UNIT 18
THE NATION AND THE WORLD
ECONOMY
HOW THE INTEGRATION OF NATIONAL ECONOMIES
INTO A GLOBAL SYSTEM OF TRADE AND INVESTMENT
PROVIDES OPPORTUNITIES FOR MUTUAL GAINS AND
CONFLICTS OVER THE DISTRIBUTION OF THE GAINS
• Globalization is a term referring to the integration of the world’s
markets in goods and services, as well as flows of investment and people
across national boundaries.
• Globalization has led to the prices of goods converging across countries,
but much less so of wages.
• Nations tend to specialize in the production of the goods and services in
which they are relatively low-cost producers, for example because of
economies of scale, an abundance of the relevant resources or skills, or
public policies.
• This specialization allows for mutual gains for the people of trading
countries.
• Increased trade and specialization may benefit some groups within a
country while harming others, for example, those producing goods that
compete with imports.
• When evaluating government policy and international agreements, we
may look at whether they fully exploit the mutual gains made possible,
distribute those gains fairly, and reduce the economic insecurities
involved in the globalization process.
In December 1899, the steamship Manila docked in Genoa, Italy, and
offloaded her cargo of grain grown in India. The Suez Canal had opened
30 years earlier, slashing the cost of moving agricultural commodities from
south Asia to European markets. Italian bakers and shoppers were delighted
at the low prices. Italian farmers were not. After a couple of months in
Genoa, the Manila headed west. She carried 69 people in steerage (the
cheapest possible passage), who were abandoning their homeland in search
of a livelihood in the US.
Container ship CSCL Venus of the China Shipping Line
795
tariff A tax on a good imported
into a country.
globalization A process by which the economies of the world
become increasingly integrated by the freer flow across
national boundaries of goods, investment, finance, and to a
lesser extent, labour. The term is sometimes applied more
broadly to include ideas, culture, and even the spread of
epidemic diseases.
offshoring The relocation of part of a firm’s activities outside of
the national boundaries in which it operates. It can take place
within a multinational company or may involve outsourcing
production to other firms.
The low prices were made possible by a revolution in transportation and
farming technology. As with the opening of the Suez Canal, the expansion
of the railway system to the fields of North America, the Russian plain and
northern India, and the development of steam-powered ships like the
Manila, had cut the cost of transporting grain to distant markets. Across the
vast plains of the American midwest, new strains of wheat, newly developed
reapers and sowers, and improved drainage technologies had created a hi-
tech, capital-intensive form of farming that was as productive as anywhere
in the world.
Across Europe, parliaments and state bodies struggled to adjust to the
grain price shock. In France and Germany, farmers and their advocates
prevailed. Despite the benefits of lower grain prices to families, and despite
the protests of workers who consumed the grain, governments imposed
tariffs to protect the incomes of farmers.
Denmark, among other countries, responded differently. Instead of pro-
tecting grain farmers from cheap imports, the government helped them to
start dairy farming instead. Using cheap imported grain as an input, farmers
responded to the incentives to produce milk, cheese, and other commodities
that could not be transported cheaply over long distances. In turn, cheaper
grain meant families could increase spending on these dairy products.
In Italy, the children of some farmers took up jobs in the booming textile
industry, which was exporting to the rest of the world. Many bankrupted
farmers made the trip to the US. They slept on the decks of empty
freighters that were returning to the US to pick up grain for Europe. About
750,000 Europeans made this voyage each year during the decade after the
Manila’s visit to Genoa. Some of their grandchildren would end up as
American farmers, growing grain in Kansas.
There were big winners and big losers from the grain price shock. Many
of the changes made economic sense. For example, the world’s grain was
now grown increasingly in places where it could be produced most effi-
ciently. But tariffs designed to protect the farmers of Germany and France
held back this reallocation, preventing owners and workers in other sectors
of the economy from enjoying lower grain prices. This continues to this
day—rich countries still commonly protect their agricultural sectors
through subsidies.
The battle line was not between rich and poor,
or landlords and tenants, or employers and
employees. The conflict was between the
producers of different commodities. Those
involved in manufacturing welcomed the
expansion of trade with the US, while those
farming grain did not.
Globalization is the word commonly used to
describe our increasingly interconnected world.
This term refers not only to the trade in grain and
migration across national borders illustrated by
the Manila, but also to non-economic aspects of
international integration, such as the International
Criminal Court (https://tinyco.re/2116436), the
flow of ideas across borders, or our increasingly similar taste in music.
In Unit 6, we looked at firms like Apple that choose to produce their
goods in other parts of the world where costs are lower. This offshoring is
an important dimension of globalization, and it can involve outsourcing
In the European Union, the
Common Agricultural Policy seeks
to protect the agricultural sector
for member countries. In the US,
the most recent legislation
supporting the sector is The
Agricultural Act of 2014, known as
‘The Farm Bill’.
UNIT 18 THE NATION AND THE WORLD ECONOMY
796
production to other companies, or it can take place within the boundaries
of a multinational company. For example, Figure 18.1 shows that the Ford
Motor Company operates offices or plants in 22 economies outside the US.
The company started offshoring a year after it was founded, first in Canada
in 1904, and began manufacturing in many other economies soon after-
wards, for example in Australia (1925) and even the Soviet Union (1930). In
2016 this ‘American’ company had 201,000 employees, 144,000 of them
located outside the US.
In the case of a multinational company, owners, managers and employees
in many economies have become part of the same unified, transnational struc-
ture. This is because the costs of doing business within the company are lower
than the costs of doing business with other companies. But, as we saw with
the cotton market in Units 8 and 11, globalization not only involves the integ-
ration of firms in different economies; it involves the integration of markets
themselves, bringing sellers and buyers in different economies closer together.
You have already learned the basic concepts that you need to understand
the global economy:
• Exchange involves the possibility of mutual gains and also conflicts over
how these gains will be distributed.
• The resulting outcomes may not be Pareto efficient (there may be
technically feasible mutual gains that remain unrealized).
• The resulting distribution may seem unfair in the eyes of many.
• Well-designed government policies can improve the efficiency or
fairness of the outcomes.
While this is true of any set of market exchanges, when goods, services,
people, and financial assets cross national boundaries, governments have
additional powers and policies that include:
• Imposition of tariffs: These are taxes on imports that effectively
discriminate against goods produced in other countries.
• Immigration policies: Governments regulate the movement of people
between nations in a way that would not be possible (or acceptable)
within most nations.
0
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20,000
30,000
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Figure 18.1 Ford employees across the world in 2014.
View this data at OWiD https://tinyco.re/
7261874
Ford Motor Company.
UNIT 18 THE NATION AND THE WORLD ECONOMY
797
merchandise trade Trade in
tangible products that are
physically shipped across borders.
• Capital controls: Limits on the ability of individuals or firms to transfer
financial assets among countries.
• Monetary policies: They affect the exchange rate, and so alter the relative
prices of imported and exported goods.
While national boundaries give governments additional policy tools, they
also limit the reach of governments. Within a nation, governments
generally succeed in protecting private property rights where these exist,
and in enforcing contracts. Because there is no world government (and
international agencies are often weak), enforcing contracts and protecting
property rights globally is sometimes impossible.
This raises controversial questions about the fairness of the distribution
of mutual gains from exchange. The conflicting interests sometimes
coincide with national differences between poorer and richer economies. It
is tempting, though often inaccurate as we will see, to consider these
conflicts as ‘us’ at home versus ‘them’ abroad.
In this unit, we will consider three markets that became more integrated
with globalization: international markets for goods and services (trade),
international labour markets (migration), and international capital markets
(international capital flows, which are flows of savings and investment).
18.1 GLOBALIZATION AND DEGLOBALIZATION IN THE
LONG RUN
The trade in goods, sometimes called merchandise trade, concerns tangible
products that are physically shipped across borders by road, rail, water, or air.
Trade of this sort has been happening for millennia, although the nature of
the goods traded, and the distances over which they have been shipped, have
changed dramatically. Trade in services is a more recent phenomenon,
although it has also been occurring for centuries. Services that are commonly
traded across borders are tourism, financial services, and legal advice. Many
traded services make merchandise trade easier or cheaper—for example,
shipping services, or insurance and financial services.
The UK became the leading provider of these services during the
nineteenth century, when it was the most advanced industrial economy, the
major naval and imperial power, and the most important trading nation.
Nowadays, countries also export educational services (for example, people
travel from all over the world to study in US or European universities),
consulting services, and medical services. India has become a major
exporter of software-related services. For example, the ebook for the CORE
project was initially developed in Bangalore. We will study these service
exports together with merchandise trade, since the same principles can help
us to understand them.
How can we measure the extent of globalization in goods and services?
One approach would simply be to measure the amount of trade in a country
or region, or the world as a whole, over time. If it increased, we conclude
that the country, region or the whole world was becoming more globalized.
It is common to measure trends in the share of imports, exports, or total
trade (imports plus exports) in GDP as an indicator of globalization, so as to
take account of the growth of GDP as well as trade.
Figure 18.2 shows world merchandise exports (which excludes services),
expressed as a share of world GDP, between 1820 and 2020. The share rose
by a factor of 8 between 1820 and 1913, from 1% to 8%. In 1950, the share
was lower (5.5%) but recovered rapidly during the prosperous postwar
UNIT 18 THE NATION AND THE WORLD ECONOMY
798
law of one price Holds when a
good is traded at the same price
across all buyers and sellers. If a
good were sold at different prices
in different places, a trader could
buy it cheaply in one place and sell
it at a higher price in another. See
also: arbitrage.
price gap A difference in the price
of a good in the exporting country
and the importing country. It
includes transportation costs and
trade taxes. When global markets
are in competitive equilibrium,
these differences will be entirely
due to trade costs. See also:
arbitrage.
period. It reached 10.5% in 1973, 17% in 1998, and 26% in 2011. In the long
run, the trend has overall been upwards, with a sharp acceleration between
the 1990s and 2010. However, this trend was interrupted between 1914 and
1945, which included two world wars and the Great Depression.
A second method is to measure the additional costs associated with
exporting goods relative to selling them domestically. When the costs of
trading between countries fall, then in economic terms, the world has shrunk.
It is as if countries were closer. In Unit 8, you learned about Alfred Marshall
and his model of supply and demand. We saw that the law of one price holds
in markets with many potential buyers and sellers, where all goods are
identical and where buyers and sellers are aware of all trading opportunities.
But this assumes that it is costless to take advantage of those trading
opportunities. If, on the other hand, trading between markets in two coun-
tries is costly because of transport costs, trade barriers, or other factors, then
there is no reason to suppose that prices will be the same in both.
Consider the market for a good that is produced in (and exported from)
one country and consumed in (and imported into) another. Let’s use the
example of Japan exporting cars to the US. To keep the analysis straight-
forward, imagine that these are the two only countries in the world, that the
Japanese do not consume cars, and that the US does not produce any cars
itself. This means that everything that is produced is traded. The blue line
in Figure 18.3 represents the supply curve in Japan: it is an upward-sloping
function of the price in Japan. The red line represents the demand curve in
the US. It is a downward-sloping function of the price in that country.
Let t be the cost of shipping a car from Japan to the US, including all
transportation costs, trade taxes and so on. If the market is competitive,
then the total cost of obtaining a car in the US will be the cost of buying it
in Japan, plus the trade cost t. t is a measure of the price gap between cars
in Japan and cars in the US. Follow the analysis in Figure 18.3 to see how
changes in trade costs are reflected in price gaps.
• In the right circumstances, globalization can benefit both exporting
producers and importing consumers.
• It does so by bringing them closer together, and it leads to an increase in
both the supply of exports and the demand for imports.
1861
Cotton blockade
1899
Manila docking
1918
End of WWI
First Ford plants opened abroad
(1926 in Australia)
(1930 in Soviet Union)
(1931 in Japan and Germany)
1929
Start of Great
Depression
1945
End of WWII
1950–60
Decolonization
1978
Reforms in
China
1990
Collapse of Soviet
Union
2002
Apple
outsources
production
to China
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Figure 18.2 World merchandise exports as a share of world GDP (1820–2020).
(1) Appendix I in Angus Maddison.
1995. Monitoring the World Economy,
1820–1992. Washington, DC:
Development Centre of the
Organization for Economic Co-operation
and Development; (2) Table F-5 in Angus
Maddison. 2001. The World Economy: A
Millennial Perspective (Development
Centre Studies). Paris: Organization for
Economic Co-operation and
Development; (3) World Trade
Organization. 2013. World Trade Report
(https://tinyco.re/2912108). Geneva:
WTO; (4) International Monetary Fund.
2014. (5) World Bank Database 2021; (6)
UNCTAD Merchandise: Total trade and
share, annual. 2021.
18.1 GLOBALIZATION AND DEGLOBALIZATION IN THE LONG RUN
799
arbitrage The practice of buying a
good at a low price in a market to
sell it at a higher price in another.
Traders engaging in arbitrage take
advantage of the price difference
for the same good between two
countries or regions. As long as the
trade costs are lower than the price
gap, they make a profit. See also:
price gap.
The concept of arbitrage explains why the price gap should tend to equal
the sum of all trade costs. By buying at a low price in export markets and
selling at a higher price in import markets, traders can make a profit as long
as the price gap is higher than the total costs of trade. When traders engage
in arbitrage in this fashion, they lower the supply of the good in the export
market, driving up its price, and they increase the supply of the good in the
import market, lowering its price. Both of these effects cause the price gap
to decline. This should continue until price gaps have been driven down to
the trade cost, and further arbitrage is unprofitable. A high price gap
reflects a world in which trade is expensive and globalization is limited. A
low price gap, on the other hand, reflects a much more globalized world in
which trade is cheap.
This means we can learn about globalization from data on prices:
• Globalization should lead to falling import prices: But if we observe falling
import prices, this does not necessarily mean that globalization is
Pr
ic
e
0
10
Price at which good sells = 7.25
Price at which good sells = 6
Marginal cost of producing
amount traded = 4
Marginal cost of producing
amount traded = 2.75
0 4,000 6,000 15,000
Quantity
Price
gap = t
Price
gap = t’
The exporter’s
supply curve
The consumer’s
demand curve
Figure 18.3 The market for cars: Price gaps reflect trade costs.
1. The exporter’s supply curve
The blue line represents the supply
curve in the producing (exporting)
country, which is Japan. It is an upward-
sloping function of the price in that
country.
2. The consumer’s demand curve
The red line represents the demand
curve in the consuming (importing)
country, which is the US. It is a down-
ward-sloping function of the price in
that country.
