CHAPTER 8

INTERNATIONAL TRADE AND CAPITAL

FLOWS
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1. INTRODUCTION
International trade enhances economic growth by
increasing the efficiency of the allocation of resources,
providing larger capital and product markets,
assisting specialization based on comparative advantages, and
increasing the efficiency of the flow of capital among countries.

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2. INTERNATIONAL TRADE
We can measure aggregate output of a country by using the gross national
product (GNP) or the gross domestic product (GDP), which differ with
respect to goods and services produced by foreigners and by its citizens
abroad:
Gross national product (GNP)
Add

Production of goods and services by foreigners within the

country

Subtract

Production of goods and services by the countrys citizens

outside the country

Equals

Gross domestic product (GDP)

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TERMINOLOGY
Imports are goods and services that a domestic economy purchases from other
countries.
Exports are goods and services that a domestic economy sells to other countries.
The terms of trade is the ratio of the price of exports to the price of imports.
- Increasing terms of trade indicate improvement.
- Decreasing terms of trade indicate deterioration.
Net exports = Exports Imports
- If positive, there is a trade surplus.
- If negative, there is a trade deficit.
A country that does not trade with other countries is referred to as a closed
economy or being in autarky; the price of goods and services is the autarkic price.
An economy that is not closed is an open economy.
- If there are no restrictions to trade, the price of goods and services is the world
price.
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TERMINOLOGY
Free trade is the case in which there are no restrictions on a countrys trade
with other countries.
- Trade protections are restrictions on trade that prevent pricing based on
supply and demand.
- Capital restrictions are limits on the flow of funds into or out of a country.
Measure of international trade:
- Trade as a percentage of GDP
- Foreign direct investment (FDI): the amount of the investment by a firm in
one country in the assets in another country.
A multinational corporation (MNC) is a company that operates in more than
one country.
A foreign portfolio investment (FPI) is a short-term investment in foreign
financial instruments.

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BENEFITS AND COSTS OF

INTERNATIONAL TRADE
BENEFITS
Gain from exchange and
specialization
Greater economies of scale
Greater product variety

COSTS

Increased competition

Greater income inequality

More efficient resource allocation

Loss of jobs in developed countries

Adjustments as resources are
reallocated

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COMPARATIVE ADVANTAGE
An absolute advantage exists if the country is able to produce a good at a
lower cost or use fewer resources.
A comparative advantage exists if the countrys opportunity cost of producing
a good is less than its trading partner.
It is possible to have a comparative advantage while not having an absolute
advantage in producing a good.
The greater the difference between the world price of a good and its autarkic
price, the more potential to gain from trade.
A countrys comparative advantage can change over time.
Comparative
advantage
Absolute
advantage

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Lowest-cost producer of a good

Best producer of a good
Based on productivity in terms of
opportunity cost, but not necessarily
the lowest-cost producer.
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ADVANTAGES: EXAMPLE
COUNTRY A
COUNTRY B
Assume identical feed and labor supply.
Can produce 5 cows or 25 hogs
Can produce 5 cows or 12 hogs
Relative price for a cow: 5 hogs
Relative price for cow: 2.4 hogs
Relative price for a hog: 0.20 cow
Relative price for a hog: 0.42 cow
Comparative advantage in hogs
Comparative advantage in cows
Absolute advantage in hogs
Specialize in hogs
Specialize in cows
60

Country A

Country B

40
Hogs

20
0

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5
Cows

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SOURCES OF COMPARATIVE ADVANTAGE

RICARDIAN
Countries specialize in the goods
and services for which they have a
comparative advantage.
The source of comparative
advantage is labor productivity.
- Labor productivity is attributed to
differences in technology.
Countries trade because of
differences in labor productivity.

HECKSCHEROHLIN
Comparative advantages arise from
different endowments of capital and
labor.
Capital and labor are variable factors
of productivity.
Countries trade because of different
relative amounts of capital and labor.
- Efficiency of production matters.
This model allows for income
redistribution between owners and
capital and labor through trade.

