Theories of Theories of International TradeInternational Trade

The Gravity ModelThe Gravity Model

Patterns of TradePatterns of Trade

Philippines’ Major Trading PartnersPhilippines’ Major Trading Partners

1.1. USAUSA

2.2. JapanJapan

3.3. SingaporeSingapore

4.4. TaiwanTaiwan

5.5. Hong KongHong Kong

6.6. GermanyGermany

7.7. South KoreaSouth Korea

8.8. Saudi ArabiaSaudi Arabia

9.9. MalaysiaMalaysia

10.10. NetherlandsNetherlands

U.S. Major Trading Partners - 2006U.S. Major Trading Partners - 2006

Who Trades with Whom?Who Trades with Whom?

The 5 largest trading partners of the The 5 largest trading partners of the US in 2006 were Canada, Mexico, China, US in 2006 were Canada, Mexico, China, Japan and Germany.Japan and Germany.

Three of the top ten U.S. trading partners are Three of the top ten U.S. trading partners are European nations: Germany, United Kingdom, European nations: Germany, United Kingdom, and France.and France.

The Size of European Economies, and the The Size of European Economies, and the Value of Their Trade with the United StatesValue of Their Trade with the United States

Source: U.S. Department of Commerce, European Commission

3 of the top 10 trading partners of the US 3 of the top 10 trading partners of the US in 2006 were also the 3 largest European economies: in 2006 were also the 3 largest European economies: Germany, UK and France.Germany, UK and France.

These countries have the largest These countries have the largest gross domestic gross domestic product (GDP)product (GDP) in Europe. in Europe.

(GDP measures the value of goods and services produced in an (GDP measures the value of goods and services produced in an economy.)economy.)

Why does the US trade most with these European Why does the US trade most with these European countries and not other European countries?countries and not other European countries?

The Size of European Economies, and the The Size of European Economies, and the Value of Their Trade with the United StatesValue of Their Trade with the United States

The size of an economy is directly related to its The size of an economy is directly related to its volume of imports and exports.volume of imports and exports.

– (Analogy) Newton’s Law of Gravity: The gravitational (Analogy) Newton’s Law of Gravity: The gravitational attraction between any two objects is proportional to attraction between any two objects is proportional to the product of their masses and diminishes with the product of their masses and diminishes with distance.distance.

– The trade between any two countries is, other things The trade between any two countries is, other things equal, proportional to the product of their GDPs and equal, proportional to the product of their GDPs and diminishes with distance. diminishes with distance.

The Gravity ModelThe Gravity Model

The Gravity Model SpecificationThe Gravity Model Specification

In its basic form, the gravity model assumes that only In its basic form, the gravity model assumes that only size and distance are important for trade in the following size and distance are important for trade in the following way:way:

TTijij = = A x YA x Yii x Y x Yjj

DDijij

wherewhere TTijij is the value of trade between country is the value of trade between country ii and country and country jj

A is a constantA is a constant

YYii the GDP of country the GDP of country ii

YYjj is the GDP of country is the GDP of country jj

DDijij is the distance between country is the distance between country ii and country and country jj

Perhaps surprisingly, the gravity model works fairly well Perhaps surprisingly, the gravity model works fairly well in predicting actual trade flows.in predicting actual trade flows.

The Logic of the Gravity ModelThe Logic of the Gravity Model

– Larger economies produce more goods and Larger economies produce more goods and services, so they have more to sell in the services, so they have more to sell in the export market.export market.

– Larger economies generate more income Larger economies generate more income from the goods and services sold, so people from the goods and services sold, so people are able to buy more imports.are able to buy more imports.

DistanceDistance between markets influences transportation between markets influences transportation costs and therefore the cost of imports and exports. costs and therefore the cost of imports and exports. Distance may also influence personal contact and Distance may also influence personal contact and communication, which may influence trade. communication, which may influence trade.

Estimates of the effect of distance from the gravity model Estimates of the effect of distance from the gravity model predict that a 1% increase in the distance between predict that a 1% increase in the distance between countries is associated with a decrease in the volume of countries is associated with a decrease in the volume of trade of 0.7% to 1%.trade of 0.7% to 1%.