3. A competitive market
If the market is competitive, then the
price of the car in the US will be the
cost of buying it in Japan, plus the trade
cost t. Let us assume that the cost of
shipping a unit of the good is 4.5. We
will show that 4,000 cars will be
produced.
4. Why 4,000?
Because at that quantity, the difference
between the supply curve and the
demand curve is equal to the trade
cost, 4.5. The marginal cost in Japan
will be 2.75, while the customers in the
US are willing to pay 7.25 per unit.
5. The effect of globalization
If we think of globalization as a
process, then a world that is becoming
more globalized is one in which trade
costs are falling. In the figure, this is
represented by a decline in trade costs
from t to t′.
6. The price gap declines
As can be seen, falling trade costs
imply a decline in the price gap
between the import price and the
export price, and an increase in the
number of cars traded from 4,000 to
6,000.
UNIT 18 THE NATION AND THE WORLD ECONOMY
800
occurring. The demand for the good in question may simply have
declined (or the supply may have increased).
• Globalization should also lead to rising export prices: But rising export
prices do not necessarily imply globalization. Demand for the good in
question may simply be rising (or the supply may have declined).
• Declining price gaps between importing and exporting countries are a much
surer sign of globalization: This is particularly true if we can also observe
rising trade volumes.
For example, Figure 18.4 shows unmistakable evidence of declining
transatlantic trade costs during the nineteenth century. The wheat price gap
between the UK and the US (expressed as a percentage) fluctuated wildly
before 1840 or so, around a roughly constant trend. It then started to
decline at about the same time that shipping costs started to fall, a result of
the introduction of steamships on long-distance routes. The price gap had
almost vanished by 1914. At the same time, the volume of wheat shipped
across the Atlantic rose dramatically.
The transatlantic trade in wheat is not an isolated example. International
price gaps fell sharply on many routes and for many commodities between
1815 and 1914, the first epoch of modern globalization.
Figure 18.5 gives ‘American-Anglo’ price gaps (the reverse of Figure
18.4) for a variety of commodities between 1870 and 1913. For agricultural
commodities such as wheat and animal products, British prices were higher
than American ones, so the price gaps are the percentage by which the
British price exceeded the American price. In the case of industrial
commodities such as cotton textiles or iron bars, American prices were
higher than British ones, so the price gaps quoted are the percentage by
which prices in Boston or Philadelphia exceeded prices in Manchester or
London. In nearly all cases price gaps fell (sugar is the outstanding
exception), indicating that transatlantic commodity markets were becoming
better integrated. Much like the dramatic reduction in grain prices in
Genoa after the opening of the Suez Canal, which we discussed in the
introduction to this unit, price gaps between the US and the UK reduced
over time because of a revolution in transportation and improvements in
farming and production technology. This is hardly an isolated example.
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Anglo-American wheat price gap (left axis) British imports of US wheat (right axis)
Figure 18.4 The Anglo-American wheat trade (1800–1914).
Figure 3 in Kevin H. O’Rourke and Jeffrey
G. Williamson. 2005. ‘From Malthus to
Ohlin: Trade, Industrialization and distri-
bution since 1500’. Journal of Economic
Growth 10 (1) (March): pp. 5–34.
18.1 GLOBALIZATION AND DEGLOBALIZATION IN THE LONG RUN
801
protectionist policy Measures
taken by a government to limit
trade; in particular, to reduce the
amount of imports in the economy.
These are designed to protect local
industries from external competi-
tion. They can take different forms,
such as taxes on imported goods or
import quotas.
quota A limit imposed by the gov-
ernment on the volume of imports
allowed to enter the economy
during a specific period of time.
There exists evidence of similar convergence for Liverpool-Bombay cotton,
London-Calcutta jute, and London-Rangoon rice prices.
Railways were probably even more important than steamships in
integrating global commodity markets. Without them, it would have been
prohibitively expensive to ship grain and other goods to and from the
interior of continents and coastal seaports. Where price gaps fell less
sharply during the late nineteenth century, this was often because of
tariffs—taxes on imports—which were rising in several countries for
reasons that we will discuss later, and which counteracted the effects of
declining transport costs.
Transatlantic shipments of wheat fell after 1914, and price gaps rose,
suggesting a rise in trade costs and therefore deglobalization. International
price gaps rose during the interwar period for many agricultural
commodities, because governments raised tariffs in response to unemploy-
ment and economic insecurity. When a country undertakes protectionist
policies, its government is taking steps to limit trade, in particular by
reducing the amount of imports coming into the economy. This is often
done to protect domestic industries against foreign competition (hence
protectionism), but it also means consumers have to pay more for imports.
Protectionist measures include taxes to raise the domestic price of imports
(a tariff) and quantitative restrictions on imports (a quota).
The post-1945 period was one of ‘reglobalization’, which began slowly
but then accelerated, especially after 1990. Agricultural markets were
largely protected for much of the period, and there is no reason to suppose
that international price gaps for agricultural commodities fell sharply. The
markets for industrial goods and components, on the other hand, were
liberalized, and several studies have found evidence of declining interna-
tional price gaps in the late twentieth century.
Economists have measured trade costs indirectly, by looking at trade
between pairs of countries. This shows the long-term changes in
impediments to trade, and can separate the effects of distance between the
countries from national policies of those countries. If trade between
Germany and France, for example, increased from one year to the next, but
it did not increase between these two countries and their other trading
Negative value means US
price lower than UK price
Positive value means US
price higher than UK price
−100
−75
−50
−25
0
25
50
75
100
Wheat Meat and
animal fats
Cotton
textiles
Iron bars Cotton Copper Sugar
Pr
ic
e
ga
p
(%
)
1870 1895 1913
Figure 18.5 Commodity price gaps between the US and UK (1870–1913).
Table 2 in Kevin O’Rourke and Jeffrey G.
Williamson. 1994. ‘Late Nineteenth-
Century Anglo-American Factor-Price
Convergence: Were Heckscher and
Ohlin Right?’ (https://tinyco.re/
9800043) The Journal of Economic
History 54 (04) (December): pp. 892–916.
UNIT 18 THE NATION AND THE WORLD ECONOMY
802
Globalization I and II Two separate
periods of increasing global eco-
nomic integration: the first
extended from before 1870 until
the outbreak of the First World War
in 1914, and the second extended
from the end of the Second World
War into the twenty-first century.
See also: globalization.
partners at the same time, we can interpret this as an indirect measure of
declining trade costs for this pair of countries.
If we sum total trade costs each year for all major economies, we have an
indicator of the process of globalization. Figures 18.6 and 18.7 do this for
the period 1870 to 2015.
Trade costs declined substantially from 1870 to 1913, reflecting
declining transport costs and reductions in tariffs. Trade costs then rose in
the interwar period because of rising tariffs. This was particularly the case
following the onset of the Great Depression in 1929: countries attempted to
solve unemployment problems by discouraging imports.
From 1970, trade costs started to fall worldwide again as countries
began to reliberalize trade, and transport technologies improved. Tariffs
tend to be higher in low-income countries than in rich countries, in part
because alternative methods of raising government revenue such as the
income tax are difficult to administer in developing countries. As Figure
18.7 shows, however, most countries have reduced their tariffs in recent
decades.
The price evidence therefore suggests interrupted commodity market
integration over the past 150 years. Nineteenth century integration was
briefly reversed, followed by reintegration after the Second World War. We
call these two periods of integration Globalization I and Globalization II.
EXERCISE 18.1 PRICE GAPS THAT DID AND DIDN’T FALL
Figure 18.5 (page 802) shows the price gap of different commodities
between the US and UK over time. Can you think of a reason why price
gaps for meat and animal fats such as butter did not start to fall until
1895? Propose an explanation for the smaller price gaps and the more
rapid fall for copper as compared with iron ore. What might account for
the increase in the price gap for sugar?
Globalization I
1918
End of WWI
1929
Start of
Great Depression
1945
End of WWII
Globalization II
0.50
0.60
0.70
0.80
0.90
1.00
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year
In
de
x
(1
87
0
=
1)
Figure 18.6 Impediments to trade (1870–2000).
David S. Jacks, Christopher M. Meissner,
and Dennis Novy. 2011. ‘Trade Booms,
Trade Busts, and Trade Costs’. Journal of
International Economics 83 (2) (March):
pp. 185–201. Note: Presented as an
index, with 1870 = 1.
18.1 GLOBALIZATION AND DEGLOBALIZATION IN THE LONG RUN
803
EXERCISE 18.2 LEARNING MORE ABOUT TARIFFS
Download the data set, ‘Tariff rate, applied, weighted
mean, all products, 1988–2017’, by going to the World
Bank website and clicking ‘EXCEL’ (listed under the
Download section on the right). This data was used to
produce Figure 18.7.
1. Choose one country from each income category
(high, low, lower middle, upper middle) and plot the
evolution of tariffs in these four countries. Use your
plots to describe how tariffs in your chosen countries
have changed over time.
2. Evidence from other studies suggests that on
average, tariffs tend to be higher in lower-income
countries than in high-income countries, but that
most countries have reduced tariffs substantially in
recent decades. Do your plots support this claim?
Suggest an explanation for some of the observed dif-
ferences between your chosen countries (if any). (As
a starting point you may want to consider your
chosen countries’ membership of global trade
agreements such as GATT/WTO (https://tinyco.re/
2336439) or the EU (https://tinyco.re/7856603), and
also whether the country has followed the structural
adjustment programs of the IMF (https://tinyco.re/
3029947)).
QUESTION 18.1 CHOOSE THE CORRECT ANSWER(S)
Figure 18.3 (page 800) depicts the supply curve in the exporting
country and the demand curve in the importing country in a market for
a traded good. Assume that the good is produced exclusively in the
exporting country and consumed exclusively in the importing country.
Based on this information, which of the following statements is
correct?
At quantity 4,000, the price received by the producers is 7.25.
At quantity 6,000, the price paid by the consumer is 4.
The price gap represents the trade costs, such as transportation
costs and trade taxes.
Increasing the quantity sold to 6,000 causes the price gap to fall to
2.
0
10
20
30
40
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Year
Av
er
ag
e
ta
ri
ff
ra
te
s
(%
)
Low and middle income (134 countries)
High income (30 countries)
Figure 18.7 Average tariff rates, per cent (1982–2015).
View this data at OWiD https://tinyco.re/
7347265
The World Bank. 2021. ‘Data on Trade
and Import Barriers’ (https://tinyco.re/
5486521). Note: 3-year centred moving
average.
UNIT 18 THE NATION AND THE WORLD ECONOMY
804
BALANCE OF PAYMENTS ACCOUNT (BP)
Records all payment transactions between the home country
and the rest of the world and is divided into two parts: the
current account and the capital and financial account.
If there is a current account surplus, this is a source of foreign
exchange and it is either used to purchase foreign assets such
as factories (FDI) or financial assets (recorded as a private net
capital outflow) or it adds to the home country’s official foreign
exchange reserves. As a consequence, the home country’s
wealth rises. The opposite is the case for a current account
deficit.
QUESTION 18.2 CHOOSE THE CORRECT ANSWER(S)
Figure 18.6 (page 803) is a graph of an index that represents trade
costs. A higher index represents higher trade costs and less
globalization. Based on this information, which of the following state-
ments are correct?
The graph suggests a consistent decline in trade costs since 1870.
Attempts by countries to address their unemployment problems
after the 1929 Great Depression seem to have led to a decline in
globalization.
There does not seem to be any evidence of increased globalization
after the Second World War.
The graph suggests that commodity market integration over the
past 150 years was one of interrupted integration.
18.2 GLOBALIZATION AND INVESTMENT
As in commodity markets, in international capital markets there is a similar
pattern of nineteenth century globalization, followed by a brief episode of
interwar deglobalization, and late twentieth century reglobalization.
If countries existed in isolation, they would have to finance their invest-
ment needs using their own savings. If this were the case, they could not
spend more than they earned in a year, and all their income would have to
be spent domestically. Domestic expenditure would have to equal domestic
income. In reality, we see lending and borrowing across borders, between
individuals, financial institutions, companies, and governments. To keep the
language simple, let’s talk about countries lending to or borrowing from
other countries, bearing in mind the fact that these countries are not actors
themselves but are made up of many individuals, companies, and institu-
tions. A country can spend more than it earns by borrowing from abroad.
Similarly a country can decide not to use its savings to finance domestic
investment, and instead lend it abroad and earn a return on these foreign
loans. In this case, its savings will exceed domestic investment, or
(equivalently) its income will be higher than its expenditure.
We use the balance of payments accounts to
track lending and borrowing abroad. We first
need to explain how lending and borrowing
abroad is related to international trade in goods
and services. This is because imports represent
payments from the domestic economy to the rest
of the world, while exports represent payments
from the rest of the world to the domestic eco-
nomy. The balance of payments records the
sources and uses of foreign exchange. If the
records of transactions were complete, the balance
would sum to zero because the source and use of
each dollar crossing an international border could
be accounted for (in reality, an entry called ‘errors
and omissions’ is added to the balance of
payments accounts to make it sum to zero).
To see how the balance of payments accounts
work, think first about an economy where the only international payments
are due to trade. If the home country imports more than it exports, then its
18.2 GLOBALIZATION AND INVESTMENT
805
foreign portfolio investment The acquisition of bonds or shares
in a foreign country where the holdings of the foreign assets
are not sufficiently great to give the owner substantial control
over the owned entity. Foreign direct investment (FDI), by
contrast, entails ownership and substantial control over the
owned assets. See also: foreign direct investment.
foreign direct investment (FDI) Ownership and substantial
control over assets in a foreign country. See also: foreign
portfolio investment.
remittances Money sent home by international migrant
workers to their families or others in the migrants’ home
country. In countries which either supply or receive large
numbers of migrant workers, this is an important international
capital flow.
CURRENT ACCOUNT (CA)
The sum of all payments made to a country minus all payments
made by the country.
Since the current account includes all international payments, it
also tells us directly whether a country is borrowing or lending:
• CA deficit: This means the country is borrowing—it has to
do so to cover the excess payments it is making to the rest
of the world.
• CA surplus: This means the country is lending (saving) to
allow other countries to send it the excess payments.
residents are making more international payments than they are receiving.
For example, a country buying a higher value of imports from the US than
it receives from selling its exports to the US needs to get hold of the US
dollars—by borrowing from the US or the rest of the world—to cover the
difference.
Conversely, if the home country is exporting more than it is importing,
then its nationals must be lending to their trading partners so they can pay
for the exports. These loans are a use of foreign exchange for the home
country, and a source of foreign exchange for its trade partners.
