of US trade with Europe is roughly equal to its share of European GDP.

The relation between Germany GDP and percentage of U.S. trade with EU sums up the assumption perfectly. But there are other factors (A) that are implied in the graphic that we’re seeing (having English only as a second language, so a cultural barrier can be implied and can affect the trade flow with the US).

Italy is engaging trade with the U.S. less proportionally than their economic size, considering their representation of percentage of EU GDP, as an example of how cultural factors and language barriers or other elements that we noted before can affect trade.

The size of an economy is usually directly related to the volume of imports and exports:

• Larger economies produce more goods and services, so they have more to sell in the export market.
• Larger economies generate more income from the selling of goods and services, so they are able to buy more imports (macroeconomy, bigger PIL, bigger incomes, salaries, and they come with an increase of consumption, which implies an increase of foreign goods). So trade between any two countries is larger, the larger is either country.

A gravity model fits the data on U.S. trade with European countries well but not perfectly (as Italy can be an example of it). The Netherlands, Belgium and Ireland trade much more with the United States than as is predicted by a gravity model (strong cultural affinities due to common language and migration, location, transport cost advantages). We as Italy are trading less than expected.

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Other things besides size matter for trade:

• Distance between markets influences transportation costs and therefore the cost of imports and exports.
• Cultural affinity: close cultural ties, such as a common language, usually lead to strong economic ties.
• Geography: ocean harbors and lack of mountain barriers make transportation easier.
• Multinational corporations: corporations spread across different nations import and export many goods between their divisions.
• Borders: crossing borders involves formalities that take time, often different currencies need to be exchanged, and perhaps monetary costs like tariffs reduce trade.

Countries that have positive economic relationships try to reduce bureaucracy and formalities when it comes to trade and commercial relations, and they also tend to take part in a certain trade area in order to eliminate these obstacles even better (we will discuss it later on).

Estimates of the effect of distance from the gravity model predict that 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0.7% to 1%, so it is not perfectly proportional. Besides distance, borders increase the cost and the time needed for the trade to happen. Trade agreements between countries are intended to reduce the formalities and tariffs needed to cross borders, and therefore to increase trade.

Some examples: the U.S. signed a free trade agreement with Mexico and Canada in 1994, the NAFTA (North American Free Trade Agreement). Because of this agreement and the close distance of Mexico and Canada to the U.S., the amount of trade between the U.S. and its northern and southern neighbors as a fraction of GDP is larger than between the U.S. and European countries.

Canada’s economy is roughly the same size as Spain’s (around 10% of EU GDP) but Canada trades as much with the United States as does all of Europe (considering the free trade area).

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Yet even with a free trade agreement between the U.S. and Canada, which use a common language, the border between these countries still seems to be associated with a reduction in trade. Data shows that there is much more trade between pairs of Canadian provinces than between Canadian provinces and U.S. states, even when holding distance constant —> borders still play a significant role in trading flows between the two countries. Estimates indicate that the U.S. - Canadian border deters trade as much as if the countries were 1500 — 2500 miles apart.

Trade with British Columbia, as percent of GDP, 2009:

Trade agreements and free trade zones have largely spread since 1950s.

The most important ones:

EU, EFTA, EEA (in Europe); the European Union represent a much more integrated area than NAFTA area, since the EU is a customs union (a customs union is a trade agreement where member countries eliminate internal tariffs and adopt a common external tariff CET for goods from non-member countries, creating a single trade bloc that simplifies trade, promotes economic operation and strengthens negotiation power with the rest of the world); it’s a single market and an economic and monetary union furthermore.

• NAFTA (in North-America)
• MERCOSUR (in Latin America)
• ASEAN, South East Asian Nations (in Asia)

Spazio Schengen: lo spazio Schengen consente a più di 450 milioni di persone di circolare liberamente trai paesi membri senza sottoporsi ai controlli di frontiera. Promuove una maggiore cooperazione tra le forze di polizia, le autorità doganali e le autorità preposte ai controlli alle frontiere esterne di tutti gli stati membri.

An increase in GDP turns proportionally into an increase of trade flows between two or more countries. Considering all the other exogenous elements and factors (culture, tradition, language, multinationals presence), the costs, even inside the same geographical areas, the costs tend to 0 but they are almost never = 0.

PTA: preferential trade agreement.

Changing pattern of world trade: has the world gotten smaller?

The negative effect of distance according to the gravity model is significant, but has grown smaller over time due to modern transportation and communication. Technologies have facilitated the spread of international trades among countries all over the world, even very far from each other —> we’re talking about developments in wheels, sails, railroads, telegraph, steam power, automobiles, telephones, airplane, computers, fax machines, Internet, fiber optics etc.

Political factors, such as wars, can also change trade patterns, in a way more defining and impactful way than innovations in transportation and communication.

History details (examples):

World trade grew rapidly from 1870 to 1923, but then it suffered a sharp decline due to the two world wars and the great depression. It started to recover around 1945 but did not fully recover until around 1970.

Since 1970, world trade as a fraction of world GDP has achieved unprecedented heights:

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• Vertical disintegration of production has contributed to the rise in the value of world trade through extensive cross-shipping of components (vertical disintegration means that various diseconomies of scale or scope have broken a production process into separate companies, each performing a limited subset of activities required to create a finished product; splitting of a production process into smaller reasons, outsourcing).

