International Economics

1. International Economics University of Helsinki September 22nd – October 17th, 2008

2. Practicalities Lecturer:Matti Sarvimäki matti.sarvimaki@vatt.fi / (09) 703 2953 Lectures:Mondays 14-16, Wednesdays 14-16 Fridays 10-12 at Economicum Exam: 27.10.2008 at 8 - 10 ECO, lecture room Retake: 24.11.2008 at 8 - 10 ECO, lecture room

3. Requirements • Lectures • Krugman (1993): What Do Undergrads Need to Know About Trade? The American Economic Review 83(2): 23–26 (available from JSTOR) • There are two textbooks that are likely to be helpful (one by Krugman & Obstfeld another by Appleyard & Field). Both are called International Economics. The course covers most of the first half of the books (trade theory and policy) and the books cover most of the material I will present during the lectures

4. Outline The course • Basic Trade Models • Introduction to Trade Policy • Further Topics This lecture: Introduction • Stylised facts • What models do • Mercantilism and Adam Smith • (introduction to comparative advantage)

5. World Trade 1820-1992 World Exports/GDP (in 1990 constant dollars, percent) Source: Rodrik (2000), original data from Maddison (1995)

6. Real GDP per capita (population weighted averages, 1950-2000) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

7. World Inequality 1820-1992 (mean logarithmic deviation) Source: Bourguignon & Morrisson (2002). See also Human Developments Trends in http://www.gapminder.org/, in particular slides 1/15 and 2/11.

8. Change in the U.S. Real Wages(per percentile between 1970 and 2002 ) Change in real wages 1970–2002 Percentile Source: Smith (2006)

9. Openness to Trade, GDP per capita and population (2000) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

10. Openness to Trade, GDP per capita and population (2000) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

11. Openness to Trade and GDP per capita over time (Finland, 1950-2000) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

12. Openness to Trade and GDP per capita over time (Selected countries, 1950-2000)

13. Changes in Openness to Trade and changes in GDP per capita (1950/60 - 1990/00) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

14. Changes in Openness to Trade and GDP per capita (1950/60 - 1990/00) Source: Calculations from Penn World Table, data available at http://pwt.econ.upenn.edu/

15. Leading Merchandise Traders (2004, excluding intra-EU trade) Billions of dollars, Source: WTO http://www.wto.org/english/res_e/statis_e/its2005_e/section1_e/i06.xls

16. Structure of Trade (Finland, 2000) Billons of dollars, Source: Calculations from the NBER-United Nations Trade Data. Data available at http://cid.econ.ucdavis.edu/. Stata code available by request (from me). In 2000, Finland’s GDP was about 130 billion dollars.

17. Finland’s Top 6 Trading Partners, 2000 Billons of dollars, NBER-United Nations Trade Data

18. Structure of Bilateral Trade (Finland, 2000) Billons of dollars, NBER-United Nations Trade Data

19. Structure of Trade (Finland 1962, 1989, 2000)

20. Economic Theory / Models “. . . just talking plausibly about economics is not the same as having a real understanding; for that you need crisp, tightly argued models.” Paul Krugman (1996) “[Models] reduce a complex problem to a few essentials and illustrate the relationships between them. A good model is one which is wide in scope and unexpected in implications.” John Kay (2003) “…The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.” John Maynard Keynes (1936)

21. Economic Models as Simplifications • The point of economic models is to simplify the complex reality in order to understand it. A good model is such that • it is easy to understand (simple) • it increases the understanding of reality • Mathematics is the language of economics. The point is to be consistent and to make assumptions transparent. In this course we use geometry to make the math more intuitive • Gibbard & Varian (1978) describe models as “caricatures”, “approximations”, “stories with a specific structure” etc. Models typically ask “what would happen if this and this was the case?” and exaggerate to make a point

22. Example: London

23. A model of London

24. Another model of London

25. Economic Models as Imitations “[…] a "theory" is not a collection of assertions about the behavior of the actual economy but rather an explicit set of instructions for building a parallel or analogue system […] A "good" model, from this point of view, will not be exactly more "real" than a poor one, but will provide better imitations. Of course, what one means by a "better imitation" will depend on the particular questions to which one wishes answers.” Lucas (1980) • For an example of this kind of model in trade contest, visit www.gtap.agecon.purdue.edu • However, in this course we will concentrate on models that are best described as caricatures.

26. International Economics • 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. • In this course we will concentrate on the former. HSE provides a similar course that concentrates on the latter. • The study of international trade can be extended to study international capital, labour flows and diffusion of technology

27. 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…

28. Mercantilism • 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” For short discussion, see Appleyard & Field (chapter 2). If you’re more interested, see Landreth & Colander (2002)

29. 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

30. Mercantilist Policy Recommendations International • Tariffs & Quotas on imports • Subsidies on exports • Exclusive trading rights • Government control on exchange of precious metals Domestic • Regulating production (exclusive product charters, tax exemptions, subsidies, special privileges…) • Regulating labour (crafts guilds, low wages, subsidies for children, financial incentives for marriage…)

31. 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)

32. 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

33. Labour theory of value • The amount of labourrequired to produce a good determinesits’ 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

34. Smith on Trade: Absolute Advantage

35. 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

36. 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

37. 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)