Thus a trade deficit will imply that the country is borrowing, while a
trade surplus implies it is lending (which is equivalent to saving, as we saw
in Unit 10).
There are other reasons that people in one
country make payments to people in another. The
most important is the purchase of assets in
another country. If a US company purchases
shares in a company in China, it is making a
payment for a Chinese asset. This implies a
payment from the US to China. This is a use of
foreign exchange called foreign portfolio invest-
ment. Similarly, if a US company purchases a
factory in China, this is a use of foreign exchange
called foreign direct investment (FDI).
In subsequent years, however, the US company
will receive dividends from its portfolio investment
or profits from its direct investment, which will be
sent back (‘repatriated’) to the US company. These
repatriated profits are payments from China to the
US. They are recorded in the US balance of
payments as a source of foreign exchange.
Other important international payments
include money sent home by migrant workers to their families (called
remittances) and official aid flows, mostly from the governments of rich to
poor countries.
All of these international payments are tracked
in the balance of payments accounts, and the net
value of these payments is called the current
account (CA)—so the CA is the sum of all
payments made to a country minus all payments
made by the country. A country might have a
trade deficit—that is, import more than it is
exporting—but still have a current account
surplus if it is receiving more than enough income
from its foreign investments, remittances or
foreign aid to pay the difference. In this case it will
not need to borrow. For simplicity we ignore
remittances and international aid and assume that
the current account is equal to exports (X) minus
imports (M) plus net earnings from assets owned
abroad.
UNIT 18 THE NATION AND THE WORLD ECONOMY
806
current account deficit The excess of the value of a country’s
imports over the combined value of its exports plus its net
earnings from assets abroad. See also: current account, current
account surplus.
current account surplus The excess of the combined value of
its exports and net earnings from assets abroad over the value
of its imports. See also: current account, current account deficit.
net capital flows The borrowing and lending tracked by the
current account. See also: current account, current account
deficit, current account surplus.
The borrowing and lending tracked by the
current account are known as net capital flows.
In this context, capital refers to money that is
being lent and borrowed, rather than capital
goods. A country that is borrowing (has a CA
deficit) is receiving net capital flows—it is
borrowing cash in order to cover its CA deficit.
This cash will have to be paid back in the future,
so capital inflows also represent rising foreign
debt for the country. If the borrowed money is
used for productive investments though, the
investment can help generate the income needed
to repay the debt. Thus, when a country wants to
invest more than it can afford using its own savings, borrowing from
abroad can be used to finance the extra investment.
Historically, increased trade tends to lead to larger CA imbalances. That
is, when countries trade more, they also tend to borrow and lend more. The
measure shown in Figure 18.8 is the sum of the absolute values of the
current account balances of 15 countries from 1870 to 2017. We add up the
absolute value of the current accounts to capture both borrowing and
lending across countries.
As with commodity trade (Figure 18.6), the volume of capital flows in
Figure 18.8 reflects a pattern of interrupted globalization. During the late
nineteenth century there were huge capital flows from northwest Europe
where there were current account surpluses—the UK especially, but also
France and Germany—which financed investment in railways and
infrastructure in countries such as Argentina, Australia, Canada, and the
US. These were all countries with abundant and underexploited natural
resources, especially land, but railways had to be extended into the interior
in order to exploit these resources, and the land had to be settled with
immigrants. In Europe, the countries that succeeded in attracting foreign
investment during this period, such as Russia and Sweden, were also
relatively resource-abundant. The investments made a healthy return, since
they increased the productive capacity of the borrowing countries, who
1929
Start of Great
Depression
Start of liberalization
of global capital markets
Global
financial
crisis
0
1
2
3
4
5
6
7
18
70
18
75
18
80
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85
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90
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95
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Year
Av
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so
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rr
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ta
cc
ou
nt
ba
la
nc
es
(1
5
co
un
tr
ie
s,
%
of
G
D
P)
Figure 18.8 International capital flows (1870–2017).
See more https://tinyco.re/8892301
(1) Figure 2.2 from Maurice Obstfeld and
Alan M. Taylor. 2005. Global Capital
Markets: Integration, Crisis, and Growth
(Japan–US Center UFJ Bank Monographs
on International Financial Markets).
Cambridge: Cambridge University Press;
(2) International Monetary Fund.
2020. World Economic Outlook
Database: October 2020
(https://tinyco.re/2218637). Note: The
data shown in the figure is the average
absolute current account balance (as a
percentage of GDP) for 15 countries in
five-year blocks (from 1870–74 through
to 2015–19). The countries in the sample
are Argentina, Australia, Canada,
Denmark, Finland, France, Germany,
Italy, Japan, Netherlands, Norway, Spain,
Sweden, UK, US.
18.2 GLOBALIZATION AND INVESTMENT
807
were able to pay back the loans with interest based on the increased
incomes that they enjoyed as a result.
In the interwar period these capital flows fell sharply—especially after
the beginning of the Great Depression in 1929, which had led many coun-
tries to impose strict limits on the movement of capital across frontiers.
These limits on capital flows meant that countries had to keep their
current account deficits and surpluses relatively low— they prevented the
capital inflows that would be required to finance large current account
deficits. Unlike international trade, which resumed growth soon after the
end of the Second World War, capital controls persisted for longer and only
started to be relaxed in the 1970s and 1980s. Since then capital flows have
increased sharply, although not yet to their dizzying heights of the early
twentieth century.
Figure 18.9 shows how international asset holdings evolved during the
twentieth century. The pattern is U-shaped. For the rich countries that
dominated international lending, the share of foreign assets divided by
GDP was high in the early part of the century, but collapsed in the 1930s.
After 1945, New York took over from London as the global financial centre
and the US eclipsed Britain as the dominant international asset holder.
To measure price gaps in international capital markets, we need prices of
identical financial assets in different countries. Where researchers have
been able to locate such prices, they have found that the late nineteenth
century saw significant globalization in capital flows.
For most of the nineteenth century, if a would-be arbitrageur in New
York (or London) wished to act on a price gap between New York and
London, the speed at which information travelled limited his opportunities
(we tracked the speed at which information travelled over the past 1,000
years in Unit 1). Information about price gaps travelled on ships that
crossed the Atlantic. By the time the arbitrageur learned of the price gap,
the information was already several days out of date. To act on it, he had to
send written instructions to his agent in the other city to buy or sell. These
instructions travelled by ship too. It took a large price gap, therefore, to
1929
Start of Great
Depression
Start of
liberalization
of global
capital markets
The global
financial
crisis
0
0.5
1
1.5
2
2.5
3
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Year
As
se
ts
/s
am
pl
e
G
D
P
Figure 18.9 International asset holdings (1900–2020).
(1) Figure 2.2 from Maurice Obstfeld and
Alan M. Taylor. 2005. Global Capital
Markets: Integration, Crisis, and Growth
(Japan-US Center UFJ Bank Monographs
on International Financial Markets).
Cambridge: Cambridge University Press;
(2) Lane, Philip R., and Gian-Maria Milesi-
Ferretti. 2007.‘Europe and Global
Imbalances’ (https://tinyco.re/2740164).
IMF Working Papers 07 (144). The series
shows the ratio of international assets to
the GDP of the sample of countries in
each year.
UNIT 18 THE NATION AND THE WORLD ECONOMY
808
create speculation, since prices may have changed by the time the orders
made it across the Atlantic.
In 1866, investors in London and New York (and their agents) could, for
the first time, communicate with each other on the same day. They were
using the first transatlantic telegraph cable, running from Ireland to
Newfoundland in Canada. Once the cable was installed, investors could act
immediately when they heard of a potential arbitrage opportunity, and
price gaps immediately collapsed.
In most countries, residents and companies do the majority of invest-
ment. One dimension of globalization is the foreign direct investment (FDI)
mentioned earlier by companies abroad, including subsidiaries. Unlike the
use of savings to buy foreign bonds or shares in a foreign company
(portfolio investment), the intention of FDI is to exercise control over the
use of resources in the foreign company.
Figure 18.10 shows the destination of investments by US companies
when they invested directly in other companies abroad between 2001 and
2012. Perhaps surprisingly, when US firms chose to produce outside the
US, they mostly went to countries in Europe; and in Europe, largely to
countries in which wages were higher than in the US. The Netherlands,
Germany, and the UK alone received more US investment than Asia and
Africa combined. In this respect the location of Ford plants around the
world shown in Figure 18.1 is not typical, because Ford has far more
employees in China, Brazil, Thailand, and South Africa combined than in
Germany, UK, Canada, Belgium, and France combined.
Countries with manufacturing wages
higher than the US (53.7% of total)
Countries with manufacturing wages
lower than the US (46.3% of total)
UK
11.5%
Netherlands
10.7%
Luxembourg
8.7%
Canada
7.6%
Switzerland
4.0%
Australia
3.8%
Germany
2.5%
Belgium 1.8%
France
1.3%
Nordic nations 0.9%
Italy
0.7%
Austria 0.2%
Rest of Europe
13.8%
Latin America
12.0%
Rest of Asia
10.4%
Rest of total
6.5%
Africa
1.7%
China 1.0%
India
0.9%
0 10 20 30 40 50 60 70 80 90 100
Share of total (%)
Figure 18.10 Foreign direct investment: Investment by US firms in other countries
according to whether wages are lower or higher than in the US (2001–2012).
United Nations Conference on Trade
and Development. 2014. Bilateral FDI
Statistics (https://tinyco.re/5690113).
Note: Data is for US FDI flows abroad.
The countries shown to have
manufacturing wages higher than the
US are those that are classified by the
US BLS International Labor Comparisons
as having higher hourly compensation in
manufacturing than the US on average
over the 2005–09 period.
18.2 GLOBALIZATION AND INVESTMENT
809
EXERCISE 18.3 INTERNATIONAL CAPITAL FLOWS: DOES CAPITAL FLOW
FROM RICHER TO POORER COUNTRIES?
1. China has enjoyed a period of rapid development over recent decades.
Using data from FRED (https://tinyco.re/3965569), plot China’s current
account balance over the period 1998–2012, and describe how it has
evolved since the late 1990s (Hint: search for ‘total current account
balance for China’). Make sure to highlight whether it is a CA surplus or
deficit.
2. On the same graph, plot the current account balance of the US over the
same time period, and compare it with China’s current account balance
(you can also find the data for the US at FRED by searching for ‘total
current account balance for United States’).
3. What does your graph suggest about capital flows between richer and
poorer countries? Read the 2007 article ‘The paradox of capital’
(https://tinyco.re/9576333) by Eswar Prasad, Raghuram Rajan and
Arvind Subramanian, who are IMF economists. Explain what is meant by
‘capital flowing uphill’ and whether or not it is a paradox.
4. Look at Figure 18.8 (page 807) and note that international capital flows
(as measured by average absolute current account balances as a
proportion of GDP) in the first decades of the twenty-first century are
similar to those of the late nineteenth century. Using the discussion of
capital flows in this section and in the article from question 3, was
capital ‘flowing uphill’ during Globalization I or Globalization II? Why,
or why not?
QUESTION 18.3 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements regarding current accounts is
correct, ceteris paribus?
An increase in the trade surplus would lead to a decrease in a
country’s current account.
A country with zero trade balance but historically high foreign
direct investment would always have a current account deficit.
An increase in remittances by a country’s nationals abroad would
lead to a lower current account.
An increase in the official aid payment sent to other countries
means a lower current account.
UNIT 18 THE NATION AND THE WORLD ECONOMY
810
18.3 GLOBALIZATION AND MIGRATION
In the late nineteenth century, declining transport costs and rising wages
made passage to America affordable for millions. Since then, labour
migration is probably the dimension of globalization along which interna-
tional economic integration has advanced the least. Indeed, labour into and
out of some countries is less mobile internationally today than it was in
1913. Figure 18.11 plots immigration into the US as a percentage of the
increase in the US population. During the late nineteenth and early
twentieth century immigrants accounted for more than half of the increase
in the US population, their numbers more than equalling the number of
births minus the number of deaths. Restrictive legislation curbed
immigration between the world wars. Although the contribution of
immigrants to the growth in population has been rising again since the
Second World War, it has not matched the growth before 1914. The low
figures from the mid-1940s to the 1970s can in part also be explained by
the relatively high birth rate in the US over this period.
There were relatively few institutional barriers to immigration in the
late nineteenth century. Today, migrants without appropriate docu-
mentation may be deported or imprisoned. This meant that when Europe
was experiencing its population boom, as death rates fell sharply and birth
rates fell only with a lag, it was able to ship its surplus population to what
the fifteenth-century explorer Amerigo Vespucci had named the ‘New
World’ in America. Today’s lower-income countries are not so fortunate.
Immigration barriers were already in place during the late nineteenth
century, but they became much stricter during and after the First World
War, and rich countries retain strict immigration barriers to this day.
Thus the movement of goods and finance between countries is easier,
and greater in magnitude, than the movement of people. Sending your
money or your goods to some distant economy is much easier than sending
yourself. You might have to learn an entirely new language or culture, not
to mention leaving behind family and your home community. This is one
reason why, for labour, there is nothing equivalent to the reduction in price
gaps for goods that we discussed above. There is no tendency of wages in
different countries around the world to become more similar.
1845
Start of potato famine
in Ireland
1880s
US wheat destroys
European farming
1918
End of WWI
1923Restrictive
immigration law
1945
End of WWII
0
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50
60
70
80
90
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20
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95
Year
Im
m
ig
ra
tio
n
to
U
S
(%
of
in
cr
ea
se
in
po
pu
la
tio
n)
Figure 18.11 Immigration into the US as a percentage of the change in US
population (1820–1998).
Susan B. Carter, Michael R. Haines,
Richard Sutch, and Scott Sigmund
Gartner (editors). 2006. Historical
Statistics of the United States: Earliest
Times to the Present. New York:
Cambridge University Press.
18.3 GLOBALIZATION AND MIGRATION
811
Figure 18.12 shows the trends in wages paid to manufacturing workers
expressed as a ratio of the wages of US manufacturing workers. It indicates,
for example, that in the late 1970s, workers in Germany were paid 80% of
the wage of US workers but, by 2016, they were paid more than 10% more.
There are three developments that we can see in Figure 18.12:
• Like Germany, other European countries also caught up with the US in
manufacturing wages, in some cases surpassing them by more than 20%
(Norway).
• Wages in South Korea and Japan rapidly converged towards the US wage
level.
• A number of low-wage countries (for example, Sri Lanka) remained far
behind, some falling even further behind (Mexico).