The Logic of the Gravity ModelThe Logic of the Gravity Model

The Size of European Economies, and the The Size of European Economies, and the Value of Their Trade with the United StatesValue of Their Trade with the United States

Source: U.S. Department of Commerce, European Commission

The Gravity ModelThe Gravity ModelOther things besides size and distance matter for trade: Other things besides size and distance matter for trade:

1.1. Cultural affinityCultural affinity: if two countries have cultural ties, it is : if two countries have cultural ties, it is likely that they also have strong economic ties.likely that they also have strong economic ties.

- Ireland and USA- Ireland and USA

- Philippines and USA- Philippines and USA

2.2. GeographyGeography: ocean harbors and a lack of mountain : ocean harbors and a lack of mountain barriers make transportation and trade easier.barriers make transportation and trade easier.

- Belgium and Netherlands- Belgium and Netherlands

- Landlocked African countries (e.g. Burkina Faso, - Landlocked African countries (e.g. Burkina Faso, Zimbabwe, Ethiopia, Chad, Botswana, Rwanda)Zimbabwe, Ethiopia, Chad, Botswana, Rwanda)

3.3. Multinational corporationsMultinational corporations: corporations spread across : corporations spread across different nations import and export many goods different nations import and export many goods between their divisions.between their divisions.

- Ireland and USA - Ireland and USA

4.4. Trade AgreementsTrade Agreements

- Canada and Mexico - Canada and Mexico

Source: U.S. Department of Commerce, European Commission

Trade Agreements - NAFTATrade Agreements - NAFTA

The US has signed a free trade agreement with The US has signed a free trade agreement with Mexico and Canada in 1994, the North American Mexico and Canada in 1994, the North American Free Trade Agreement (NAFTA).Free Trade Agreement (NAFTA).

Because of NAFTA and because Mexico Because of NAFTA and because Mexico and Canada are close to the US, the and Canada are close to the US, the amount of trade between the US and its northern amount of trade between the US and its northern and southern neighbors as a fraction of GDP is and southern neighbors as a fraction of GDP is larger than between the US and European larger than between the US and European countries.countries.

Source: U.S. Department of Commerce, European Commission

5. Borders5. Borders: crossing borders involves formalities that take : crossing borders involves formalities that take time and perhaps monetary costs like tariffs. time and perhaps monetary costs like tariffs.

– These implicit and explicit costs reduce trade. These implicit and explicit costs reduce trade. – How wide is the border?How wide is the border?

Distance and BordersDistance and Borders

Trade agreementsTrade agreements between countries are intended to between countries are intended to reduce the formalities and tariffs needed to cross reduce the formalities and tariffs needed to cross borders, and therefore to increase trade. borders, and therefore to increase trade.

The gravity model can assess the effect of trade The gravity model can assess the effect of trade agreements on trade: does a trade agreement lead to agreements on trade: does a trade agreement lead to significantly more trade among its partners than one significantly more trade among its partners than one would otherwise predict given their GDPs and distances would otherwise predict given their GDPs and distances from one another? from one another?

Canadian Provinces and U.S. States That Trade with British ColumbiaCanadian Provinces and U.S. States That Trade with British Columbia

Distance and BordersDistance and Borders

Trade with British Columbia as a Percentage of GDP, 1996

Distance and BordersDistance and Borders

Even with a free trade agreement between the U.S. and Even with a free trade agreement between the U.S. and Canada (NAFTA), which use a common language, the Canada (NAFTA), which use a common language, the border between these two countries still seems to be border between these two countries still seems to be associated with a reduction in trade.associated with a reduction in trade.

The Changing Pattern of World TradeThe Changing Pattern of World Trade

Has the World Become “Smaller”?Has the World Become “Smaller”?

The negative effect of distance on trade according The negative effect of distance on trade according to the gravity models is significant, but it has grown to the gravity models is significant, but it has grown smaller over time due to modern transportation smaller over time due to modern transportation and communication.and communication.

