E371 Theory, Policy and Empirics of

International Trade
Introduction
Valeria Merlo

University of Tübingen

1
Outline
1. A preview of trade theory

2. Empirical approaches to international trade

3. Patterns of international trade

2
References and resources
Chapter 1, Applied International Trade, 2nd Edition, Bowen, H., Hollander,
A. and J. Viaene, Palgrave Macmillan, 2012, [AIT]

3
A preview of trade theory

4
International trade theory
Applied microeconomic theory of production and exchange to
study economic transactions across countries

Why do countries trade?

What goods will they export and import?
Effect of trade on resource allocation within and between
countries?
Do countries benefit from international trade?

Key questions

How does trade affect goods prices?

How do changes in prices affect factor prices, factor allocation,
production and welfare?

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General equilibrium analysis
Exogenous model parameters

Determined outside the model and unaffected by other elements of

the model
We want to know how the outcome of the model changes when
their values change (comparative static)

Endogenous model outcomes

Determined inside the model by the exogeneous parameters and

other endogenous outcomes
What we aim at explaining with the model

Equilibrium conditions

Set of rules that specify what the endogenous outcomes should be

for a given set of exogenous parameters

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Asymmetry between goods and factors
International goods markets

Goods can be freely traded internationally

Elastically supplied and demanded

Enter consumer's utility function directly

Domestic factor markets

Cannot be traded across countries at all

Fixed domestic supply

Only affect utility through income they generate

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Why do countries trade?
Country differences (Type-1 models)

Countries specialize in things they can do relatively well

Differences can be in technology and/or factor endowments
Differences in demand typically ignored

Economies of scale (Type-2 models)

Average cost falls with larger scale of production

Trade allows specialized production and diversified
consumption

Contesting non-competitive markets (Type-3 models)

Trade has potential to squeeze price-cost markups

Prices fall even with constant unit cost of production

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Comparative Advantage
Fundamental idea behind all Type-1 models:

It is costly for a country to produce a good because doing so

keeps it from producing another good

Opportunity cost of good x: Number of units of another good

that cannot be produced in order to increase production of x
by one unit

Country is said to have comparative advantage in the good for

which opportunity cost are lower ⟶ basis for trade

Note the double comparison:

Opportunity cost defined in terms of two goods

Comparative advantage relative to the other country

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What determines CA?
Differences in relative autarky prices is the basis for trade

Supply and demand determine price

Fundamental determinants of supply and demand determine

differences in pre-trade prices and hence trade patterns

Why are relative autarky prices different across countries?

Technological differences (ricardian theory)

Factor endowment differences (factor proportion theory)

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Determinants of relative prices

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Economies of scale and variety
Large trade volumes between similar countries

Similar countries trade similar goods (intra-industry trade)

At odds with traditional CA-driven trade theory

Differentiated goods, increasing returns to scale & love for variety

Krugman (1979, 1980): rationale for trade between identical

countries

With IRS, accessing a larger market through trade reduces

average costs (incentive to specialize in one product variety)

Consumers have a preference for variety and will consume

some of each variety

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Oligopoly with homogeneous goods
Oligopolistic competition as a source of trade

Independently of CA and even with homogeneous goods,

trade can be a result of oligopolistic competition

Motive to trade: selling into a market previously dominated

by a monopolist

Gains from trade arise due to larger competition wich

results in lower product prices and increased output

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Interplay between theory and evidence
Increasing availability of trade data at a finer dis-
aggregation level

Country → Industry → Firm → Product → Transaction

Analyzing newly available data led to new evidence that was

at odds with previous theory and motivated new models

New trade theory accommodates intra-industry trade

Heterogenous firm models (Melitz, 2003) accommodates

firm heterogeneity and the large number of zero trade
between country pairs

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Empirical approaches to international
trade

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Two separate strands of literature
Traditional trade empirics