In conclusion, there was a dramatic increase in the integration of the world
economy during the nineteenth century, which was marked by increasing
volumes of trade and corresponding reduction in price gaps, as well as the
movement of capital. This was followed by a brief period of deglobalization
during the Great Depression and the Second World War, and renewed
globalization afterwards, especially since the 1990s. These three waves of
globalization, deglobalization, and reglobalization are equivalent to those in
Figure 18.4.
Trade costs and barriers to the mobility of capital and labour fell in the
nineteenth century, largely as a result of steam-driven transportation tech-
nologies. They rose again in the interwar period, largely due to government
intervention—taxes and other barriers to trade, capital controls and
immigration restrictions—and fell again in the late twentieth century, as a
result of more liberal policies and technological change. National
boundaries, however, have continued to be important barriers to the global
integration of labour markets.
0
20
40
60
80
100
120
140
1975–79 2016
Year
M
an
uf
ac
tu
ri
ng
w
ag
es
re
la
tiv
e
to
U
S
(U
S
=
10
0)
Norway
Sweden
Germany
France
US
Italy
Japan
UK
South Korea
Portugal
Mexico
Taiwan
Sri Lanka
Figure 18.12 Manufacturing wages relative to the US (1975–79 and 2016).
View this data at OWiD https://tinyco.re/
8242745
US Bureau of Labor Statistics. 2015.
International Labor Comparisons
(https://tinyco.re/2780183); The
Conference Board. 2021. International
Labor Comparisons (https://tinyco.re/
8746332). Note: (1) Data is for hourly
compensation costs in manufacturing,
which includes total hourly direct pay
(pre-tax), employer social insurance
expenditures, and labour-related taxes.
National currency data converted into
US dollars at the average daily
exchange rate for the reference year; (2)
Graph of Sri Lanka shows most recent
available data, for the year 2008.
UNIT 18 THE NATION AND THE WORLD ECONOMY
812
specialization This takes place
when a country or some other
entity produces a more narrow
range of goods and services than it
consumes, acquiring the goods and
services that it does not produce by
trade.
QUESTION 18.4 CHOOSE THE CORRECT ANSWER(S)
Figure 18.11 (page 811) depicts the level of immigration into the US as
a percentage of the change in the US population.
Based on this information, which of the following statements is
correct?
In the decade prior to the First World War, the number of
immigrants was higher than the number of births minus the number
of deaths.
Wars cause permanent declines in the level of migration.
As with trade in goods and capital flows, there is evidence of a
continued trend of ‘reglobalization’ in migration since the end of
the Second World War.
The trend in the graph suggests that with high migration over the
past 150 years the wages in different countries around the world
should now be similar.
18.4 SPECIALIZATION AND THE GAINS FROM TRADE
AMONG NATIONS
The result of this process of global economic integration means that today
virtually all nations are part of a global economy characterized by:
• Specialization: Particular locations specialize in the production of distinct
goods.
• International trade: These goods are then exchanged with other locations
specializing in other goods.
Specialization entails trade because by producing a narrower range of
goods and services than you use, you must engage in trade to acquire the
ones you do not produce. International trade is the outcome of
specialization among countries.
Machine tools (such as precision-cutting tools) produced in southern
Germany are used in the production of computers in coastal south China
running software produced in Bangalore and California. These are then
flown on aircraft produced near Seattle in the US to be sold to users
throughout the world. Producers of these commodities put food on their
table grown in the Canada or Ukraine and wear shirts made in Mauritius.
As these examples show, trade and specialization are two sides of the
same process. Each provides the conditions necessary for the other. In the
absence of trade, machine tool workers in Stuttgart could not eat bread
made from grain grown in Ukraine or Canada and wear clothes made in
Mauritius. If they had to provide for themselves, many of them would be
farmers or clothing workers. In the absence of specialization, there would
be little to trade.
In Section 1.8, you met Greta and Carlos, who each wanted to consume
both apples and wheat. With their own land and labour they each could
have produced both crops, and been entirely self-sufficient. But they found
that they could be better off by specializing; Carlos producing only apples
and Greta producing only wheat.
18.4 SPECIALIZATION AND THE GAINS FROM TRADE AMONG NATIONS
813
comparative advantage A person
or country has comparative
advantage in the production of a
particular good, if the cost of
producing an additional unit of that
good relative to the cost of produc-
ing another good is lower than
another person or country’s cost to
produce the same two goods. See
also: absolute advantage.
economies of scale These occur
when doubling all of the inputs to a
production process more than
doubles the output. The shape of a
firm’s long-run average cost curve
depends both on returns to scale in
production and the effect of scale
on the prices it pays for its inputs.
Also known as: increasing returns
to scale. See also: diseconomies of
scale.
The two were better off by specializing because their land differed in
what it was best at producing. While Carlos could produce 50 times as
many apples as tonnes of wheat on his land if he produced just one crop,
Greta could only produce 25 times as many apples as tonnes of wheat
(again, if she produced just one or the other). Although Greta could produce
more of either crop than could Carlos, Carlos had a comparative
advantage in producing apples (in terms of productivity, he was less
inferior to her in producing that crop compared to the other). Make sure
you understand the term comparative advantage and Figures 1.9a and b
before going on.
We are going to use the same reasoning to explain why entire countries
specialize in some goods and services, and some in others.
For Greta and Carlos, the reason for specialization was that they had
different land. In the same way, the natural resources and climate of coun-
tries differ. It would be very costly to produce bananas in Germany given
the climate, and this is one of the reasons why Germans make their living
doing other things. But there are many other reasons for specialization.
Suppose instead that Greta and Carlos had identical plots of land and the
same set of skills. They are equally adept at growing either wheat or apples,
but the production of both apples and wheat is subject to economies of
scale. This would mean, for example, that doubling the amount of land and
their own time devoted to the production of, say, apples would more than
double the quantity of apples produced. Whether or not this is a reasonable
assumption depends on the production technology of each good.
So we will replace Figure 1.9a, which showed the case of specialization
based on factor endowments, with Figure 18.13. In the table in this figure,
you see that if 25 hectares (and a proportional amount of either Greta’s or
Carlos’ labour is devoted to the production of apples), 625 apples will be
produced. If the land devoted to apple production is doubled to 50 (with
half of labour time still applied to its production) apple production
increases by a factor of four, to 2,500.
Imagine the two working as self-sufficient farmers, each with 100
hectares, dividing their land and labour equally between the two crops.
They would each have 250 tonnes of wheat and 2,500 apples to consume.
But if either one of them were to specialize in wheat and the other in
apples and then share the resulting crops equally, they could have four
times as much wheat and apples as they would have in the absence of
specialization. The important point here is that it doesn’t matter who
specializes in what. The advantage of specialization does not come from
any difference between the endowments (skills, land) of Greta and Carlos
but instead from the fact that people each producing a lot of one thing may
be more efficient than them producing lesser amounts of many things.
Area of land used in production (hectares) 1 25 50 75 100
Wheat (tonnes) 0.1 62.5 250 562.5 1,000
Apples 1 625 2,500 5,625 10,000
Figure 18.13 Economies of scale in the production of wheat and apples. Note that
the entries in the ‘Apples’ row are just the square of the amount of land devoted to
the production of apples, and the ‘Wheat’ row is just one-tenth of the number of
apples produced in each column.
UNIT 18 THE NATION AND THE WORLD ECONOMY
814
ECONOMIES OF AGGLOMERATION
The cost reductions that firms may
enjoy when they are located close
to other firms in the same or
related industries.
Don’t confuse this with economies
of scale or economies of scope,
which apply to a single firm as it
grows.
We’ll get back to Carlos and Greta in the next section, but what do the
examples featuring them tell us about global integration and trade between
nations? For example, why do southern Germans specialize in producing
machine tools, high-end automobiles and other manufactured goods, while
the southern coast of China is the world centre of manufacturing
computers that run on US-produced software, while Mauritians produce
shirts, and the residents of Alberta, Canada grow grain? There are two
kinds of answers:
• Economies of scale, agglomeration, and other positive feedbacks: The produc-
tion of aircraft is subject to extraordinary economies of scale. The
Boeing Plant in Everett, Washington is the largest building in the world
(over 13 million cubic metres in volume). Writing computer code is not
subject to economies of scale, but good software is produced in areas in
which a very large number of people are working on similar tasks,
sharing information and innovating.
• Differences between regions: Alberta has an appropriate climate and soil
for growing grain. The production of clothing requires a lot of labour
but not an extensive amount of capital goods, fitting the availability of
these factors of production in Mauritius. German apprenticeship
training schemes support the high level of skills needed for the machine
tool industry.
The distinctive aspect of the first source of specialization is its accidental
quality. Why Everett, Washington rather than Osaka, Japan? Why is
Bangalore a software hub, and not Singapore or Sydney?
To explain specialization we often need to draw on both types of ex-
planation. German machine tool production, for example, benefits not only
from the high level of skill of the German workforce but also from eco-
nomies of co-location, called economies of agglomeration. Firms also
share information and develop common industry standards for components,
and they stimulate research in the region, from which they benefit.
Figure 18.14 (page 816) summarizes our explanation of specialization
and trade.
EXERCISE 18.4 ASSESS SOME COUNTRY PRODUCTION SPECIALIZATION
PATTERNS
Choose a few goods and services not discussed in this unit (for example,
wine, automobiles, professional services such as accounting and auditing,
consumer electronics, bicycles, or fashion goods). Use Figure 18.14 (page
816), along with what you know or can research about your chosen
products, to provide an explanation of country specialization patterns.
18.4 SPECIALIZATION AND THE GAINS FROM TRADE AMONG NATIONS
815
Economies of scale and
agglomeration and other positive
feedbacks in each country
Country differences in the supply of
factors of production (including skills),
technologies, institutions and policies.
Between-country differences in
the relative costs of particular
goods and services
Between-country trade in the goods
and services in which each
country specializes
Country specialization in production of the
goods and services in which they have
a comparative advantage
Figure 18.14 Between-country cost differences, specialization, and trade.
absolute advantage A person or
country has this in the production
of a good if the inputs it uses to
produce this good are less than in
some other person or country. See
also: comparative advantage.
18.5 SPECIALIZATION, FACTOR ENDOWMENTS, AND
TRADE BETWEEN COUNTRIES
In this section, we look in more detail at trade specialization based on
factor endowments, extending the analysis in Section 1.8. We show how
trade between the people of different nations—specialized in the produc-
tion of different things—can result in mutual gains, and also in conflicts
over how these gains are distributed.
Imagine Greta lives on Wheat Island and Carlos lives on Apple Island.
The land on each island can be used for growing both wheat and apples,
and they consume both wheat and apples in order to survive. For the
example in this section, we will use the numbers shown in Figure 18.15, and
assume that Greta and Carlos each have the same amount of land. We have
already seen that Greta is lucky. Wheat Island has better soil for both crops.
She has an absolute advantage in both crops. Although Carlos’ land is
worse overall for producing both crops, his disadvantage is less, relative to
Greta, in apples than in wheat.
Remember, even those who have an absolute advantage in nothing at all
will specialize in the thing at which they are least bad, and get the other
goods they consume by exchange. Similarly, people who are better at
producing everything will specialize in the goods at which they are
Production if 100% of time is spent on one good, per year
Greta 12,500 apples or 10,000 tonnes of wheat
Carlos 10,000 apples or 4,000 tonnes of wheat
Figure 18.15 Absolute and comparative advantage in the production of apples and
wheat.
UNIT 18 THE NATION AND THE WORLD ECONOMY
816
comparatively best, while importing other goods. Both Greta and Carlos
can benefit from specialization and trade.
To see how this works, follow the analysis in Figure 18.16a.
Diversification in the absence of trade
In the absence of trade, Carlos and Greta do best by selecting a point on the
highest indifference curve possible, given the constraint of their feasible
production frontier. In our simple example, the feasible production frontier
is also the feasible consumption frontier, because each person spends time
producing only wheat and apples, and can consume only the amount they
produce. Follow the analysis in Figure 18.16b to how Carlos and Greta
make their production and consumption decisions.
To
nn
es
o
f w
he
at
10,000
4,000
5,000
2,000
10,000
Carlos’ feasible set
Carlos’ feasible
production frontier
A
C
B
Number of apples
To
nn
es
o
f w
he
at
10,000
12,500
Greta’s feasible set
Greta’s feasible
production frontier
Number of apples
Figure 18.16a Carlos’ (Apple Island’s) and Greta’s (Wheat Island’s) feasible
production frontiers.
1. Carlos’ production
The left-hand panel of the figure shows
the combinations of wheat and apples
that Carlos can produce in a year. If he
produces only apples, he can produce
10,000 of them in a year. This is shown
by point A on the horizontal axis.
2. Specialization in wheat
Similarly, if Carlos produces only wheat
then he can produce 4,000 tonnes, as
shown by point B on the vertical axis.
3. The feasible production frontier
The red line that joins points A and B is
the feasible production frontier for
Carlos. It shows all the combinations of
wheat and apples that can be produced
by Carlos in a year.
4. Carlos’s choice
He can choose to produce any combin-
ation on (or inside) the frontier. For
example, he could produce 2,000
tonnes of wheat and 5,000 apples, as
shown by point C.
5. Carlos’ feasible set
He can produce anywhere between the
origin and the feasible production
frontier. The red shaded area shows his
feasible set.
6. The feasible production frontier for
Greta
This is shown in the right hand panel.
Greta can produce more of both goods
than Carlos can. If she only produces a
single good, she can produce either
12,500 apples or 10,000 tonnes of
wheat in a year.
7. Wheat Island has an absolute
advantage
It has this advantage in producing both
goods because Greta can produce
more of both of them. Graphically,
Greta’s feasible set includes Carlos’
within it.
18.5 SPECIALIZATION, FACTOR ENDOWMENTS, AND TRADE BETWEEN COUNTRIES
817
Trade and specialization
What will happen when Greta and Carlos are able to trade? The decision to
trade could be made for a number of reasons, such as the development of a
new technology (maybe a boat) or the removal of barriers to trade (perhaps
the end of a feud between the two islands). As we learned in Unit 1, it is the
relative, not the absolute, cost of producing the two goods that matters for
mutually beneficial trade.
We will show that both Carlos and Greta gain when one island
specializes in the production of wheat and the other specializes in the pro-
duction of apples. Carlos can produce 4,000 tonnes of wheat a year, or
10,000 apples. In order to produce one more tonne of wheat, Carlos has to
produce 2.5 fewer apples, so the marginal rate of transformation between
tonnes of wheat and apples is 2.5. Since it takes the same amount of inputs
(land and labour) to produce one tonne of wheat as it does to produce 2.5
apples, a tonne of wheat will cost the same as 2.5 apples. Thus the relative
price of wheat to apples will be 2.5. The relative price is another way of
referring to the marginal rate of transformation or the opportunity cost.
