Chapter 2

World Trade:

An Overview

Preview

• The largest trading partners of the U.S.

• Gravity model:

 influence of an economy’s size on trade

 distance and other factors that influence trade

• Borders and trade agreements

• Globalization: then and now

• Changing composition of trade

• Service outsourcing Who Trades with Whom?

• The 5 largest trading partners with the

U.S. in 2005 were Canada, China,

Mexico Japan and Germany.

• The total value imports from and exports

to Canada in 2005 was about $500

billion dollars.

• The largest 10 trading partners with the

U.S. accounted for 56% of the value of

U.S. trade in 2005.

Fig. 2-1: Total U.S. Trade with Major

Partners, 2006

Source: U.S. Department of Commerce Size Matters: The Gravity Model

• 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.

• Why does the U.S. trade most with these European

countries and not other European countries?

Size Matters: The Gravity Model (cont.)

• 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.

Fig. 2-2: The Size of European Economies, and

the Value of Their Trade with the United States

Source: U.S. Department of Commerce, European Commission The Gravity Model

Other things besides size matter for trade:

1. Distance between markets influences transportation

costs and therefore the cost of imports and exports.

 Distance may also influence personal contact and

communication, which may influence trade.

2. Cultural affinity: if two countries have cultural ties, it

is likely that they also have strong economic ties.

3. Geography: ocean harbors and a lack of mountain

barriers make transportation and trade easier.

The Gravity Model (cont.)

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.

 These implicit and explicit costs reduce trade.

 The existence of borders may also indicate the existence of

different languages (see 2) or different currencies, either of which may impede trade more.

The Gravity Model (cont.)

• In its basic form, the gravity model assumes that only

size and distance are important for trade in the

following way:

T = A x Y x Y /D ij i j ij

• where

T is the value of trade between country i and country j ij

A is a constant

Y the GDP of country i i

Y is the GDP of country j j

D is the distance between country i and country j ij The Gravity Model (cont.)

• In a slightly more general form, the gravity model that

is commonly estimated is

T a b c = A x Y x Y /D

ij i j ij

where a, b, and c are allowed to differ from 1.

• Perhaps surprisingly, the gravity model works fairly

well in predicting actual trade flows, as the figure

above representing U.S.–EU trade flows suggested. Distance and Borders

• Estimates of the effect of distance from the

gravity model predict that a 1% increase in

the distance between countries is associated

with a decrease in the volume of trade of

0.7% to 1%.

Distance and Borders (cont.)

• Besides distance, borders increase the cost and time

needed to trade.

• Trade agreements between countries are intended to

reduce the formalities and tariffs needed to cross

borders, and therefore to increase trade.

• The gravity model can assess the effect of trade

agreements on trade: does a trade agreement lead to

significantly more trade among its partners than one

would otherwise predict given their GDPs and

distances from one another?

Distance and Borders (cont.)

• The U.S. signed a free trade agreement with

Mexico and Canada in 1994, the North

American Free Trade Agreement (NAFTA).

• Because of NAFTA and because Mexico

and Canada are close to the U.S., the

amount of trade between the U.S. and its

northern and southern neighbors as a fraction

of GDP is larger than between the U.S. and

European countries.

Fig. 2-3: Economic Size and Trade

with the United States

Source: U.S. Deparment of Commerce, European Commission Distance and Borders (cont.)

• Yet even with a free trade agreement between

the U.S. and Canada, which use a common

language, the border between these countries

still seems to be associated with a reduction

in trade.

Fig. 2-4: Canadian Provinces and U.S.

States That Trade with British Columbia

Table 2-3: Trade with British Columbia, as

Percent of GDP, 1996

Has the World Become “Smaller”?

• 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.

 Wheels, sails, compasses, railroads, telegraph, steam

power, automobiles, telephones, airplanes, computers, fax machines, internet, fiber optics, personal digital assistants, GPS satellites… are technologies that have increased trade.

• But history has shown that political factors, such as

wars, can change trade patterns much more than

innovations in transportation and communication.

Has the World Become “Smaller”? (cont.)

• 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…

Has the World Become “Smaller”? (cont.)

• Only in the last few decades has international

trade become more important to the British

economy than it was in 1910.

• Even today, international trade is less

important for the U.S. than it was to the UK

before 1910.

Fig. 2-5: The Rise, Fall, and Rise of

International 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). Changing Composition of Trade

• What kinds of products do nations currently trade,

and how does this composition compare to trade in

the past?

• 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. Fig. 2-6: The Composition of World

Trade, 2005

Source: World Trade Organization Changing Composition of Trade (cont.)

• In the past, a large fraction of the volume of trade

came from agricultural and mineral products.

 In 1910, Britain mainly imported agricultural and mineral

products, although manufactured products still represented most of the volume of exports.

 In 1910, the U.S. mainly imported and exported agricultural

products and mineral products.

 In 2002, manufactured products made up most of the volume

of imports and exports for both countries.

Table 2-4: Manufactured Goods as a

Percent of Merchandise Trade

Changing Composition of Trade (cont.)

• Low and middle-income countries have also

changed the composition of their trade.

 In 2001, about 65% of exports from low and

middle-income countries were manufactured products, and only 10% of exports were agricultural products.

 In 1960, about 58% of exports from low and

middle-income countries were agricultural products and only 12% of exports were manufactured products.

Fig. 2-7: The Changing Composition of

Developing-Country Exports

Source: United Nations Council on Trade and Development Service Outsourcing (cont.)

• 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.

• For example, a firm may move its customer

service centers whose telephone calls can be transmitted electronically to foreign location.

Service Outsourcing (cont.)

• Service outsourcing is currently not a

significant part of trade, but about 19% of

service jobs are “tradeable” and thus have the

potential to be outsourced.

 In comparison, about 12% of manufacturing jobs

are “tradeable” and thus have the potential to be outsourced.

 Most jobs, however, are non-tradeable because

they need to be done close to the customer.

Fig. 2-8: Tradable Industries’ Share of

Employment

Source: J. Bradford Jensen and Lori G. Kletzer, “Tradable Services: Understanding the Scope and Impact of

Services Outsourcing,” Peterson Institute of Economics Working Paper 5-09, May 2005

Summary

1. The 5 largest trading partners with the U.S.

are Canada, China, Mexico, Japan, and Germany.

2. The largest economies in the EU undertake

the largest fraction of the total trade between the EU and the U.S.

3. The gravity model predicts that the volume of

trade is directly related to the GDP of each trading partner and is inversely related to the distance between them.

Summary (cont.)

4. Besides size and distance; culture, geography,

multinational corporations, and the existence of borders influence trade.

5. Modern transportation and communication have

increased trade, but political factors have influenced trade more in history.

6. Today, most trade is in manufactured goods, while

historically agricultural and mineral products made up most of trade.

Additional Chapter Art

Table 2-1 Hypothetical World Spending

Shares and GDP

Table 2-2 Values of Exports ($ trillion)