International Trade, Globalization, and Environmental Policy

Posted on Sep 22, 2025 in Economy

Ricardian Model of International Trade

The Ricardian model explains international trade as a result of differences in labor productivity. It highlights:

  • Market mechanisms that allow specialization in sectors with a comparative advantage.
  • How international trade is organized for mutual benefits.

Let’s imagine that the world only produces cheese and wine, and is composed of two countries: the domestic and the foreign one. There are obvious gains from trade if the domestic country can only produce cheese and the foreign country only wine. Trade benefits are also evident if each country specializes in the activity or product for which it is most efficient (has the lowest cost).

Production Possibilities Frontier (PPF)

The Production Possibilities Frontier (PPF) represents different combinations of goods that an economy can produce.

The PPF indicates, for each cheese production level, the amount of wine that can be produced. In autarky (absence of international trade), the PPF equals the consumption possibilities frontier.

Absolute advantage: the comparison between producers of the same good with respect to their productivity. Gains exist because everyone focuses on the activity for which they have the lowest opportunity cost.

Exchange benefits all members of society because it allows them to specialize in activities in which they have a comparative advantage.

Globalization and Its Measurement

Globalization: the process by which the world’s economies become more integrated through the freer flow of goods, investment, finance, and labor across national borders.

Offshoring: the relocation of a part of a firm’s activities outside the national boundaries in which it operates. It can take place within a multinational company or may involve outsourcing production to other firms. For example, Apple chooses to produce its goods in other parts of the world where costs are lower. Offshoring is an important aspect of globalization.

In the case of a multinational company, owners, managers, and employees in many economies have become part of the same unified, transnational structure because the costs of doing business within the company are lower than the costs of doing business with other companies.

Market exchanges involve several considerations:

  1. Exchange involves the possibility of mutual gains and also conflicts over how these gains will be distributed.
  2. The resulting outcomes may not be Pareto efficient (there may be technically feasible mutual gains that remain unrealized).
  3. The resulting distribution may seem unfair in the eyes of many.
  4. Well-designed government policies can improve the efficiency or fairness of the outcomes.

While this is true for 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: taxes on imports that effectively discriminate against goods produced in other countries.
  • Immigration policies: governments regulate the movement of people between nations.
  • 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.
  • Trade in goods: tangible products that are physically shipped across borders.

Common Measures of Globalization

  1. Imports/Exports/Total Trade: measured as a percentage of GDP (imports + exports).
    • There has been a clear upward trend in the amount of world trade (except from 1914 to 1945), with a strong acceleration since the 1990s.
  2. Reduction of Trade Costs: measured by price gaps between countries.

The Law of One Price should be upheld if there are no transportation costs or barriers to trade.

Price gap: the difference in the price of a good in the exporting and importing country.

Arbitrage: the practice of buying a good at a low price in one 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. As long as the trade costs are lower than the price gap, they make a profit. Due to arbitrage, in competitive equilibrium, the price difference should be equal to the sum of all trade costs.

Evidence of Goods Market Integration

In general, price differences between countries have decreased over time, while the volume of traded goods has generally increased.

Declining Transatlantic Trade Costs (19th Century)

The wheat price gap between the UK and the US 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. Price gaps almost vanished by 1914, and at the same time, the volume of wheat shipped across the Atlantic rose dramatically.

This was not an isolated case: international price gaps fell sharply on many routes and for many commodities between 1815 and 1914, the first epoch of modern globalization.

  • Agricultural commodities (wheat and animal products): British prices were higher than American ones (negative price gap).
  • Industrial commodities (cotton, textiles, iron bars): American prices were higher than British ones (positive price gap).

In general, price gaps fell (except for sugar): transatlantic commodity markets were better integrated.

Price gaps between the US and UK reduced over time due to:

  • Revolution in transportation
  • Improvements in farming and production technology

Railways were probably even more important than steamships in integrating global commodity markets by making it affordable to ship goods to and from the interior continents and coastal seaports.