Greta is more productive in producing both goods. Greta can produce
10,000 tonnes of wheat in a year, or 12,500 apples. The relative price of
wheat to apples on Wheat Island is therefore 1.25. Wheat Island therefore
has a comparative advantage in producing wheat.
The relative price of apples is simply the inverse of the relative price of
wheat, so if Wheat Island has a comparative advantage in producing wheat,
then Apple Island will have a comparative advantage in producing apples.
Figure 18.17 summarizes the key numbers from the example. The relative
5,000
To
nn
es
o
f w
he
at
10,000
6,000
12,500
Greta’s feasible
consumption
frontier
Number of apples
Greta’s indifference
curves
E
To
nn
es
o
f w
he
at
10,000
4,000
3,750
2,500
10,000
Carlos’ feasible
consumption frontier
Carlos’ indifference
curves
D
Number of apples
Figure 18.16b Carlos’ (Apple Island’s) and Greta’s (Wheat Island’s)
utility-maximizing choices of consumption.
1. Carlos’ feasible consumption frontier
This is in the left-hand panel,
coinciding with his feasible production
frontier.
2. Carlos’ indifference curves
The shape of the indifference curves
represents Carlos’ preferences over
wheat and apples.
3. The highest indifference curve Carlos
can attain
It will be the one that is tangent to his
feasible consumption frontier. He will
choose to consume 2,500 tonnes of
wheat a year and 3,750 apples, as
shown by point D.
4. Greta’s superior productivity
This means she can consume more of
both goods than Carlos. We assume her
preferences are the same as Carlos’
(the indifference curves are the same
shape). She consumes 6,000 tonnes of
wheat a year and 5,000 apples, as
shown by point E.
UNIT 18 THE NATION AND THE WORLD ECONOMY
818
prices of the good for which each island has a comparative advantage are
shown in bold.
Gains from trade
When there is no trade (autarky, closed economies), the feasible production
frontier is also the feasible consumption frontier. From Figure 18.16b, we
can see that when the economies are closed, total production between the
two countries is 2,500 + 6,000 = 8,500 tonnes of wheat and 3,750 + 5,000 =
8,750 apples. When countries fully specialize however, Greta is able to
produce 10,000 tonnes of wheat and Carlos can produce 10,000 apples, so
there is more of both goods overall. As long as they can trade, they can both
consume more of each good and can, ideally, both be better off.
If we assume that there are no trade costs, it is obvious that the relative
price of wheat and apples is the same in each country when they trade.
What will the new price be? From Carlos’ point of view, the supply of wheat
has increased more than the supply of apples, so the price of wheat relative
to apples will go down to something less than 2.5. Equally, from Greta’s
point of view the supply of wheat has increased by less than the supply of
apples, so the relative price of wheat will go up for her to something higher
than 1.25. When trading, the prices will lie between the prices experienced
by the two economies when they are closed.
To see what happens when they trade, work through the analysis in
Figure 18.18.
Because both countries are now specializing in the good in which they
have a comparative advantage, the new consumption frontiers are above
their production frontiers. For each country, the two frontiers meet at the
point at which they do not trade, which given full specialization,
correspond to each axis. We can see that specialization and international
trade have led to an increase in the size of the feasible consumption set for
both countries. Note that through trade, Greta cannot consume more than
the maximum amount of apples Carlos can produce (10,000), which is why
her feasible consumption frontier does not extend beyond 10,000 apples.
If we look back to Figure 18.16b we can see that any expansion of their
feasible sets makes it possible for both Carlos and Greta to reach a higher
level of utility (a higher indifference curve), so trade has been mutually
beneficial.
Specialization has enlarged the feasible consumption set of both in the
same way that borrowing and investing increased the feasible consumption
set of Marco in Unit 10. By investing, Marco specialized in having income
in the future, which increased the total income he earned over all periods.
Apple Island (Carlos) Wheat Island (Greta)
Tonnes of wheat produced per year 4,000 10,000
Number of apples produced per year 10,000 12,500
Relative price of wheat 10,000/4,000 = 2.5 12,500/10,000 = 1.25
Relative price of apples 4,000/10,000 = 0.4 10,000/12,500 = 0.8
Figure 18.17 An island has a comparative advantage in producing a good when it is
relatively cheaper in their economy (in the absence of trade).
18.5 SPECIALIZATION, FACTOR ENDOWMENTS, AND TRADE BETWEEN COUNTRIES
819
bargaining power The extent of a
person’s advantage in securing a
larger share of the economic rents
made possible by an interaction.
Then, by borrowing, he imported some of his future income to the present
so that he could consume in both periods.
The relative price determines the extent to which trade increases the
feasible set of each island. This, in turn, depends on how the price is
determined. Suppose that Greta can unilaterally determine the price. To
increase her gains from trade, Greta will choose a price that increases the
amount of apples she receives for each tonne of wheat she sells to Carlos.
Intuitively, Greta wants the good she produces to command a higher price.
If we assume that she has chosen a price of wheat of 2.25, then how does
this affect the expansion of the feasible sets? Follow the analysis in Figure
18.19 to find out.
Of course, if Greta could set any price she wished, she could have set an
even higher price. If she set the price at 2.5 apples per tonne, she would
eliminate Carlos’ gains from trade entirely. At this price Carlos would be
equally well off if he produced his own wheat and would have no reason to
engage in trade with Greta. When the people of a country are better able to
influence the price in their favour, we say they have bargaining power.
To
nn
es
o
f w
he
at
10,000
4,000
5,000
8,000
4,000 6,000 12,500
2,000
10,000
Carlos’ feasible
production frontier
Greta’s feasible
production frontier
Greta’s feasible consumption
frontier (through trade)
A
Number of apples
B
Carlos’ feasible
consumption frontier
(through trade)
Figure 18.18 The effect of trade and specialization on Carlos’ and Greta’s feasible
consumption frontiers.
1. Before specialization and trade
The figure shows the feasible produc-
tion frontiers for Carlos and Greta.
2. The effect of specialization and trade
The dotted red lines show the outward
shift of the feasible consumption
frontiers due to specialization and
trade. We assume that the relative
price of wheat after specialization and
trade is 2 (an arbitrary price in between
1.25 and 2.5).
3. Consumption after specialization and
trade
Carlos specializes in apples, producing
10,000, and exports (10,000 – 6,000 =
4,000) apples to Greta, who specializes
in wheat, producing 10,000 tonnes and
exports (10,000 – 8,000 = 2,000) tonnes
of wheat to Carlos.
UNIT 18 THE NATION AND THE WORLD ECONOMY
820
To
nn
es
o
f w
he
at
4,000 6,000
Carlos’ feasible
production frontier
Greta’s feasible
production frontier
Greta’s feasible consumption
frontier (through trade)
A
Number of apples
B
12,50010,000
10,000
4,000
4,444
8,222
1,778
Carlos’ feasible
consumption frontier
(through trade)
Figure 18.19 The effect of trade and specialization on the feasible consumption
frontiers for Carlos and Greta, when Greta is able to dictate the price.
1. Feasible production frontiers
The figure starts with the same feasible
production frontiers as Figure 18.18.
2. After trade
Greta now dictates the relative price of
wheat to be 2.25. Trade still shifts out
both feasible sets, but it shifts Greta’s
by more. This means trade and
specialization will increase the utility
of both Carlos and Greta, but will
increase Greta’s utility by more.
3. At the new price
Greta has to give up fewer tonnes of
wheat to get 4,000 apples. She is better
off than she was at a price of 2 in
Figure 18.18. In contrast, Carlos is
worse off relative to the price of 2. He
gets fewer tonnes of wheat in return for
the same number of apples.
18.5 SPECIALIZATION, FACTOR ENDOWMENTS, AND TRADE BETWEEN COUNTRIES
821
David Ricardo. 1815. An Essay on
Profits. London: John Murray.
David Ricardo. 1817. On The
Principles of Political Economy and
Taxation (https://tinyco.re/
2109109). London: John Murray.
GREAT ECONOMISTS
David Ricardo
David Ricardo (1772–1823)
developed the theory of
comparative advantage. He was
also the first economist to warn
that a rapidly growing capitalist
economy would confront the
limits of its natural environment.
The son of a successful
stockbroker and the third of 17
children, Ricardo grew up in
London and eloped at the age of
21, which led to a long period of
estrangement from his parents. He
went on to build a huge fortune through trading in stocks before
interesting himself in political economy. He entered parliament (by
purchasing a seat, which then was possible) where, besides his
contributions on economic questions, he favoured liberal social causes
such as religious tolerance, freedom of speech, and opposition to slavery.
Ricardo’s central contribution to economic theory was an analysis of
the principles of production and distribution in a growing capitalist eco-
nomy with a large agrarian sector. In An Essay on Profits, published in
1815, he developed the Ricardian model, which came to dominate
British economic thought for much of the next 50 years. In this model,
agricultural production relied on three inputs: labour, capital, and land.
As production and population expanded, either existing land had to be
farmed more intensively with greater doses of capital and labour, or less
fertile plots had to be brought into production.
Drawing on ideas of diminishing returns, he explained how this
would lead to a squeeze on profits and the eventual stagnation of the
economy. Like Thomas Malthus, whose ideas we studied in Unit 2, he
reasoned that wages could not be below subsistence. As farming
expanded to less good land, the price of food and hence wages would
have to increase. A result would be that profits (which Ricardo presumed
would be invested) would fall. Rents (presumed to be spent on luxuries)
would increase due to the growing scarcity of land. The result would be
the eventual slowdown and stagnation of the economy.
Ricardo therefore advocated a repeal of tariffs on the import of grains
(known as the Corn Laws), which his friend Malthus defended. Ricardo
reasoned that if Britain could acquire more of its food from the US and
elsewhere, then paying workers a subsistence wage would cost less to the
employers, raising the rate of profit and investment. Importing grain
rather than growing it in Britain would make land less scarce and there-
fore limit the landlord’s share of total output. The result, according to
Ricardo, would be continued growth rather than stagnation.
His greatest work, On the Principles of Political Economy and Taxation
(published in 1817), introduced the labour theory of value, later used by
Karl Marx. This theory holds that the value of goods is proportional to
the amount of labour required, directly or indirectly, in their produc-
tion. Wassily Leontief (1906–1999) devised a way that these values could
UNIT 18 THE NATION AND THE WORLD ECONOMY
822
EXERCISE 18.5 COMPARATIVE ADVANTAGE
Suppose that there are only two countries in the world, Germany and
Turkey, each with four workers. Within a given time period, each worker in
Germany can produce three cars or two televisions, and each worker in
Turkey can produce two cars or three televisions.
1. Draw the feasible production frontier for each country, with televisions
on the horizontal axis and cars on the vertical axis. In the absence of
trade, what is the relative price of cars in each country?
2. Suppose that, in the absence of trade, Germany consumes nine cars and
two televisions while Turkey consumes two cars and nine televisions.
Mark these consumption points as G and T, respectively. Draw the feas-
ible consumption frontier for each country in the absence of trade.
Comment on the relationship between the production and consump-
tion frontiers you have drawn for each country.
3. Now suppose Germany and Turkey start trading. What is the range of
possible values for the world relative price of cars? If the world relative
price of cars is PC/PTV = 1, in which good will each country specialize?
4. Now use the world relative price given above to draw the feasible con-
sumption frontier of each country in the figures you have drawn. Use
these figures to explain whether or not each country gains from trade.
5. What is the marginal rate of transformation between cars and
televisions in each country? Explain the relationship between
comparative advantage and the marginal rate of transformation
between goods.
EXERCISE 18.6 POWER AND BARGAINING
Going back to our example of Carlos and Greta, assume that Greta has the
power to set the relative price. Based on what you have learned in Unit 4
about how people play the ultimatum game, how do you think Carlos
would react to a price offer of 2.4 apples per tonne of wheat?
be calculated (see ‘When economists disagree: Heckscher–Ohlin, and the
Leontief Paradox’ later in this unit).
In Principles, Ricardo laid out the principle of comparative advantage,
recognizing that two countries could trade to the mutual advantage of
each, even if one of them was absolutely better at producing all goods.
Ricardo is not as famous an economist as Smith, Malthus, Mill, or
Marx, but he is greatly respected for the theory of comparative
advantage. In addition, his method of structuring thought using an
abstract model as a guide to economic understanding makes him a very
modern great economist.
18.5 SPECIALIZATION, FACTOR ENDOWMENTS, AND TRADE BETWEEN COUNTRIES
823
QUESTION 18.5 CHOOSE THE CORRECT ANSWER(S)
The following diagram shows Carlos’ and Greta’s feasible production
frontiers and their utility-maximizing choices of consumption between
wheat and apples under autarky (no trade).
To
nn
es
o
f w
he
at
10,000
4,000
5,0003,750
2,500
10,000 12,500
Carlos’ feasible
consumption frontierCarlos’ indifference
curves
Greta’s indifference
curves
Greta’s feasible
consumption frontier
E
D
Number of apples
6,000
Based on this information, which of the following statements is
correct?
Carlos will choose to consume 10,000 apples.
Greta can consume 3,750 apples and 2,500 tonnes of wheat but will
choose not to do so.
Greta has an absolute advantage in the production of wheat, while
Carlos has an absolute advantage in the production of apples.
Regardless of the shape of the indifference curves (which could be
different from those depicted in the diagram), Greta will always
choose to consume more of both goods than Carlos.
QUESTION 18.6 CHOOSE THE CORRECT ANSWER(S)
Figure 18.18 (page 820) depicts the feasible frontier and the consump-
tion frontier of Carlos and Greta if they specialize and trade. The
resulting relative price of wheat is assumed to be 2.
Let the resulting consumption be at A and B, respectively, for Greta and
Carlos. Then which of the following statements is correct?
As Greta has the absolute advantage in production of both goods,
she will produce both apples and wheat.
Carlos produces 6,000 apples and 2,000 tonnes of wheat, while
Greta produces 4,000 apples and 8,000 tonnes of wheat.
Carlos trades 4,000 of his apples for 2,000 tonnes of Greta’s wheat.
Greta is better off while Carlos is worse off as a result of the trade.
UNIT 18 THE NATION AND THE WORLD ECONOMY
824
QUESTION 18.7 CHOOSE THE CORRECT ANSWER(S)
The following diagram shows Alex’s and Jose’s feasible production
frontiers for oranges and melons.