Focused on testing hypothesis derived from theoretical

models

Bulk of work devoted to testing implications of factor-

proportion theory

Gravity model estimation

Focused on empirically explaining bilateral trade flows

between countries and estimating the effect of trade barriers
on trade flows

Gravity specification: trade between 2 countries is proportional

to the product of their sizes and inversely proportional to
measures of trade frictions between them
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Convergence of the literature
First formal derivation of a gravity equation from a theory
model by Anderson (1979)

Leamer and Levinsohn in a Handbook of International

Economics chapter (1995): gravity models "have
produced some of the clearest and most robust findings
in economics"

Important contributions by Eaton and Kortum (2002) &

Anderson and van Wincoop (2003) led to many empirical
applications

Work by Chaney (2008), Helpman et al (2008), Melitz and

Ottaviano (2008) derive gravity equation from
heterogenous firms models

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Patterns in international trade

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Patterns in international trade
Trade growth over the last century

Cross-sectional variation

Changes in regional patterns

Changes in the type of trade

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Historical evolution of aggregate trade

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Trade growth over the last century

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Trade growth exceeded GDP growth

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Communication and transaction costs

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Cross-sectional variation

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Shares of world trade by region
Shares of World Trade by Region (%), 2019
Intra- Rest of the Total trade of
group world group

Africa 0.40 2.29 2.69

Asia and Oceania 26.17 14.68 40.85
Europe 25.09 12.29 37.38
Latin America and the
0.85 4.79 5.64
Caribbean
Northern America 3.13 10.32 13.45

Data source: UNCTADstat Merchandise Trade Matrix

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Trade openness
Trade Openness, 2017
Trade openness is measured as the sum of a country's exports and imports as a share of that country's GDP
(in %).
World

No data 0% 20% 40% 75% 100% 150% >350%

Source: Feenstra et al. (2015) Penn World Tables version 9.1 OurWorldInData.org/trade-and-globalization • CC BY

1950 2017

CHART MAP TABLE SOURCES DOWNLOAD

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Changes in trade between regions

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Regional trade growth
Growth in intra-regional and inter-regional trade, 1999–2009

North South and C. Middle

Europe CIS Africa Asia
America America East
North America 5.1
South and C.
-3.4 3.0
America
Europe -0.9 -3.2 3.7
CIS -3.0 -9.4 -1.2 -5.4
Africa -4.4 -2.4 -3.3 1.9 4.6
Middle East -3.6 -6.6 -5.5 -6.0 3.2 7.5
Asia 1.1 2.9 2.9 0.0 4.0 0.7 7.9

Source: Table 1.3, Bowen et al (2012)

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Trade by income groups
Exports between rich and non-rich countries
The 'rich to non-rich' trade series shows the proportion of global merchandise exports that correspond to sales
from rich countries to non-rich countries. The other series show similar ows within and across these countries.
In the sources you nd the complete list of 'rich' and 'non-rich' countries.

100%

Non-rich to
Non-rich
80%

60% Non-rich to Rich

40% Rich to Non-rich

20%
Rich to Rich

0%
1840 1860 1880 1900 1920 1940 1960 1980 2000 2014
Source: Fouquin and Hugot (CEPII 2016) CC BY

CHART TABLE SOURCES DOWNLOAD

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Changes in the type of trade

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Merchandise exports by component

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Trade in intermediate goods

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Intra- rm trade

Source: Figure 1.8, Bowen et al (2012)

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Trade in services
Share of services in total exports, 1979 to 2017
Services refer to economic output of intangible commodities that may be produced, transferred, and consumed
at the same time. The share of services in total exports comes from comparing trade in goods and services at
current US dollars.

Add country

Bahamas
80%

60%

United Kingdom
40% India
United States
Uruguay
World
20% Germany

0%
1979 1985 1990 1995 2000 2005 2010 2017
Source: World Bank CC BY

1970 2017

CHART MAP TABLE SOURCES DOWNLOAD

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Summary of stylized facts
Growing interdependence among countries

Intra-regional trade has risen faster than inter-regional trade

Increasing importance of newly industrialized economies

Growth of world trade fueled by large increases in trade in

manufactures

Increasing importance of intermediate goods

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