What do we trade? —> what kinds of products do nations trade most nowadays, and how does this composition compare to trade in the past?

Today, most (about 53%) of the volume of trade is in manufactured products such as cars, computers and clothing:

• Services, such as shipping, insurance, legal fees, and spending by tourists accounts for about 20% of the volume of trade.
• Mineral products (e.g. petroleum, coal, copper) remain an important part of world trade at 19%.
• Agricultural products, relatively small 8% part of the trade.

In the past, a large fraction of the volume of trade came from agricultural and mineral products.

Low and middle income countries have also changed the composition of their trade.

• In 2001, about 65% of exports from low and middle income countries were manufactured products, and only 10% of exports were agricultural products.
• In 1960, about 58% of exports from low and middle income countries were agricultural products and only 12% of exports were manufactured products.
• More than 90% of the exports of China, the largest developing country and a rapidly growing force in world trade, consists nowadays of manufacturing goods.

FDI, a foreign direct investment, represents an important form to integrate/replace exports. It is a controlling ownership in a business enterprise in one country by an entity based in another country.

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Standard definitions of control use the internationally agreed 10% threshold of voting shares.

There are two typologies of FDI:

• Brownfield: international mergers (legal consolidation of two business entities into one) and acquisitions.
• Greenfield: building new facilities in a foreign country.

Service outsourcing

It occurs when a firm that provides services moves its operations to a foreign location.

Ricardian model of trade

Adam Smith and the invisible hand theory

The invisible hand, a concept coined by Adam Smith, describes the unseen market forces that drive a free economy through self interest and voluntary trades. This metaphor illustrates how individuals, in pursuing their own goals, inadvertently contribute to societal welfare. The dynamics of supply and demand naturally adjust prices and trade flows without centralized control, highlighting how personal motives can lead to broader economic benefits and fulfillment of society’s needs. Self interested individuals in free markets can unintentionally benefit society by responding to supply and demand signals. Free market economies could naturally distribute resources efficiently without external intervention. By enabling voluntary exchanges, the price system naturally guides producers and consumers to meet each other’s needs, promoting efficiency and innovation without the need for government regulation.

Critics —> economic inequality, social inequality, monopolies…

One primary critique is its assumption of perfectly competitive markets and rational actors, which are not always present in the real world. Market failures (inefficient allocation of goods and services by a free market, leading to a net loss of economic value) involving public goods and information asymmetry, monopolies, oligopolies or externalities like pollution can prevent the invisible hand from leading to optimal societal outcomes. In such cases in fact,

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individual self interest might lead to negative societal consequences if the cost or benefits are not fully reflected in market prices (e.g. a factory might reduce its costs by polluting a river, benefiting its owners but harming the community, an outcome not corrected by the invisible hand alone). Critics also argue that the invisible hand does not inherently address issues of equity or income inequality. While it may promote efficiency, it does not guarantee a fair distribution of wealth or resources (while overall wealth might grow, the distribution can become highly inequality if profits are captured by a few owners or investors, rather than shared with labor).

Invisible Hand VS Laissez faire: the invisible hand is a descriptive concept about how markets can work, while laissez faire is a prescriptive policy recommendation. The belief in the power of the invisible hand often leads to advocacy for laissez faire policies, but they’re not interchangeable.

Laissez faire: an economic philosophy advocating no government intervention in the economy. It is a prescriptive policy stance, suggesting what should be done regarding government’s role.

Key point: increased specialization naturally leads to a web of mutual interdependencies, but in some cases, some level of government intervention or regulation might be necessary to achieve socially desirable outcomes.

Example: consider an example of a small business facing stiff competition. To compete better, the small business invests in higher-quality materials and reduces prices. Though the small business may be taking these steps out of self interest — in this instance, to drive sales and capture market share — the invisible hand is at work because the market will have access to more affordable yet higher quality goods. Another example of the invisible hand is the ripple effect that a retail company can have when attempting to meet consumer demand. Imagine a hardware store that expects demand for yard tools. It coordinates with a manufacturer, who then deals with a materials supplier to meet the store's needs. Each entity acts in self-interest, yet all create economic activity for others. In addition, the entities are stringing together a process that results in consumers receiving a product that they

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need. Though each individual action taken by itself may not amount to much, the invisible hand helps move resources along a process to deliver a final product in the most efficient way possible.

Absolute advantage theory

Smith believed a nation’s wealth resided in its productive capacity. The growth of productive capacity was fostered when people were free to pursue their own interests. Self interest was the catalyst and competition was the automatic regulation mechanism.

Link between the theory and the absolute advantage principle: Adam Smith’s absolute advantage provides the foundation for his broader invisible hand concept, showing how individual self interest (nation’s specializing where they’re best) unintentionally benefits all through free trade, leading to greater global wealth, much like how self interest in a domestic market drives overall prosperity without central planning and government’s intervention.

Absolute advantage as the what: it explains what countries should specialize in — producing goods they can make with fewer resources.

Invisible hand as the how: it explains how this specialization happens and benefits everyone - though individuals (producers, traders) pursuing their own profit.

Every one specializes where they’re the best at, so everyone makes his own interest and all countries gain from that —> competition grows.

Smith believed trade to be a positive sum game, meaning that countries