N
um
be
r o
f m
el
on
s
15,000
15,000 30,000
Jose’s feasible
production frontier
Alex’s feasible
production frontier
Number of oranges
10,000
Based on this information, which of the following statements are
correct?
Jose has an absolute advantage in the production of both melons
and oranges.
Jose has a comparative advantage in the production of melons.
With trade and specialization, Jose will specialize in the production
of oranges while Alex will specialize in the production of melons.
The relative price of melons after trade will be 1.75.
18.6 WINNERS AND LOSERS FROM TRADE AND
SPECIALIZATION
Carlos and Greta both benefit from trade, so why are imports and exports
often controversial? Unlike our story, in the real world there are almost
always winners and losers. The processes of specialization and exchange
affect regions, industries, and household types differently. Had the bakers
and shoppers of Genoa known that cheap grain was aboard the Manila they
would have cheered her into port, while local farmers may have secretly
prayed for a shipwreck.
Nations are composed of people with differing economic interests. They
are not like our islands with only Greta and Carlos. Therefore, to under-
stand these issues we need to go further than assuming a single individual
or a set of identical individuals inhabits each nation.
To think about winners and losers from trade, we begin with a model of
two stylized countries, which we call the US and China, where
specialization is based on factor endowments. The US is an advanced eco-
nomy with a long tradition of manufacturing. China is less developed, but
has become the world’s second-largest economy by exporting
manufactured goods. Let us imagine, unrealistically, that the US and China
produce only two goods, which are produced under constant returns to
18.6 WINNERS AND LOSERS FROM TRADE AND SPECIALIZATION
825
cartel A group of firms that collude
in order to increase their joint
profits.
scale: passenger aircraft and consumer electronics (like games consoles,
personal computers, and TVs). Furthermore, we assume (more realistically
this time) that the US has an absolute advantage in producing both goods,
and a comparative advantage in producing aircraft.
We assume that aircraft production is capital-intensive and that capital
is relatively abundant in the US. In contrast, China has a comparative
advantage in consumer electronics production, which is more labour-
intensive and China has an abundance of labour relative to capital. Given
these assumptions, when the economies begin to trade with one another,
the US will specialize in the production of aircraft, whereas China will
specialize in the production of consumer electronics.
Opening trade between the US and China in aircraft and consumer
electronics has the following effects:
• It increases the consumption possibility set for both countries.
• Conflicts of interest emerge between the countries.
• Conflicts of interest emerge within each country.
As we have seen, the relative price of the two goods affects how the gains
from trade are divided between the countries. The usual forces of demand
and supply affect the relative price, but the balance of bargaining power
between the two affects the price too. For the US and China, and all other
countries in the real world, relative prices are subject to the same forces. In
Unit 15, for example, we investigated the macroeconomic consequences of
oil price shocks. But what caused the increase in the relative price of oil?
• The first and second oil shocks (1970s): Relative price increases were due to
political developments in the Middle East and to the ability of oil
producers to exert monopoly power through a cartel. The exercise of
monopoly power by producers shifted the supply curve upward.
• The third oil shock (2000s): The growth of China and other emerging eco-
nomies caused a large increase in global demand. The global demand
curve for oil shifted to the right.
The beneficiaries of a rise in relative price are the inhabitants of the
country that specializes in producing that product. But do all citizens bene-
fit? Not everyone in a country is the same. For example, some people have
only their labour to sell. Others have accumulated wealth, which they can
use to invest in firms.
In the example of the US and China, after trade the US specializes in
producing aircraft and China specializes in consumer electronics. Trade
and specialization mean that resources shift from one industry to another.
Workers previously employed in electronics in the US must try to find
work in the expanding aircraft manufacturing businesses. Similarly, in
China, employment will expand in consumer electronics production. In the
short run at least, those workers employed in the industry that their nation
does not specialize in will lose out. For now, let us ignore any effect that
trade has on the total size of the economy. We will return to this shortly.
The increase in production of aircraft in the US increases the demand
for the factor of production used intensively in that industry: capital. In
China, it increases demand for labour instead.
UNIT 18 THE NATION AND THE WORLD ECONOMY
826
• The winners in the US: The owners of capital benefit more from trade
than workers, because capital becomes relatively scarce as production of
aircraft rises. Since the wealthy tend to hold proportionally more of
their wealth in capital than the poor, we would predict a rise in inequal-
ity.
• The winners in China: Workers are in higher demand as consumer
electronics production expands. Wages rise as firms compete for
workers. As we have seen in Unit 6, lower unemployment lowers the
cost of job loss, and firms raise wages. Workers benefit more from trade
than the owners of capital, hence we would expect inequality to fall.
Trade and specialization in the US involves transferring labour and capital
from electronics production to aircraft production. Think of what happens
when one unit of capital, such as a factory, shifts from electronics to aircraft
production. An electronics factory closes, laying off X workers, and an
aircraft factory opens, hiring Y workers. Which is bigger, X or Y?
The answer: X is bigger than Y, since one unit of capital provides the tools
and equipment necessary to employ more workers in electronics than in
aircraft production (since electronics is relatively labour-intensive). Thus,
when capital shifts from electronics production to aircraft production, there
is a net loss of jobs. This is of course also assuming that workers do not need
to re-skill and, more generally, that there are no other frictions in the labour
market. These factors would result in a greater loss of jobs in the short run.
In this case, US workers are losing out, and US employers are winning.
Workers are working for lower wages, and profits rise. The effect of
imports of labour-intensive electronics and the shift in US production to
less labour-demanding goods (aircraft) is that employers capture most of
the gains from trade. As consumers of electronics, both employers and
workers benefit. This is an example of a general principle about who bene-
fits from international trade: The owners of relatively scarce factors of
production in their own country prior to trade (US labour in our example)
lose from specialization and trade, and the owners of relatively abundant
factors (owners of capital in the US) gain.
The reasoning behind this principle is as follows:
• Factors that are relatively scarce in their own countries, compared with
in the rest of the world, are relatively expensive compared to prices
elsewhere when there is no trade. When their economies start trading
with the rest of the world their price is dragged down towards the world
average, because they are effectively competing with their abundant
counterparts in the rest of the world.
• The same reasoning applies in reverse to factors that are relatively
abundant in their own countries relative to the rest of the world.
So, in the US in this example, workers are initially relatively scarce and lose
from trade, while employers gain; in China workers are initially relatively
abundant and gain from trade, while employers lose. The key to under-
standing this is to focus on the change in relative scarcity once labour and
capital embodied in traded goods and services can flow across borders.
This, however, ignores the overall increase in the size of the economy
resulting from trade. This could benefit everyone in the economy and could
therefore offset the losses experienced by the disadvantaged group (in this
case, the US workers).
18.6 WINNERS AND LOSERS FROM TRADE AND SPECIALIZATION
827
Figure 18.20 illustrates the two dimensions of conflict arising from
international trade.
On the left we have the US and Chinese economies with limited
specialization and trade. To make comparison easy, the economies are
normalized to a size of one, and the numbers in the pies show both the
proportion and size (in brackets) of the slice of the economic pie that accrue
to workers (red) and the owners of capital (blue). On the right we show the
US and Chinese economies with greater specialization and trade.
The gains from specialization and trade are clear from the fact that the
total size of each economy on the right is larger. The size of the US eco-
nomy has increased by 30% and the size of the Chinese economy has
increased by 40%. The prices at which they have traded (as determined by
bargaining) have resulted, in this case, in China securing more of the gains
from trade.
But notice too that China’s shift into labour-intensive electronics has
raised labour’s share of China’s larger pie, and reduced the share of profits.
Both capital and labour in China are, however, better off with higher
specialization and trade, as the absolute size of the slices going to workers
and the owners of capital have both increased (0.5 < 0.84 and 0.5 < 0.56).
With limited trade With greater trade
75%
(0.75)
25%
(0.25) 45%
(0.59)55%
(0.72)
50%
(0.5)
50%
(0.5) 60%
(0.84)
40%
(0.56)
US
(total size = 1)
US
(total size = 1.3)
China
(total size = 1)
China
(total size = 1.4)
Wages (labour’s slice of the pie) Profits (capital’s slice of the pie)
30%
growth
40%
growth
Figure 18.20 The winners and losers from trade between the US and China.
UNIT 18 THE NATION AND THE WORLD ECONOMY
828
The story is different in the US. The owners of capital goods (employers)
now have a larger slice of the US’s larger pie, but the US workers’ slice is
not only proportionally smaller (75% > 55%), but also smaller in absolute
size (0.75 > 0.715). So even after we take the growth of the economy into
account, US workers are the losers. US employers, Chinese employers, and
Chinese workers are all winners.
The same logic would continue to apply if we considered other factors
of production. For example, consider two industries that require employees
with different levels of skills and education: a skill-intensive industry
(information technology) and a non skill-intensive industry (consumer
electronics assembly). If a rich economy, relatively abundant in skilled
labour, starts trading with a poor, unskilled, labour-abundant country, then
unskilled workers in rich countries (and skilled workers in poor countries)
will lose out relative to skilled workers in rich countries (and unskilled
workers in poor countries), who will gain.
You might think that this would affect the way that different groups
viewed trade. Indeed, there is considerable survey evidence that unskilled
workers in rich countries are more protectionist than skilled workers, but
unskilled workers in poor countries are more in favour of trade than skilled
workers. Of course, as illustrated in Figure 18.20, if the gains from trade are
large enough it could still be the case that the members of the group that is
relatively less well off within a country are made better off in absolute
terms by the specialization and trade.
The example of the US and China shown in this section does not only
have relevance for the wave of globalization after 1945. One hundred years
ago, when Eli Heckscher and Bertil Ohlin, two Swedish economists, were
working on better understanding patterns of specialization and trade, they
were motivated by the globalization of the late nineteenth century. One dif-
ference between then and now is the factors of production involved. While
our example of the US and China focused on capital- and labour-intensive
manufactured goods, the globalization of the late nineteenth century
involved the exchange of land-intensive agricultural goods (food and raw
materials such as cotton) for labour-intensive manufactures.
The agricultural goods were exported by land-abundant (and labour-
scarce) countries such as the US, Canada, Australia, Argentina, and Russia;
the manufactured goods were exported by labour-abundant (and land-
scarce) countries in northwest Europe, such as Britain, France, and
Germany. In this context, the big losers were European landowners and
workers in land-abundant regions; the big winners were European workers
and the owners of land in the New World and other land-abundant eco-
nomies. In Unit 2 we saw that workers in England gained economically,
relative to landowners, from the middle of the nineteenth century onwards.
The same happened in other land-scarce, labour-abundant societies in
Europe and elsewhere (for example, Japan). Meanwhile, the ratio of land
rents to wages rose strongly in land-abundant, labour-scarce regions: not
just the New World economies mentioned earlier, but also in areas such as
the Punjab, which was a major exporter of agricultural products.
Not surprisingly, European landowners objected to this, and in coun-
tries such as France and Germany they succeeded in getting governments to
impose tariffs on agricultural imports. There was thus a political backlash
against globalization. Governments raised trade costs in the form of tariffs
to counteract the impact of the fall in other trade costs, notably
transportation.
18.6 WINNERS AND LOSERS FROM TRADE AND SPECIALIZATION
829
EXERCISE 18.7 WINNERS AND LOSERS FROM SPECIALIZATION DUE TO
ECONOMIES OF SCALE
Suppose there are two countries that are identical in their factor endow-
ments. Both would like to consume both passenger cars and commercial
vehicles, industries in which there are economies of scale. In the absence
of trade, each country would have both industries. If they could trade, both
could benefit by specializing and taking advantage of economies of scale
to lower their costs of production.
Assume that once trade becomes possible, country A specializes in
producing passenger cars and country B specializes in producing com-
mercial vehicles. Because of economies of scale, the cost of passenger
cars relative to commercial vehicles is lower in country A than in
country B.
1. Explain why we would expect to observe trade in similar products,
known as intra-industry trade, when production technology is
characterized by economies of scale.
2. Who are the winners and losers in this example? How does your result
compare with that of the winners and losers in the example of the US
and China, where specialization is based on relative factor endow-
ments?
QUESTION 18.8 CHOOSE THE CORRECT ANSWER(S)
Figure 18.20 (page 828) is a diagram that describes the effects of trade
on the employers and the workers in the US and China. The initial size
of each economy is normalized to one. The US has the comparative
advantage in the capital-intensive goods, while China has the
comparative advantage in the labour-intensive goods. As a result of
trade the US’s economy is assumed to grow by 30% and that of China
by 40%.
Based on this information, which of the following statements is
correct?
Specialization means that China will produce all the capital-
intensive goods.
The US has the stronger bargaining power in the determination of
the relative price after trade.
In the US, the employers are better off while the workers are worse
off as a result of trade.
In China, the workers are better off while the employers are worse
off as a result of trade.
UNIT 18 THE NATION AND THE WORLD ECONOMY
830
EXERCISE 18.8 THE COLLAPSE OF THE SOVIET UNION
In the late 1980s and early 1990s, the Soviet Union collapsed. The Soviet
Union comprised Russia and some of the countries that now make up
eastern Europe and central Asia. It was a planned economy, run from
Moscow by the Communist Party. Following this collapse, countries in the
former Soviet Union and elsewhere in the former Soviet bloc—with a total
of close to 300 million workers—opened their borders to international
trade.
1. Assume that Germany was a capital-intensive country, while the former
Soviet bloc states were labour-intensive. Use the analysis in this section
to identify likely winners and losers from this shock to global trade in:
(a) Germany
(b) the countries of the former Soviet bloc
2. What other information would you need to know about these countries
to identify the actual winners and losers?
18.7 WINNERS AND LOSERS IN THE VERY LONG RUN
AND ALONG THE WAY
In our example of the US and China, the short-run effect of trade was to
raise the profits of US employers while depressing the wages of US
workers. This would provide US employers with incentives to invest more
in building additional capacity to produce aircraft. Our analysis of wages
and employment in the long run (in Unit 16) provides a lens for us to study
what will happen next.
Specializing in the production of the good in which it has a comparative
advantage increases the productivity of US labour (workers have moved
from producing electronics to producing aircraft, where they are more
productive). This shifts up the price-setting curve and output per worker.
So, in this respect, specialization according to comparative advantage is
similar to technological progress as analysed in Unit 16. It may be worth
reviewing the key concepts in that unit before continuing on here.
Use the analysis in Figure 18.21 to follow through the impact effect and
adjustment process. We start with the US wage-setting curve and the price-
setting curve before specialization and trade with China. The economy
starts at point A with unemployment at the long-run rate of 6%.
When the economy has come to the new intersection of the price- and
wage-setting curves, will the US economy now employ more or fewer
workers than before?
