International Economics - Krugman

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Chapter 2 THE GRAVITY MODEL Suggest the trade between any two countries is proportional to the size of the countries (product of their GDP’s) and diminished with distance between the countries. 3 of the top 10 trading partners with the U.S. in 2005 were also the 3 largest European economies: Germany, UK, and France. These countries have the largest gross domestic product (GDP) in Europe. * GDP measures the value of goods and services produced in an economy. In fact, the size of an economy is 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 goods and services sold, so people are able to buy more imports. Tij = A x Yi x Yj /Dij Tij is the value of trade between country i and country j A is a constant Yi the GDP of country i Yj is the GDP of country j Dij is the distance between country i and country j In a slightly more general form, the gravity model that is commonly estimated is Tij = A x Yia x Yjb /Dijc where a, b, and c are allowed to differ from 1. DISTANCE, BARRIERS AND BORDERS All estimated gravity models show a strong negative effect of distance on international trade. Typical estimates say that a 1% increase in the distance between two countries is associated with a fall of 0.7 to 1% in trade between those countries. This drop partly reflects increased costs of transporting goods and services. Trade agreements (NAFTA), ensures that the most goods shipped among the partner countries are not subject to tariffs and barriers. If the FTA is effective it should lead to significantly more trade among its partners than one would otherwise predict given their GDPs and distances from one another. Besides distance, borders increase the cost and time needed to trade. The negative effect of distance on trade according to the gravity models is significant, but it has grown smaller over time due to modern transportation and communication. But history has shown that political factors, such as wars, can change trade patterns much more than innovations in transportation and communication. There were two waves of globalization. - 1840–1914: economies relied on steam power, railroads, telegraph, telephones; Globalization was interrupted and reversed by wars and depression.


- 1945–present: economies rely on telephones, airplanes, computers, internet, fiber optics, PDAs, GPS satellites… Today, most of the volume of trade is in manufactured products such as automobiles, computers, clothing and machinery. Services such as shipping, insurance, legal fees, and spending by tourists account for 20% of the volume of trade. Mineral products (ex., petroleum, coal, copper) and agricultural products are a relatively small part of trade. Low and middle-income countries have also changed the composition of their trade by switching from agriculture to manufacturing. * Service outsourcing occurs when a firm that provides services moves its operations to a foreign location. Service outsourcing can occur for services that can be performed and transmitted electronically (a firm may move its customer service centers whose telephone calls can be transmitted electronically to foreign location) Other things besides size matter for trade: 1. Distance between markets influences transportation costs and therefore the cost of imports and exports. 3. Cultural affinity: if two countries have cultural ties, it is likely that they also have strong economic ties. 4. Geography: ocean harbors and a lack of mountain barriers make transportation and trade easier. 4. Multinational corporations: corporations spread across different nations import and export many goods between their divisions. 5. Borders: crossing borders involves formalities that take time and perhaps monetary costs like tariffs. (the existence of different languages (see 2) or different currencies,...
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