Introduction to International Economics: Origins, Themes & Gravity Model

so in this video we're going to think about kind of an introduction to what international economics

is the field of Economics as as it exists today really began with International economics um it started

when David Hume published a a essay in the mid 1700s about 20 years before Adam Smith published The Wealth of Nations

and in hume's essay really what he was discussing was uh British International Trade policy and if you read The Wealth

of Nations um you'll see that a good portion of that most of it is is devoted to um British International Trade policy

and it was Hume that kind of turned the field of Economics from a a an informal discussion-based

field into a a a modelbased field which is is how you've been taught the economics that you know we we think

about models like the demand and supply model or the model of uh comparative advantage um and so it was really Hume

that that started that in terms of how important international trade is um if you go back

to say the 1960s at least with the us about 4% of real GDP um was accounted for by International Trade um and that's

continued to grow if you uh look now it's roughly 20% of of uh real GDP so international trade is a good sized

portion of of our economy it's even bigger for other countries so if you there are several countries

where more than half of their um economic activity is accounted for by international trade

let's talk for a second about how the field of international econ is different from other subdisciplines of Economics

so if you're thinking about say buying a good um from somebody in another state let's say you drive to Kansas and uh you

stop at a store and you buy something well we've studied how that transaction works we know that price is going to be

determined by demand and supply fly and um you can take the money that you've got in your pocket or the money that's

represented by your um debit card and you can buy that product and you can drive home and that's really kind of the

extent of it if you buy something from somebody in a foreign country these days the transaction still

kind of feels that way it's you're going to a lot of times get on on uh the internet and buy something maybe maybe

through Amazon or um some other online store and it'll be shipped to you and the transaction feels very

similar to that transaction of buying something from somebody in Kansas but there are some important differences and

the first one is that there are two Sovereign Nations that are involved there and so there can

be restrictions in terms of what you buy or how much you buy that are imposed by the United States they might limit how

much you can purchase from somebody in another country or those restrictions could be imposed by the other country it

could be maybe not just a limit on how much you buy but our country May impose a tax on you when you buy it or or the

foreign country May impose a tax on you when you buy it um so that's the first difference is that depending on the

country there can be different rules about what you can buy or how much you buy the other interesting thing is

that you're going to be paying for the product with a different currency than what they use in the foreign country if

you buy something from somebody in Kansas that's not even a consideration because we're using the dollar they're

using the dollar and and you don't even think about it but if you buy something from somebody in another country there's

going to be two currencies involved there's going to be an exchange rate and what we'll see in this class is that the

exchange rate is really the price of currency so if we think about the dollar and the Euro the exchange rate between

the two tells us how many dollars it takes you to buy a Euro and that can change and what we'll

see is that that's determined by the demand and supply for euros versus dollars and so um that's an interesting

um characteristic of it you could if the exchange rate changes the price that you pay for that good from the foreign

country could be different um in a week than what it is today and so we have to think about how the exchange rate and

the fact that we're using different currencies affects um economic activity there are going to be some

themes that we're going to cover in this class and the first one is one that you've already talked about and that is

gains from trade so if you think back to um your principles of macro class or possibly even at the beginning of

principles of micr class you probably studied a model of why people trade um we'll begin um in our next

video talking about that model of why people trade and the reason that people trade is that there are gains from

Trading the world is not a zero sum game we're used to thinking about a lot of people think about the world as if it's

a zero SU game and what that means is that um if I'm made better off by some transaction then that must mean that the

other person's made worse off by that transaction and it turns out that that's not really how it works there are some

times when a particular situation might be a zero sum game but in terms of of trade between two people or trade

between two countries it's actually a positive sum game and what that means is that both the parties involved in the

trade can be B made better off and that's counterintuitive to a lot of people so we'll talk about where the

gains from trade come from you probably hopefully remember that it comes from people or countries

specializing in what they have the comparative advantage in we'll review that um we'll also talk about the fact

that everybody can be made better off by trade but that's not necessarily that doesn't necessarily imply that everybody

is made better off by trade so in some of the simple models that we'll talk about at the beginning um we'll see that

that everybody involved will become better off but we'll have a little bit more complicated models that that are

