Chapter 2

World Trade:
An Overview

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 Learning Goals

• Describe how the value of trade between any two countries

depends on the size of these countries’ economies and explain the
reasons for that relationship.
• Discuss how distance and borders reduce trade.
• Describe how the share of international production that is traded
has fluctuated over time and why there have been two ages of
globalization.
• Explain how the mix of goods and services that are traded
internationally has changed over time.

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 Preview

• Largest trading partners of the United States

• Gravity model:
– influence of an economy’s size on trade
– Distance, barriers, borders and other trade impediments

• Globalization: then and now

• Changing composition of trade
• Service outsourcing

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 Who Trades with Whom?

• More than 30% of world output is sold across

national borders.
• The 5 largest trading partners with the U.S. in
2012 were Canada, China, Mexico, Japan, and
Germany.
• The largest 15 trading partners with the
U.S. accounted for 69% of the value of U.S.
trade in 2012.

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 Fig. 2-1: Total U.S. Trade with Major
Partners, 2012

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 Size Matters: The Gravity Model

• 3 of the top 10 trading partners with the U.S.

in 2012 were also the 3 largest European
economies: Germany, the United Kingdom, and
France.
• Why does the United States trade more with these
European countries than with others?
– These countries have the largest gross domestic product
(GDP), the value of goods and services
produced in an economy, in Europe.
– Each European country’s share of U.S. trade with Europe is
roughly equal to its share of European GDP.

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 Fig. 2-2: The Size of European Economies,
and the Value of Their Trade with the United
States

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 Size Matters: The Gravity Model
(cont.)

• 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 they are able to
buy more imports.

• Trade between any two countries is larger,

the larger is either country.

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 Size Matters: The Gravity Model
(cont.)

• The gravity model assumes that size and distance

are important for trade in the following way:
Tij = A x Yi x Yj /Dij
where
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
• Or more generally
Tij = A x Yia x Yjb /Dijc
where a, b, and c are allowed to differ from 1.

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 Using the Gravity Model: Looking
for Anomalies

• A gravity model fits the data on U.S. trade

with European countries well but not
perfectly.
• The Netherlands, Belgium and Ireland trade
much more with the United States than
predicted by a gravity model.
– Ireland has strong cultural affinity due to
common language and history of migration.
– The Netherlands and Belgium have transport cost
advantages due to their location.

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 Impediments to Trade: Distance,
Barriers, and Borders
Other things besides size matter for trade:
1. Distance between markets influences transportation costs
and therefore the cost of imports and exports.
2. Cultural affinity: close cultural ties, such as a common
language, usually lead to strong economic ties.
3. 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, often different currencies need to be exchanged, and
perhaps monetary costs like tariffs reduce trade.

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 Impediments to Trade: Distance,
Barriers, and Borders (cont.)
• 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%.
• 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.

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 Impediments to Trade: Distance,
Barriers, 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.
– Canada’s economy is roughly the same size as Spain’s
(around 10% of EU GDP) but Canada trades as much with
the United States as does all of Europe.

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 Fig. 2-3: Economic Size and Trade
with the United States

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 Impediments to Trade: Distance,
Barriers, 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.
• Data shows that there is much more trade between
pairs of Canadian provinces than between Canadian
provinces and U.S. states, even when holding
distance constant.
• Estimates indicate that the U.S.-Canadian border
deters trade as much as if the countries were
1,500-2,500 miles apart.

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 Fig. 2-4: Canadian Provinces and U.S. States
that Trade with British Columbia

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 Table 2-1: Trade with British
Columbia, as Percent of GDP, 2009

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 The Changing Pattern of World Trade:
Has the World Gotten Smaller?

• The negative effect of distance on trade according

to the gravity models is significant, but has grown
smaller over time due to modern transportation and
communication.
• Technologies that have increased trade:
– Wheels, sails, compasses, railroads, telegraph, steam
power, automobiles, telephones, airplanes, computers, fax
machines, Internet, fiber optics, personal digital assistants,
GPS satellites…

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 The Changing Pattern of World Trade:
Has the World Gotten Smaller? (cont.)

• Political factors, such as wars, can change trade patterns

much more than innovations in transportation and
communication.
• World trade grew rapidly from 1870 to 1913.
– Then it suffered a sharp decline due to the two world wars and
the Great Depression.
– It started to recover around 1945 but did not recover fully until
around 1970.

• Since 1970, world trade as a fraction of world GDP has

achieved unprecedented heights.
– Vertical disintegration of production has contributed to the rise in
the value of world trade through extensive cross-shipping of
components.

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 Fig. 2-5: The Fall and Rise of World
Trade

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 What Do We Trade?

• What kinds of products do nations trade now, and

how does this composition compare to trade in the
past?
• Today, most (about 53%) of the volume of trade is
in manufactured products such as automobiles,
computers, and clothing.
– Services such as shipping, insurance, legal fees, and
spending by tourists account for about 20% of the volume
of trade.
– Mineral products (ex., petroleum, coal, copper) remain an
important part of world trade at 19%
– Agricultural products are a relatively small (8%) part of
trade.

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 Fig. 2-6: The Composition of World
Trade, 2011

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 What Do We 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.

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 Table 2-2: Manufactured Goods as a
Percent of Merchandise Trade

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 What Do We 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.

• More than 90 percent of the exports of China, the

largest developing country and a rapidly growing
force in world trade, consist of manufactured goods.

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 Fig. 2-7: The Changing Composition of
Developing-Country Exports

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 Service Outsourcing

• Service outsourcing (or offshoring)

occurs when a firm that provides services
moves its operations to a foreign location.
– Service outsourcing can occur for services that
can be transmitted electronically.
• A firm may move its customer service centers whose
telephone calls can be transmitted electronically to a
foreign location.

– Other services may not lend themselves to being

performed remotely.

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 Service Outsourcing (cont.)

• Service outsourcing is currently not a

significant part of trade.
– Some jobs are “tradable” and thus have the
potential to be outsourced.
– Most jobs (about 60%) need to be done close to
the customer, making them nontradable.

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 Fig. 2-8: Tradable Industries’ Share of
Employment

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 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.

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 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.

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