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3. TRADE AND CAPITAL FLOWS:

RESTRICTIONS AND AGREEMENTS
A tariff is a tax levied by a government on imported goods.
- Intended to protect domestic industries
- Increases welfare of domestic country if (1) there is no retaliation, and (2) the
deadweight loss is less than the benefit from improving trade
An import quota is a restriction on the quantity of a good that can be imported.
- Controlled through import licenses
- Importers earn quota rents if they charge a higher price with a quota
An export subsidy is a payment by a government to a firm when it exports a
specified good.
- Encourages firms to shift to export goods, increases the domestic price
- A voluntary export restraint (VER) is a voluntary limit on goods exported to
a specific country.
- Allows exporter to earn quota rents
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TRADE AND CAPITAL RESTRICTIONS

Domestic content provisions are requirements that a specific portion of
value-added or components be produced domestically.
Capital restrictions are controls placed on ownership of assets, either of
foreign assets or of ownership of domestic assets by foreign persons or firms.
The effect of restrictions on trade and capital depends on whether the country
is a price taker or can affect price:
- A small country in the context of international trade is a price taker.
- A large country in this context can influence the price.

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SUMMARY OF EFFECTS

Impact on
Producer surplus
Consumer surplus
Government revenue

Tariff

Import Quota

Export
Subsidy

Importing
country

Importing
country

Exporting
country

Voluntary
Export
Restraint
(VER)
Importing
country

Mixed

+
+

+
+

National welfare
Small country
Large country
Price
Domestic consumption
Domestic production
Trade
Imports
Exports
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+
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TRADING BLOCS
A trading bloc is an agreement among countries to work toward eliminating
trade barriers. Trading blocs may be regional (e.g., NAFTA, EU), yet there are
different degrees of integration possible.
Economic union

Coordination of economic
policies among members

Common market

Allows free movement of

factors of production

Customs union

Common trade policy

regarding nonmembers

Free trade area (FTA)

Trading block with no trade

barriers

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WHY TRADING BLOCS?

1. Increased competition
- Lowers prices and increases quantity
2. Cost of production declines
- Easier access to natural resources and technology
3. Increased access to technology and knowledge
4. Increased specialization
5. Greater opportunity for economies of scale
6. Increased employment
7. Increased income
8. Increased interdependence among members
- Less chance of conflicts

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TRADING BLOCS AND CAPITAL RESTRICTIONS

Possible results of trading blocs:
- Trade creation: Replacement of higher-cost domestic production by lowercost imports
- Trade diversion: Replacement of lower-cost imports from nonmembers by
higher-cost imports from members
Impediments to effectiveness of trading blocs:
- National sovereignty concerns
- Differences in tastes, culture, and competitive conditions among members
Capital restrictions may affect inflows, outflows, or both:
- May be in the form of taxes, price or quantity controls, or prohibitions
- Difficult to distinguish effects of these restrictions from the effects of other
policies

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4. BALANCE OF PAYMENTS
The balance of payments is the accounting of the flow of funds into and out of a
country.
DEBITS
Increase in Assets,
Decrease in Liabilities

CREDITS
Decrease in Assets,
Increase in Liabilities

Value of imported goods and

services
Purchases of foreign financial
assets
Receipt of payments from
foreigners
Increase in debt owed by
foreigners
Payment of debt owed to foreigners

Payments for imports of goods and

services
Payments for foreign financial
assets
Value of exported goods and
services
Payment of debt by foreigners
Increase in debt owed to foreigners

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BALANCE OF TRADE COMPONENTS

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5. TRADE ORGANIZATIONS
As a result of countries building barriers to international trade in the 1930s and
1940s, international trade fell, along with the standard of living in many
countries.
International trade organizations were created to encourage international trade
and development.

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INTERNATIONAL MONETARY FUND

The purpose of the International Monetary Fund is to stabilize exchange
rates and the system of international payments.
- Provides a forum for cooperation
- Facilitates growth in international trade
- Promotes employment, economic growth, and poverty reduction
- Lends foreign currencies to member countries that are experiencing trade
deficits
In response to the global financial crisis, the IMF has expanded its scope to
include monitoring of economies, risk, capital market developments, and
financial sector vulnerabilities.