– Wheels, sails, compasses, railroads, telegraph, steam Wheels, sails, compasses, railroads, telegraph, steam power, automobiles, telephones, airplanes, computers, fax power, automobiles, telephones, airplanes, computers, fax machines, internet, fiber optics,… are all technologies that machines, internet, fiber optics,… are all technologies that have increased trade.have increased trade.

But history has shown that political factors, such as But history has shown that political factors, such as wars, can change trade patterns much more than wars, can change trade patterns much more than innovations in transportation and communication.innovations in transportation and communication.

The Rise, Fall, and Rise of The Rise, Fall, and Rise of International Trade Since 1830International Trade Since 1830

Source: Richard E. Baldwin and Phillipe Martin, “Two Waves of Globalization: Superficial Similarities, Fundamental Differences,” in Horst Siebert, ed., Globalization and Labor (Tubingen: Mohr, 1999).

Has the World Become “Smaller”?Has the World Become “Smaller”?

There were two waves of globalization.There were two waves of globalization.

– 1840–1914: economies relied on steam power, 1840–1914: economies relied on steam power, railroads, telegraph, telephones. Globalization was railroads, telegraph, telephones. Globalization was interrupted and reversed by wars and depression.interrupted and reversed by wars and depression.

– 1945–present: economies rely on telephones, 1945–present: economies rely on telephones, airplanes, computers, internet, fiber optics, PDAs, airplanes, computers, internet, fiber optics, PDAs, GPS satellites… GPS satellites…

Changing Composition of TradeChanging Composition of Trade

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

– In 1910, Britain mainly imported agricultural and mineral In 1910, Britain mainly imported agricultural and mineral products, and manufactured products represented most of the products, and manufactured products represented most of the volume of its exports.volume of its exports.

– In 1910, the US mainly imported and exported agricultural In 1910, the US mainly imported and exported agricultural products and mineral products.products and mineral products.

The Composition of TradeThe Composition of Trade

Today, most of the volume of world trade is in Today, most of the volume of world trade is in manufactured productsmanufactured products such as automobiles, computers, such as automobiles, computers, clothing and machinery.clothing and machinery.

Mineral productsMineral products (e.g., petroleum, coal, copper) and (e.g., petroleum, coal, copper) and agricultural productsagricultural products are a relatively small part of trade. are a relatively small part of trade.

Services Services such as shipping, insurance, legal fees, such as shipping, insurance, legal fees, banking services and spending by tourists account for banking services and spending by tourists account for 20% of the volume of trade.20% of the volume of trade.

The Composition of World Trade - 2005The Composition of World Trade - 2005

Changing Composition of TradeChanging Composition of Trade

Developing countries have also changed the composition Developing countries have also changed the composition of their trade.of their trade.

– In 1960, about 58% of exports of developing countries In 1960, about 58% of exports of developing countries were agricultural products and only 12% of exports were agricultural products and only 12% of exports were manufactured products.were manufactured products.

– In 2001, about 65% of exports of developing countries In 2001, about 65% of exports of developing countries were manufactured products, and only 10% of were manufactured products, and only 10% of exports were agricultural products.exports were agricultural products.

Changing Composition of TradeChanging Composition of Trade

Multinational CorporationsMultinational Corporations

Before 1945, multinational corporations played a Before 1945, multinational corporations played a small role in world trade. small role in world trade.

Today about one third of all US exports and 42% Today about one third of all US exports and 42% of all US imports are sales from one division of a of all US imports are sales from one division of a multinational corporation to another.multinational corporation to another.

International product fragmentation has become International product fragmentation has become increasingly popular. increasingly popular.

OutsourcingOutsourcing

OutsourcingOutsourcing occurs when a firm moves business occurs when a firm moves business operations out of the domestic country.operations out of the domestic country.

– The operations could be run by a subsidiary The operations could be run by a subsidiary of a multinational corporation.of a multinational corporation.

– Or they could be subcontracted to a foreign Or they could be subcontracted to a foreign firm. firm.

Outsourcing of either type increases the amount Outsourcing of either type increases the amount of trade.of trade.