International interdependence is a central feature of the world economy. The economic fortunes of countries are intertwined via trade, foreign direct investment, and financial capital flows. Production networks are spread across countries and continents, making the supply of products in one country highly dependent on economic activities in multiple foreign countries. The global crisis of 2008 illustrates this interdependence in a most vivid way; it led to a decline in the volume of world trade by more than one-quarter, negatively impacting countries whose financial systems remained sound. Moreover, the historical record shows that long-distance trade interacted in complex ways with...

Countries have traded with each other since ancient times. King Solomon ordered cedar of Lebanon from King Hiram of Tyre for the construction of the temple in Jerusalem about 3000 years ago (see 1 Kings 5:9), while many residents of modern Jerusalem build their floors from Italian tiles.

Economists have long pondered the question “What drives international trade?” As for cedar of Lebanon, the answer may appear simple: if one insists on building a temple or a palace in Jerusalem from this highquality aromatic timber, the wood has to be imported from Lebanon, because this is where it grows. And...

Smith and Ricardo believed that specialization and trade benefit all parties to an exchange. Ricardo in particular extended this view to countries, arguing that trade restrictions are harmful. He was engaged in a debate concerning the Corn Laws, a major piece of protectionist legislation that was passed in the British parliament by the landed aristocracy in 1815, two years before the publication of his magnum opus The Principles of Political Economy and Taxation.⁵⁰ In fact, Ricardo developed his theory of comparative advantage to illustrate the benefits of free trade.

Recall Ricardo’s example of trade in cloth and wine: it takes...

Traditional approaches to comparative advantage focus on industries as units of observation, and these in practice are represented by more or less disaggregated data sets. An underlying rationale behind this approach is that in every industry outputs of different firms are highly substitutable for each other, and so there is no harm in assuming that a sector supplies a homogeneous product. In this view Italian tiles from Modena are nearly perfect substitutes for Israeli tiles from Jerusalem, and Pierre Cardin shirts for men are nearly perfect substitutes for Van Heusen shirts for men. In other words, although tiles and shirts...

The integration of economies of scale and monopolistic competition into traditional trade theory was a major intellectual achievement that provided a framework for better understanding the structure of world trade. As we saw in the previous chapter, this approach emphasizes the importance of the range of products available in a country, it suggests new sources of comparative advantage, and its empirical predictions find support in the data.

Despite the desirable features of these trade models from the 1980s, they proved inadequate to explain a range of empirical findings that emerged in the 1990s from new firm-level data sets. These findings...

Despite their richness, the analytical frameworks discussed in the previous chapters miss elements of the international organization of production that have grown in prominence in recent decades. In particular, fragmentation of the production process across firms and countries is more prevalent now than ever before, and this has affected the sourcing strategies of corporations at home and abroad. The proximate cause of these changes has been developments in information technology (IT), which greatly improved communications, computer-aided design, and computer-aided manufacturing. These improvements enable producers to split the production process into stages that can be physically and geographically separated from each...

Aggregate measures of international engagement, such as trade volumes or stocks of FDI, do not fully reflect the extent of international interdependence. Over time, changes in these volumes were often driven by economic, technological, and political forces that also changed the nature of trade and investment flows around the world, thereby influencing the forms and degrees to which countries are tied in with each other. These developments also led to more complex interconnections across countries and business firms. As a result, the study of international economic activity had to be refocused time and again in order to appreciate and better...