In the late 19th century, price gaps fell less sharply, often because of tariffs (taxes on imports), which were rising in several countries, counteracting 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.

Deglobalization: an increase in trade costs, notably during the Depression, partly due to protectionist policies aimed at protecting domestic employment.

International gaps rose during the interwar period for many agricultural commodities because governments raised tariffs in response to unemployment and economic insecurity.

When a government undertakes protectionist policies, it 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, but it also means that 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).

Post-1945 Reglobalization

The post-1945 period saw reglobalization, which began slowly but then accelerated after 1990:

  • Agricultural markets: largely protected for much of the period, so international price gaps for agricultural commodities likely did not fall sharply.
  • Markets for industrial goods and components: liberalized, with several studies finding evidence of declining international price gaps in the late 20th 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.

For example, if trade between Germany and France increased from one year to another, but did not increase between these two countries and their other trading 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.

  • Globalization I: before 1870 – 1914
  • Globalization II: end of WWII – present

Macroeconomic Objectives and Well-being

  • Remember: macroeconomics focuses on human well-being.
  • However, traditional macroeconomics often has a narrow focus on stability and GDP growth.
  • Changes in work conditions, stresses on families, and developments in social and financial infrastructure are often ignored.
  • Environmental degradation.
  • Growing inequality.
  • Inadequacies in healthcare, childcare, and education.
  • Economic growth alone is not sufficient to improve well-being.
  • Finite planetary limits might make unlimited GDP growth unfeasible.

Reasons for Environmental Problems

1. Population Growth

There has been a dramatic increase in world population. Human population growth contributes to increases in many environmental pressures:

  • Food production
  • Land degradation
  • Pollution from fertilizers and pesticides
  • Overtaxing of water supplies

2. Resource Depletion

The world’s fisheries are in decline due to overfishing. Tropical forests are lost at a rapid rate. A billion people live in countries where usable water is scarce. Stocks of mineral resources are being depleted. Global production of oil will peak within the next few decades. Current dependence on fossil fuels could challenge the potential for industrialized countries to maintain their living standards and for developing countries to reduce poverty.

3. Pollution and Waste

Industrial countries generate a major share of the world’s pollution and waste. Toxic wastes are exported from industrialized countries to low-income countries. Emissions of various greenhouse gases trap heat near the Earth’s surface, leading to:

  • A general warming trend
  • Sea-level rise
  • Ecological disruption
  • An increase in severe weather events

Costs of Climate Change

The most dangerous impacts of climate change are not likely to occur for several decades or more, but the actions taken in the next few decades will almost surely have a profound effect on those ultimate impacts.

Climate change is likely to worsen global inequalities and impede economic development in poorer countries.

National and Global Climate Responses

Modern environmental problems require a coordinated international response.

The Kyoto Protocol committed industrialized countries to reduce their greenhouse gas emissions by an average of 5% below their 1990 emissions by the period 2008-2012.

  • Drafted in 1997 and ratified in 2005.

The Paris Agreement (December 2015):

  • Each country is supposed to set its own goal for the reduction in greenhouse gas emissions.
  • The treaty does not include any mechanism to actually enforce the commitments.

Cost of Action vs. Cost of Inaction

A large-scale energy transition away from fossil fuels has significant costs, but these are modest on a macroeconomic scale. These costs should be balanced against the growing costs likely to be caused by climate change:

  • Damage from extreme weather events
  • Agricultural output losses
  • Possible effects of famine, armed conflict, and mass migration

Environmental Kuznets Curve Hypothesis

The idea is that, in the long run, economic development reduces per-capita environmental damage.

  • With sufficient wealth and technology, countries adopt clean production methods and move to a service-based economy.

This suggests an inverted U-shaped relationship between development and environmental damages:

  • Environmental damage per capita increases in the early stages of economic development, reaches a maximum, and then diminishes as a country attains a higher level of income.

Tariffs tend to be higher in low-income countries than in rich countries, because alternative methods of raising government revenue, such as income tax, are difficult to administer in developing countries.