As shown in the analysis in Figure 18.21, the answer depends on the
change to the wage-setting curve. Historically, in many countries,
integration into the world economy was accompanied by unemployment in
some sectors of the economy. In addition, economic fluctuations due to
international price changes produced variations in cyclical unemployment.
The result was an increase in voters’ demands for more adequate
unemployment insurance policies, and a strengthening of employment
protection and other policies to protect households from shocks to income
and employment. Voters supported these policies for the same reason that
households seek to smooth consumption. These effects would shift the
wage-setting curve up.
18.7 WINNERS AND LOSERS IN THE VERY LONG RUN AND ALONG THE WAY
831
Re
al
w
ag
e
Employment, N
U = 6% U = 4%
Price-setting curve
(after specialization)
Price-setting curveReal wage
Real wage
(after specialization)
Output per worker
Output per worker
(after specialization)
DF
Wage-setting curve
(modest shift)
Wage-setting curve
(large shift)
C
E
B A
Wage-setting curve
U = 8%
Figure 18.21 The long-run effect of specialization on unemployment in the US.
1. Unemployment at the long-run rate
The economy starts at point A (U = 6%).
2. The US specializes in the production
of aircraft
It has a comparative advantage. By
specializing in the good it is relatively
best at, this increases the average pro-
ductivity of US labour, shifting up
output per worker and therefore, the
price-setting curve.
3. Workers producing consumer
electronics are laid off
US consumers are now buying their
DVD players from China. Some are
hired in producing aircraft, but not all,
because productive capacity in that
sector is limited. The economy moves
from point A to point B and unemploy-
ment rises.
4. US aircraft manufacturing firms are
making large profits
They expect this will continue in the
future. They build new production
capacity, expanding the demand for
labour and re-employing the former
electronics workers. The economy
moves from point B to point C, and
unemployment falls to 4% below its
original level.
5. Increased demand for labour
The demand increases workers’ bar-
gaining power. Wages increase. This
process stops when the economy has
come to the new intersection of the
price- and wage-setting curves at point
D.
6. The wage-setting curve
It may also shift if workers demand
more generous unemployment benefits
because of the increased job turnover
due to the effects of trade. If it shifts a
lot, specialization might imply a
reduction in total employment. For
example, at point E in the figure,
unemployment is higher than the
original long-run rate of 6%.
7. Specialization and unemployment
However, if there were only a modest
shift in the wage-setting curve, employ-
ment would have risen as a result of
specialization, as shown by point F.
UNIT 18 THE NATION AND THE WORLD ECONOMY
832
welfare state A set of government
policies designed to provide
improvements in the welfare of cit-
izens by assisting with income
smoothing (for example, unemploy-
ment benefits and pensions).
As we saw in Unit 17, in the era after the Second World War, many
countries integrated their economies into the world economy and at the
same time developed income-smoothing policies, commonly termed the
welfare state. In Nordic countries, for example, trade unions agreed to
unimpeded imports. In return they won support for unemployed workers,
and policies to retrain workers displaced by imports increased.
The rapid growth in world trade among the high-income countries
following the Second World War took place alongside the development of
the welfare state and falling inequality. Unemployment remained low
during this period, as we saw in Units 16 and 17. Specialization in this
period was based on trade among quite similar countries—US and western
European economies, for example—and it rested to a considerable extent
on economies of scale and agglomeration economies. Much of it was so-
called intra-industry trade where countries were trading similar goods
(exporting and importing different kinds of cars and commercial vehicles,
for example, as in Exercise 18.7).
The process of specialization created winners and losers—including
winner companies like BMW and Ford, and entire winner industries like
machine tools in Germany and aircraft production in the US, benefiting
owners and employees alike. And, unlike specialization based on factor
endowments, trade based on economies of scale does not separate out the
winners and losers according to the factor of production that is the main
endowment on which a person’s income depends (for example labour or
capital).
The renewed growth of global integration following the collapse of the
Soviet Union and the opening up of China to trade from the early 1990s has
been accompanied by rising inequality in many high-income countries,
along with geographically concentrated job losses in labour markets
affected by imports from China. For these particular displaced workers it
was not much reassurance to know that a new equilibrium would
eventually be reached in which workers would on average be better off.
With the help of the labour market model in Figure 18.21, we can see the
common features of a trade shock and a technology shock. In Section 16.7,
we contrasted the benefits of these shocks in the very long run with the
costly adjustment as jobs are lost before new ones are created in different
industries (and locations). The evidence reported there from the ‘China
shock’ that began in the early 1990s highlighted that job losses were
concentrated geographically and persisted for decades. Tennessee, which
specialized in furniture, suffered massive, long-lasting job losses, while
nearby Alabama, which produced goods that were not exported by China,
did not.
Not all countries were affected in the same way by the China trade
shock. Recent research shows that in Germany, the new opportunities to
trade with low wage countries in eastern Europe arising after the fall of the
Berlin Wall, and to trade with China, slowed down the loss of
manufacturing jobs. Although jobs in industries competing with imports
shrank, jobs in exporting industries were about the same in 2014 as in
1997. One explanation for the difference between the effects in China and
the US is that among the capital-intensive countries, Germany was more
successful than the US in expanding its markets in China. Comparing
Germany and the US, Germany’s specialization in exports of machine tools,
other capital goods (for use in Chinese factories), and transport equipment
matched the demand from rapidly industrializing China.
Wolfgang Dauth, Sebastian
Findeisen, and Jens Südekum.
2017. ‘Sectoral Employment
Trends in Germany: The Effect of
Globalization on their Micro
Anatomy’ (https://tinyco.re/
2554801). VoxEU.org. Updated 26
January 2017.
18.7 WINNERS AND LOSERS IN THE VERY LONG RUN AND ALONG THE WAY
833
QUESTION 18.9 CHOOSE THE CORRECT ANSWER(S)
Figure 18.21 is the long-run labour market model for the US as a result
of specialization according to its comparative advantage.
The US has a comparative advantage in the production of capital-
intensive aircraft, while China, its trade partner, has a comparative
advantage in the production of labour-intensive consumer electronics.
Before trade, the German labour market equilibrium is at A. Which of
the following statements are correct?
As a result of specialization, at first both worker productivity and
the total employment level rise.
With the rise in productivity, the firms expand employment resulting
in a lower unemployment rate.
With lower unemployment, workers demand higher wages for high
effort, resulting in a higher price-setting curve.
The wage-setting curve rises if workers demand unemployment
insurance as a result of globalization. Then the long-run employ-
ment level is unambiguously lower than at A.
18.8 MIGRATION: GLOBALIZATION OF LABOUR
Just as the Italian farmers had not been happy to see the cheap Indian grain
being offloaded from the steamer Manila in Genoa, workers in North
America did not always welcome Europeans in search of a more affluent
life, like the 69 passengers sailing west on the Manila after leaving Genoa on
their way to New York. Immigration hurt unskilled workers in the New
World. Where unskilled wages lagged furthest behind average incomes,
immigration barriers were raised the most.
This resulted in another type of globalization backlash during the first
period of globalization in the nineteenth and early twentieth centuries:
gradually rising barriers to immigration.
In Unit 9, we analysed the effect of immigration on unemployment (see
Figure 9.19 (page 394)). The model helps us to see why opposition to
immigration was common among workers in land-abundant economies
like the US or Canada at that time and in many countries since. When new
people arrive in a nation they are unemployed, so we might expect the first
impact of immigration to be that it increases unemployment. This means
that immigration also increases the cost of job loss for residents, because
the worker who loses a job is now in a larger pool of unemployed workers.
Workers have more to fear from losing their jobs, and firms will be able to
make employees work effectively at a lower wage.
This is not the end of the story. Firms are now getting work at lower wages,
and so are more profitable. As a result they will seek to expand production. To
do this, they will invest in new machinery. This will increase labour demand in
the rest of the economy, and when the new capacity is ready, firms will hire
more workers. Return to the analysis in Figure 9.19 (page 394) to follow the
steps from the impact effect to the long-run outcome.
In this story, the short-run impact of immigration is bad for existing
workers in that country: wages fall and the expected duration of unemploy-
ment increases. The short run may last for years or even decades.
In the longer run, the increased profitability of firms leads to expanded
employment that eventually will restore the real wage and return the eco-
UNIT 18 THE NATION AND THE WORLD ECONOMY
834
The economic effects of
immigration are widely debated
among the public. This interview
from 2006 with Christian Dustmann,
an economist who specializes in the
effects of migration, captures this
debate—in particular the impact of
migrant workers on the British town
of Swindon. https://tinyco.re/
3390155
trilemma of the world economy
The likely impossibility that any
country, in a globalized world, can
simultaneously maintain deep
market integration (across
borders), national sovereignty, and
democratic governance. First
suggested by Dani Rodrik, an
economist.
nomy to its initial rate of unemployment (if no further changes in the situ-
ation take place, like another wave of immigration). As a result, incumbent
workers are no worse off. Immigrants are likely to be economically better
off too—especially if they left their home country because it was difficult to
make a living.
EXERCISE 18.9 THE ECONOMIC EFFECTS OF IMMIGRATION
1. Summarize the evidence on migrants’ skills suggested in the video.
2. Use the labour market model to show what may happen to wages and
employment after an influx of migrant workers.
3. What is the evidence on the effect of immigration on wages in Britain
reported in the video? Compare this with your prediction from question
2. Try to modify the price- and wage-setting model to come up with an
explanation of this evidence.
18.9 GLOBALIZATION AND ANTI-GLOBALIZATION
As the nineteenth-century examples of European agricultural protection and
New World immigration restrictions show, globalization can undermine
itself. It produces winners and losers. We have seen that by allowing countries
to specialize, globalization of trade in goods and services can expand the con-
sumption possibilities of all nations. But the freer movement of capital
around the world in search of profit-making opportunities also allows busi-
nesses to seek countries with lax environmental regulation and low taxation
or where workers do not have rights to organize in trade unions.
So governments that wish to attract overseas investments are often
under pressure to oppose policies that would address problems of environ-
mental sustainability and economic justice. The freer movement of goods
and capital, as we saw in Units 13 to 15, also limits the effectiveness of poli-
cies to stabilize aggregate demand and employment. The movement of
labour from one country to another creates gains for some, but threatens
losses for others.
If the losers, whether from the mobility of goods, investment or people,
are ignored, globalization may turn out to be politically unsustainable in a
democracy.
These concerns have been analysed by Dani Rodrik, an economist, who
developed what he calls the fundamental political trilemma of the world
economy. His trilemma refers to three things, all of which are valued, but
which (according to Rodrik) cannot all occur at the same time. Rodrik’s
trilemma is really just another trade-off, like that between low inflation and
low unemployment (it’s hard to have both), except that Rodrik’s trade-off is
in three dimensions.
He defines the three dimensions as:
1. Hyperglobalization: A world in which there are virtually no political or
cultural barriers to the location of goods and investment.
2. Democracy within nation states: This means (as we said in Unit 1) that the
government respects both individual liberty and political equality.
3. National sovereignty: Each national government can pursue policies that
it chooses without any significant limits imposed on it by other nations
or by global institutions.
Dani Rodrik. 2012. The
Globalization Paradox: Democracy
and the Future of the World Eco-
nomy. United States: W. W. Norton
& Company.
18.9 GLOBALIZATION AND ANTI-GLOBALIZATION
835
hyperglobalization An extreme
(and so far hypothetical) type of
globalization in which there is
virtually no barrier to the free flows
of goods, services, and capital. See
also: globalization.
As an example of one of the tensions among these objectives, according to
Rodrik, hyperglobalization means that countries have to compete with
each other for investment, with the result that wealth owners will seek
locations for their investments in which labour has fewer rights and the
environment is less protected. This makes it difficult for national govern-
ments to adopt regulatory standards or other policies, or raise taxes on
mobile capital or highly paid workers, even when citizens think that
fairness requires this. Implementing hyperglobalization may be impossible
in a democratic society. The outcome may therefore either be the demise of
hyperglobalization (top row of Figure 18.22) or the demise of democracy
(middle row).
Figure 18.22 illustrates the three possible outcomes of Rodrik’s political
trilemma.
Let us take each row of the table in turn to clarify the trade-offs.
• Hyperglobalization is ruled out (top row): This happens if national
sovereignty and democracy at the national level endure. The reason is
that there have to be limits on labour and capital mobility in order to
Democracy
National
sovereignty
Hyper-
globalization
If we have then and as a consequence
Hyperglobalization
National sovereigntyDemocracy
National sovereignty
(limited global governance)
and
Democracy
Effective national
economic policies
of stabilization,
environmental
protection and
redistribution require
limits on labour and
capital mobility,
the opposite of
hyperglobalization
National sovereignty
(limited global governance)
Hyperglobalization
and
Hyperglobalization
policies are unpopular
with voters because
they increase economic
insecurity and weaken
labour rights and
environmental
protection and
hyperglobalization can
only survive if
democracy does not
Democracy
Hyperglobalization
and
Demands for global
governance (e.g. labour
standards, global
environmental protection,
tax treaties, coordinated
macro policies) that
compromise nationally
differentiated policies
mean that
effective global
governance is
inconsistent with
complete national
sovereignty
Figure 18.22 Rodrik’s political trilemma.
Adapted from Dani Rodrik. 2012. The
Globalization Paradox: Democracy and
the Future of the World Economy.
United States: W. W. Norton & Company.
UNIT 18 THE NATION AND THE WORLD ECONOMY
836
race to the bottom Self-destructive
competition between national or
regional governments, resulting in
lower wages and less regulation to
attract foreign investment in a
globalized economy.
Dani Rodrik explains in our
‘Economist in action’ video that
economics is a science of trade-offs,
and that we can have too much
globalization. His ‘Globalization
Trilemma’ shows that when eco-
nomies are increasingly globalized,
they must ‘give up some
sovereignty or some democracy’.
https://tinyco.re/2901543
deliver effective national policies of stabilization, environmental
sustainability, and redistribution that will be demanded by a democratic
electorate.
• Democracy is ruled out (middle row): Hyperglobalization policies can only
be implemented by the national government if the citizens’ opposition
to them is weakened by a dilution of democratic processes.
• National sovereignty is ruled out (bottom row): If hyperglobalization poli-
cies are accompanied by supranational institutions that can prevent a
race to the bottom in environmental and labour standards, for
example, and therefore gain democratic support, this restricts the ability
of countries to choose national policies independently.