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THE WORLD BANK GROUP

The objective of the World Bank is to help developing countries fight poverty
and enhance environmentally sound economic growth.
Economic development in developing nations requires strong governmental
system, developed legal and judicial systems, individual and property rights,
support of contracts, financial systems robust enough for all sizes of business,
and willingness and ability to fight corruption.
It provides funds, as well as technical and financial expertise, to developing
nations.
- It helps to create the basic economic infrastructure for a developing nation.
Nonprofit affiliates:
- International Bank for Reconstruction and Development (IBRD)
- International Development Association (IDA)

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THE WORLD TRADE ORGANIZATION

The purpose of the World Trade Organization is to provide the legal and
institutional foundation for the multinational trading system.
It addresses barriers to trade and subsidies that inhibit trade.
The WTO implements and administers individual agreements, which
encourages trade by providing a platform for negotiations and settling of
disputes.

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CONCLUSIONS AND SUMMARY

The benefits of trade include gains from exchange and specialization, gains from
economies of scale, a greater variety of products available to households and
firms, increased competition, and more efficient allocation of resources.
A country has an absolute advantage in producing a good (or service) if it is able to
produce that good at a lower absolute cost or use fewer resources in its production
than its trading partner.
A country has a comparative advantage in producing a good if its opportunity cost
of producing that good is less than that of its trading partner.
- In the Ricardian model of trade, comparative advantage and the pattern of trade
are determined by differences in technology between countries.
- In the HeckscherOhlin model of trade, comparative advantage and the pattern
of trade are determined by differences in factor endowments between countries.
Trade barriers prevent the free flow of goods and services among countries.
Governments impose trade barriers for various reasons, including to promote
specific developmental objectives, to counteract certain imperfections in the
functioning of markets, or to respond to problems facing their economies.
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CONCLUSIONS AND SUMMARY

In a small country, trade barriers generate a net welfare loss arising from
distortion of production and consumption decisions and the associated inefficient
allocation of resources.
Trade barriers can generate a net welfare gain in a large country if the gain from
improving its terms of trade (higher export prices and lower import prices) more
than offsets the loss from the distortion of resource allocations. But the large
country can only gain if it imposes an even larger welfare loss on its trading
partner(s).
An import tariff and an import quota have the same effect on price, production,
and trade. With a quota, however, some or all of the revenue that would be
raised by the equivalent tariff is instead captured by foreign producers (or the
foreign government) as quota rents. Thus, the welfare loss suffered by the
importing country is generally greater with a quota.
A voluntary export restraint is imposed by the exporting country. It has the same
impact on the importing country as an import quota from which foreigners
capture all of the quota rents.
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CONCLUSIONS AND SUMMARY

An export subsidy encourages firms to export their product rather than sell it in
the domestic market. The distortion of production, consumption, and trade
decisions generates a welfare loss. The welfare loss is greater for a large
country because increased production and export of the subsidized product
reduces its global pricethat is, worsens the countrys terms of trade.
Capital restrictions are defined as controls placed on foreigners ability to own
domestic assets and/or domestic residents ability to own foreign assets. In
contrast to trade restrictions, which limit the openness of goods markets, capital
restrictions limit the openness of financial markets.
A regional trading bloc is a group of countries that have signed an agreement to
reduce and progressively eliminate barriers to trade and movement of factors of
production among the members of the bloc.
From an investment perspective, it is important to understand the complex and
dynamic nature of trading relationships because they can help identify potential
profitable investment opportunities as well as provide some advance warning
signals regarding when to disinvest in a market or industry.
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CONCLUSIONS AND SUMMARY

The major components of the balance of payments are the current account
balance, capital account balance, and the financial account.
Created after WWII, the International Monetary Fund, the World Bank, and the
World Trade Organization are the three major international organizations that
provide necessary stability to the international monetary system and facilitate
international trade and development.
- The IMFs mission is to ensure the stability of the international monetary
system.
- The World Bank helps to create the basic economic infrastructure essential
for creation and maintenance of domestic financial markets and a wellfunctioning financial industry in developing countries.
- The World Trade Organizations mission is to foster free trade by providing a
major institutional and regulatory framework of global trade rules.

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