Balance of Payments

  • Imports: outflows of money.
  • Exports: inflows of money.
  • Trade deficit: more imports than exports, meaning a country borrows from abroad.
  • Trade surplus: more exports than imports, meaning a country lends abroad.
  • Trade imbalances link directly to borrowing/lending activities.

Financial Investments and Other Flows

  • Foreign portfolio investment: the purchase of financial assets across borders (e.g., a US company buys shares of a Chinese company).
  • Foreign direct investment (FDI): investment in businesses abroad.

Returns are repatriated to the investor’s home country.

Other International Payments

  • Remittances: money sent home by migrant workers.
  • Foreign aid: financial support from richer to poorer countries.

All these flows are part of the Balance of Payments.

Current Account (CA)

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). It is the sum of all payments made to a country minus all payments made by the country.

CA = Exports – Imports + Net earnings from assets abroad

A trade deficit does not always mean a CA deficit.

A CA deficit means a country is borrowing to cover the excess payments it is making to the rest of the world.

A CA surplus means it is lending to allow other countries to send it the excess payments.

Balance of Payments Account (BP)

The Balance of Payments Account (BP) records all payment transactions between the home country and the rest of the world, divided into the current account and the capital and financial account.

BP = CA + (Capital and Financial Account)

A CA surplus is a source of foreign exchange and is used to purchase factories (FDI) or financial assets, or it adds to the home country’s official foreign exchange reserves, thereby increasing the home country’s wealth.

The opposite is true for a CA deficit.

Does the Environmental Kuznets Curve Hold?

Not for many environmental problems:

  • Studies on municipal waste and energy use show environmental problems continue to rise as income rises.
  • CO2 emissions show a positive relationship with average income.

Economic growth appears unlikely to provide a guaranteed path to environmental sustainability. How can policies be designed to maintain well-being and promote human development, especially in developing countries?

Sustainable growth: a contradiction in terms?

  • Can any system grow without limits?

There is nothing in standard macroeconomics to guarantee that economic growth will be equitable or environmentally benign.

Specific policies for sustainable development are needed.

Green Taxes

Green taxes make it more expensive to undertake activities that deplete important natural resources or contribute to environmental degradation. They discourage energy and material-intensive economic activities while favoring the provision of services and labor-intensive industries. Green taxes serve as a means of internalizing negative externalities, such as pollution.

Objections include:

  • Green taxes fall disproportionately on lower-income households.
  • They are politically unpopular.

Eliminating Subsidies

Agricultural and energy subsidies that encourage the overuse of energy, fertilizer, pesticides, and irrigation water could be reduced or eliminated. This would improve government finances.

Money saved could be used to:

  • Lower taxes
  • Promote more sustainable agricultural systems

Recycling and Renewable Energy

Policies can promote greater recycling of materials and the use of renewable energy through measures such as:

  • Deposit/fund systems
  • Targeted subsidies

Governments can support the expansion of energy from solar power, wind, and geothermal heat.

Tradable Permits

Tradable permits set an overall limit on pollution by:

  • Issuing a limited number of permits.
  • Allowing the emission of specific quantities and types of pollution.

Pollution reduction may be most efficiently achieved by allowing businesses to choose between finding low-cost ways to reduce their emissions and paying to buy permits.

After permits are distributed to firms, they can then buy or sell them to other firms.

Nudging Toward Sustainable Transportation

Efficient transportation systems can replace energy-intensive automotive transport, including:

  • High-speed trains
  • Public transit
  • Greater use of bicycles
  • Redesign of cities and suburbs to minimize transportation needs

Governments need to finance and implement these systems.

Feed-in Tariffs

Feed-in tariffs are used to promote the construction of renewable energy supplies.

Suppliers of power from renewable energies get the right to feed their electricity into the grid at a predetermined rate (often above the market rate for electricity).

  • This allows renewable energy to be competitive.
  • It creates an incentive for the installation of renewable energy capacities.