A way of understanding the bottom row is to think of existing arrange-
ments in a federation like the US or Germany. There is free flow of goods,
investment, and people across states of the federation. The race to the
bottom is prevented by federal legislation and by democratic elections at
federal level. This restricts the ability of the states to implement policies
that would interfere with the benefits of ‘hyperglobalization’ across the
whole country, with the protection of standards and the operation of
stabilization policy.
A second example is the political integration of Europe over the last few
decades. It happened, in part, so that governments could obtain the benefits
of free trade, plus the free movement of capital and labour, while retaining
some ability at the supranational EU-wide level to regulate profit-making
in the interests of fairness and economic stability.
The obvious problem is how to make sure that this EU-wide or global
governance is democratic as well as technocratic, and to allow voters to
change the system if they don’t like it.
Other supranational governance initiatives include world agreements on
climate change, and efforts by the International Labour Organization to
require that all nations meet at least minimal standards for the treatment of
labour (eliminating child labour or the physical coercion of employees, for
example).
EXERCISE 18.10 RODRIK’S TRILEMMA
Watch Dani Rodrik’s ‘Economist in action’ video.
1. According to the video, what are some of the benefits and trade-offs
due to globalization?
2. State some historical examples of the policy trilemma that were given
in the video.
Use Rodrik’s trilemma and other information you can find to describe:
3. The popular support that led to the election of Donald Trump as
president of the US in 2016.
4. The popular support that led to the vote in 2016 for ‘Brexit’, that is, for
the UK to leave the European Union.
18.9 GLOBALIZATION AND ANTI-GLOBALIZATION
837
EXERCISE 18.11 EXAMINE THE RESPECTIVE STRENGTHS AND COSTS OF
ECONOMIC INDEPENDENCE, AND INTERDEPENDENCY
In an essay titled ‘National Self-Sufficiency’, published in 1933, John
Maynard Keynes warned of the consequences of globalization before the
word even existed:
We each have our own fancy. Not believing that we are saved
already, we each should like to have a try at working out our own
salvation. We do not wish, therefore, to be at the mercy of world
forces working out, or trying to work out some uniform equilibrium
according to the ideal principles, if they can be called such, of
laissez-faire capitalism … We wish for the time at least … to be our
own masters and to be as free as we can … to make our own
favourite experiments towards the ideal social republic of the
future.
It became conventional wisdom that global integration would eventually
make the idea of national economic sovereignty impractical. A third of a
century after Keynes wished for time ‘to be our own masters’, Charles
Kindleberger, an international trade economist, wrote that:
The nation-state is just about through as an economic unit … It is too
easy to get about.
Two-hundred-thousand-ton tankers … airbuses and the like will
not permit the sovereign independence of the nation-state in eco-
nomic affairs. (American Business Abroad, 1969)
1. Explain in your own words Keynes’ case in favour of ‘national self-
sufficiency’ and Kindleberger’s claim that ‘the national state is …
through’.
2. Frame the views of Keynes and Kindleberger in terms of Rodrik’s
Trilemma, and use the data in this unit and other units to assess their
statements. (You may want to recall the role of economic policies in
helping nations adjust to technological change and trade in Sections
16.8–16.10, and look ahead to the data on the size of the government
and how this has changed over time in Unit 22.)
18.10 TRADE AND GROWTH
What are the best policies for governments to adopt if they seek to promote
long-run growth in living standards? Some argue that it is a choice between
two policy extremes:
• Seal the national borders and withdraw from the world economy!
• Let trade, immigration, and investment across national boundaries take
place in the absence of government regulation of any kind!
Few (if any) economists advocate either policy. The question is how to
exploit the contributions of the global economy to a nation’s wellbeing,
while minimizing the ways in which integration into the global economy
may retard it. Among the growth-enhancing aspects of greater global eco-
nomic integration are:
UNIT 18 THE NATION AND THE WORLD ECONOMY
838
infant industry A relatively new
industrial sector in a country that
has relatively high costs, because
its recent establishment means that
it has few benefits from learning by
doing, its small size deprives it of
economies of scale, or a lack of
similar firms means that it does not
benefit from economies of
agglomeration. Temporary tariff
protection of this sector or other
support may increase productivity
in an economy in the long run.
learning by doing This occurs when
the output per unit of inputs
increases with greater experience
in producing a good or service.
• Competition: Limiting the impediments to trade in goods and services
among nations increases the degree of competition faced by firms in the
local economy. This means that firms that fail to adopt new technologies
and other cost-cutting methods are more likely to fail and to be replaced
by more dynamic firms. The result will be an increase in the rate of tech-
nological progress.
• The size of the market: A firm that can export to the world market has the
opportunity (if it can meet the competition) of selling far more than it
could were it restricted to the domestic market. This allows lower-cost
production, which benefits home-economy buyers, employees, and
owners of these successful firms, as well as external buyers.
Ways that greater integration into the global economy might retard growth
include:
• Learning by doing in infant industries: In addition to economies of scale,
another factor contributing to cost reductions is termed learning by
doing. Even if the firm never achieves large-scale production, costs of
production typically fall over time. Tariffs protecting infant industries
can give firms the time and possibly the scale of operation necessary to
become competitive.
• Disadvantageous specialization: For reasons of history, some countries
may specialize in sectors where there is a lot of potential for innovation,
whereas others specialize in sectors with little such potential. Many
Latin American countries, for example, slowed growth by specializing in
low-innovation sectors such as natural resource extraction. Developing
new specializations may require direct government intervention, includ-
ing infant industry protection.
It is clear from Figure 18.23 that during the second period of globalization,
workers in some countries—China and South Korea for example—have
seen rapid increases in their income levels. But the same figure also makes
it clear that in other countries, such as Mexico and Sri Lanka, workers have
seen few benefits from the increasingly integrated world economy.
There has not been a unique route to economic success during the past
150 years. For example:
• Early protectionism in Germany and the US: These countries developed
modern manufacturing sectors behind high tariff barriers that sheltered
them from British competition. In the late nineteenth century, the cor-
relation between tariffs and economic growth across relatively rich
countries was positive. In particular, higher manufacturing tariffs were
associated with higher growth. During the interwar period, tariffs were
also positively correlated with growth.
• Scandinavian prosperity through openness: These countries have been very
open to trade for more than 100 years and have prospered. So as to
mitigate the fluctuations in household income associated with changes
in international prices, they also have high tax rates to support generous
social insurance and subsidies for retraining.
18.10 TRADE AND GROWTH
839
• Picking national winners: Many East Asian governments have promoted
trade while influencing its pattern by favouring certain industries, or
even certain firms, and by directing firms to compete in export markets
whilst providing some protection from import competition.
• Two directions after 1945: On the one hand, countries in East Asia that
encouraged their firms to compete in international markets grew faster
than Latin American countries that were more closed to international
trade. On the other hand, after those Latin American countries reduced
their tariffs in the early 1990s, their subsequent economic growth rates
were lower than during the more closed period 1945 to 1980.
If there is a lesson from this, it is that success does not depend on whether a
country is more or less integrated into the world economic system—more
or fewer exports and imports, for example, or a greater amount of interna-
tional investment by its firms—but rather on how well economic
integration is managed by policies that promote growth.
EXERCISE 18.12 THE EFFECT OF TRADE ON GROWTH
The empirical evidence on how trade affects growth is
mixed.
1. Suppose you are a consultant with the World Trade
Organization (https://tinyco.re/2008074) and are
asked to design an empirical study to find the effect
of a country’s openness to trade on growth. How
would you approach this exercise? (Hint: see Section
1.9, the introduction to Unit 13, and Section 14.7 for
some ways that economists learn from data.)
2. How would you measure openness to trade (tariffs,
export ratios, or other indices of openness)? Discuss
the advantages and limitations of your chosen
method.
3. Explain the problems you would face in designing a
convincing study. Hint: think back to the examples
given in Section 1.9, the introduction to Unit 13, and
Section 14.7 about the ways that it is sometimes
possible to establish that something (like trade, in
this example) causes something else (like growth or
lack of growth).
Germany
Japan
Mexico
South Korea
PhilippinesSri Lanka
China
1
10
100
1,000
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year
M
an
uf
ac
tu
ri
ng
w
ag
es
re
la
tiv
e
to
th
e
U
S
(r
at
io
sc
al
e:
U
S
=
10
0)
Figure 18.23 Catching up and stagnating: Manufacturing wages relative to the US
(1950–2016).
View this data at OWiD https://tinyco.re/
2652653
(1) Andrew Glyn. 2006. Capitalism
Unleashed: Finance, Globalization, and
Welfare. Oxford: Oxford University Press;
(2) National Bureau of Statistics of
China. Annual Data (https://tinyco.re/
2297128); (3) Bank of England; (4) US
Bureau of Labor Statistics. 2015. Interna-
tional Labor Comparisons
(https://tinyco.re/2780183); (5) The
Conference Board. 2021. International
Labor Comparisons (https://tinyco.re/
8746332). Note: Annual US BLS data for
Mexico, the Philippines and Sri Lanka
has been smoothed using a backward-
looking five-year moving average.
UNIT 18 THE NATION AND THE WORLD ECONOMY
840
Paul Krugman. 2009. ‘The
Increasing Returns Revolution in
Trade and Geography’. In The
Nobel Prizes 2008 , edited by Karl
Grandin. Stockholm: The Nobel
Foundation.
Krugman, Paul. 1987. ‘Is Free Trade
Passé?’ Journal of Economic
Perspectives 1 (2): pp. 131–44.
Leontief paradox The unexpected
finding by Wassily Leontief that
exports from the US were labour-
intensive and its imports capital-
intensive, a result that contradicts
what the economic theories
predicted: namely that a country
abundant in capital (like the US)
would export goods that used a
large quantity of capital in their
production.
WHEN ECONOMISTS DISAGREE
Heckscher–Ohlin, the Leontief paradox, and the new trade theory
It was once thought that if countries were identical none would have a
comparative advantage in the production of any good, and there would
be no reason for them to specialize and to exchange goods. For example,
Eli Heckscher (1879–1952) and Bertil Ohlin (1899–1979) reasoned that,
when accounting for comparative advantage and trade, the key differ-
ences between countries were the relative scarcity of land, labour, or
capital. Canada and the US had abundant land relative to the amount of
labour, and hence would specialize in and export agricultural goods.
With more capital and less labour than China, Germany would export
capital-intensive goods to China.
Wassily Leontief (1906–1999) challenged the widely accepted
Heckscher-Ohlin theory in 1953. Using a method of input-output
analysis that he had invented, he measured the amount of labour and
capital goods used in the production of the goods exported from, and
imported to, the US. He determined, for example, the amount of labour
required:
• to produce a car
• to produce the steel, that went into the car
• to produce the coal, that fired the steel plant, that produced the steel,
that went into the car
… and so on.
Based on the Heckscher–Ohlin theory he expected that, because the
US was the most capital-abundant country in the world when measured
by the stock of machinery, buildings and other capital goods per worker,
its exports would be capital-intensive and its imports labour-intensive.
He found the opposite.
For more than 50 years, economists have struggled to resolve this so-
called Leontief paradox. Leontief speculated that the US might be
labour-abundant if instead of simply measuring the quantity of employ-
ees, we include cultural and organizational factors that support a high
level of effective work per employee. While his hypothesis has not yet
been adequately tested empirically, it reminds us that culture and insti-
tutions may be an essential part of explaining how an economy works
and may be a source of comparative advantage.
During the 1980s, economists Avinash Dixit, Elhanan Helpman, Paul
Krugman, and others, developed models of trade in which trade was not
due to differences between countries, but instead to increasing returns
to scale. As we have seen in this unit if, through specialization, trade
allows countries to reap greater economies of scale, this makes trade a
good idea even if the countries do not differ in endowments, including
culture and institutions. This ‘new trade theory’ supports arguments for
tariff protection. For example, increasing returns means monopoly
profits—so perhaps it would be a good thing if your country gets these
profits, rather than someone else. Read Paul Krugman’s Nobel lecture,
and an earlier paper that he wrote on free trade, to find out more.
18.10 TRADE AND GROWTH
841
18.11 CONCLUSION
The world’s economies are now part of an integrated global system. Major
companies consider the entire world when deciding where to produce and
where to sell their goods and services. Investors, likewise, choose where to
hold their assets, whether financial or real, on the basis of calculations of
expected returns after taxes in all the regions of the world. But we have also
seen that labour has for the most part not been globalized, and for political,
cultural, and language reasons remains largely national. National borders
remain an essential fact of the global economy. National governments
remain major actors in affecting the course of their own and other eco-
nomies.
Globalization has brought about important changes. In the eighteenth
century, at the birth of economics as a discipline, goods were traded across
national boundaries, and investments were made in far-flung parts of the
world; but for the most part the nation and its economy had the same
boundaries.
The world today looks quite different. Trading of goods and services and
investment are now integrated into the world financial system in which
transactions are made electronically in milliseconds.
Economists can help to design and evaluate policies that secure the
greatest possible mutual gains among the world’s people participating in
this new dynamic and cosmopolitan economy. They can also identify
groups whose livelihoods are under threat from the globalization process
and propose policies to ensure that the gains made possible from
worldwide investment and exchange are fairly shared.
Concepts introduced in Unit 18
Before you move on, review these definitions:
• Globalization and hyperglobalization
• Specialization
• Comparative advantage
• Price gap, trade costs, arbitrage
• Globalization I and II
• Tariff
• Current account (CA), CA deficit, CA surplus, net capital flows
• Balance of payments accounts
• International capital flows
• Gains from trade
• Foreign direct investment (FDI)
• Foreign portfolio investment
• Economies of agglomeration
• Learning by doing
• Infant industries
18.12 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
UNIT 18 THE NATION AND THE WORLD ECONOMY
842
Dauth, Wolfgang, Sebastian Findeisen, and Jens Südekum. 2017. Sectoral
employment trends in Germany: The effect of globalisation on their micro
anatomy (https://tinyco.re/2554801). VoxEU.org. Updated 26 January
2017.
Krugman, Paul. 1987. ‘Is Free Trade Passé?’ Journal of Economic
Perspectives 1 (2): pp. 131–44.
Krugman, Paul. 2009. ‘The Increasing Returns Revolution in Trade and
Geography’. In The Nobel Prizes 2008, ed. Karl Grandin. Stockholm:
The Nobel Foundation.
Ricardo, David. 1815. An Essay on Profits. London: John Murray.
Ricardo, David. 1817. On The Principles of Political Economy and Taxation
(https://tinyco.re/2109109). London: John Murray.
Rodrik, Dani. 2012. The Globalization Paradox: Democracy and the Future of
the World Economy. United States: W. W. Norton & Company.
18.12 REFERENCES
843