more representative of the real world and we'll see that in those cases it could be the case that that one group

can be made better off while another group is not made better off they could be made worse off so we have to think

about that how how are the benefits of trade spread across different groups of people we'll spend some time talking

about what determines the pattern of trade so who trades what um in this simplest model that you've already

talked about in your principal class you know that you tend to specialize in the good for which you have the comparative

advantage but but in that particular model there's only two goods and so you specialize in one and you import the

other well typically in a country there are thousands of goods and so we'll need to talk about a model where there are

multiple Goods we won't have a thousand but we'll have more than two and we'll talk about what determines which of

those goods you export and which of those goods you import we'll also spend some time

talking about the amount of trade what it what determines how much trade takes place um

we'll talk a little bit at the end of the semester or at the excuse me at the end of the class about exchange rate

determination so what determines the price of a euro in terms of dollars um you already know I already said it just

a little bit ago that it's going to come down to demand and Supply but we'll talk more explicitly about about um how that

works let's start by talking about a model that that helps us understand empirically um something about how trade

works and the amount of trade that takes place and this is a model that is known as the gravity model um it it's really

nothing more than an empirical relationship and what that means is it it's something that helps us understand

the data we can look at the data and we can um start to get a basic understanding of of what are the

important determinants in term that that help us understand the amount of trade that takes place um so

if we think about how this gravity model works it's actually very simple so if we start with ti J we're going to let TI

represent the amount of trade that takes place between country I and Country J okay so this is the amount of

trade and empirically what we see is that the amount of trade that takes place between two countries is going to

be a function of the GDP of those two countries the size essentially of their economies and it's also going to be a

function of the distance between these two countries now the way this relationship works is we're going to put

a number a out here we're just going to let that be a general number for right now but when we would empirically

estimate this this might turn out to be a model a number like five or 7 okay so for now just think about it as some some

number and we're going to multiply that by y i times y j these are going to be the gdps of our

two countries so this is the GDP of country I and the GDP of country J okay and then we're going to divide that by D

J and this is going to represent the distance between the two countries so here's

distance and right here is uh GDP so what this tells us is that the amount of trade that takes place between

two countries is related to the the size of the two economies and notice that if the size of the two economies goes up or

if one of these goes up that's going to increase the amount of trade so all other things equal the bigger the two

countries are the bigger the amount of trade that takes place between them we've got the distance between the

two down here in our denominator and so what that tells us is that the bigger D is the farther apart these two countries

are the smaller the amount of trade that takes place and on the other side of the coin the smaller the distance here the

bigger the amount of trade that we tend to observe between the two countries and that makes intuitive sense we tend to

see that countries that are close to each other Canada and the United States tend to have a large volume of trade

countries that are far apart all other things equal tend to have a smaller amount of trade

that takes place between them and this is again referred to as the gravity model and the reason it's referred to as

the gravity model because this is really based upon Newton's idea of the gravitational pull between two celestial

bodies so if you think about how that works we can think about the mass of the two bodies if you have two celestial

bodies the bigger those two bodies are the greater the gravitational pull between them and then the farther apart

those two celestial bodies are the less gravitational pull between them so this is very much based upon Newton's idea of

how much how to estimate the gravitational pull between two bodies now in terms of of how we take this and

and make it useful we're not in this class going to be gathering information on this and

somehow estimating it if you've had an econometrics class then then you may have talked about how you would estimate

a uh a function like this it's actually relatively easy um but we're not going to be doing that

in this class if if we did want to estimate it and you might in the future um typically what we do is we estimate a

little bit more General version of this so if we take the amount of economic activity I'm going to kind of rewrite

what we've got here the way that we tend to actually estimate this is to estimate parameters

on it alpha beta and gamma and again if you've had an econometrics class you know that that

doesn't really make it any more complicated it just makes it operational it it it helps us estimate the relative

importance how the data tells us Yi y j and this distance variable are actually related to each other so that's the

gravitational or the gravity model um we're really not going to do anything more with that it it just helps us

understand empirically um how the amount of trade is is determined

we'll get in the next set of videos we'll start talking about actual models that help us understand behaviorally why

countries would trade with each other so we'll do that in our next video