By:

Masih ullah Rahimullah

Mohammad Khalil zaytoon

Assigned by:
Dr. Sudhakar Kota

Course:
International Business

What is the difference between GDP and GNP?

GDP is the market value of everything produced within a country; GNP is the value of
what's produced by a country's residents, no matter where they live
To explain further: GDP (gross domestic product) is, as we say on our FactCheckED.org
site, "the total market value of goods and services produced within the borders of a
country,” regardless of the nationality of those who produce them. GNP (gross national
product) is the total market value of goods and services produced by the residents of a
country, even if they’re living abroad. So if a U.S. resident earns money from an
investment overseas, that value would be included in GNP (but not GDP). And the value
of goods produced by foreign-owned businesses on U.S. land would be part of GDP (but
not the other measure).

As for which is the better indicator of economic health, GDP is the primary measure used
by the U.S. Department of Commerce’s Bureau of Economic Analysis. The BEA says that
GDP "refers to production taking place in the United States. It is, therefore, the
appropriate measure for much of the short-term monitoring and analysis of the U.S.
economy." Prior to 1991, however, the BEA used GNP as its primary measure. When it
made the switch, the BEA noted that GDP was already being used by "virtually all other
countries," so making comparisons between the U.S. and other nations would be easier.
GDP is also consistent with other economic indicators, such as employment.

The BEA continues to provide GNP figures, and it says the measure is particularly useful
in looking at topics such as income of U.S. residents and how income is used. There has
not been a large difference between the two measures in this country, but in other nations,
such as those with a high number of foreign investments, the GDP will be notably higher
than GNP

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Index of openness explanation:

During the last three decades, the economic conjuncture of the world has been shaped under neo-
liberal ideas. Free trade and economic freedom are seen as the major determinants of higher
prosperity levels for countries by their potential benefits on production and efficient distribution of
sources. Thus, by the effect of globalization, liberalization of trade and economic activities has
become the most highlighted policies for world economies.
In this paper, we have two main purposes. Firstly, we try to test the accuracy of ongoing neo-liberal
ideas by questioning whether international trade and economic freedom are related with income
levels of nations as defined in theories. Secondly, we search how international trade and economic
freedom show their effect on different economic levels by dividing countries in two as advanced
and developing economies. We also try to explain the ways that affect income through international
trade and economic freedom and why there are distinctions between countries’ benefits from
international trade and economic liberty. Our main hypothesis is that trade openness and economic
freedom are positively correlated with the prosperity level of countries. In addition, we expect that
advance countries have more gains from trade and freedom in contrast to developing countries.
In theory, international trade is concerned as one of the most important factors in growth and
prosperity. It is believed that international trade provides opportunities for countries to participate
in mutually beneficial exchanges. Countries can specialize on certain goods that they have
comparative advantage by using their factor abundance. As a result, total production tends to
increase by the gained specialization all around the world. Furthermore, increased international
trade volume enhances competition among nations which raises efficiency in production,
distribution and allocation techniques. The extended market size that is caused by the increasing
integration of economies benefits all producers and consumers by facilitating the flow of goods and
services across borders as well. Also, the influence of multinational companies accelerates the
diffusion of technology and new ideas by their variation of production locations. Thus, with these
positive externalities, it is expected that trade will stimulate production, growth and so does income
in countries. In accordance with these theoretical remarks, after 1980s the tariff and non-tariff
barriers on trade are lowered and new free trade arrangements between nations are formed on
international stage. Also World Trade Organization (WTO) was established to oversee trade
activities between nations by prescribing regulations to ease the flow of goods and services cross-
borders.
On the other hand, economic freedom which contains many sub-headings such as reduced
government size, free circulation of labor and capital, ease of entering or coming out of business
environment, advanced property rights and free international trade activities etc. in an economy
become one of the most dictated topics of liberal doctrine that lie in the root of Adam Smith’s
“invisible hand” phenomenon to achieve a higher level of welfare by risen efficiency, activity and
production. In theory, property and individual rights which are seen as fundamental determinants of
the incentive of making production and investment should be protected in order to ensure the
smooth operation of markets and activities of economic actors. Theoretically lack of freedom in
economic environment can distort economy. For instance, high regulations on business
environment and entrepreneurship can deteriorate the enthusiasm of individuals and firms. Also
large government size and high spending that require higher taxation can obstruct economic
activities, investments, production and so does economic prosperity. Price controls and inflationary
policies can damage the functioning of markets as well by rising inefficiencies and ambiguities. On
the other hand, as the reasons underlined above, trade is an important topic for economic freedom.
Lowering tariff and non-tariff barriers accelerate economic traffic and lead to more outturn.
Furthermore, free investment environment which contains low bureaucratic obstacles and
restrictions on capital movement create opportunities and incentives to make investment in new
ideas for entrepreneurs. An efficient financial system that is regulated by independent authorities is
needed to support investment environment by facilitating the matching of borrowers and lenders in
the market. Also the flexibility of labor market is a crucial factor in providing efficient match
between workers and jobs. Thus, in order to benefit from these theoretical inferences of freedom,

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many countries have moved toward a freer economic environment which is more consistent with
neo-liberal ideas and market capitalist systems become dominant all around the world.
In order to determine the effect of international trade and economic freedom on income levels, we
use econometrical analysis. Firstly, we investigate the relationship between GDP per capita and
trade openness by the regression analysis of 48 countries’ records for finding the connection
between international trade and economic prosperity. Then, we categorize countries as advanced
and developing to see the impact of international trade separately on both of the groups. Secondly,
we attempt to give the relation between economic freedom and GDP per capita by analyzing the
data of 50 biggest GDP producer countries in 2008 according to IMF. Again, we try to show the
effects of economic freedom on GDP per capita separately by grouping countries as advanced and
developing.
The outline of this paper is as follows, in next section, we investigate the prior literatures that are
related with our subjects. Then, we present the data and give the estimation of the models with rude
interpretation of results. In following section, the results are argued broadly by giving the reasons
behind them. The last section is the conclusion part which summarizes the study and delivers the
last opinions about the subject.

II.1.1 Trade openness

We examined the relation between the trade openness and GDP per capita by using the panel data
of 48 of 50 biggest GDP producer countries in 2008 according to IMF between the years 1994 and
2007. We excluded Taiwan and United Arab Emirates (UAE) because of the unavailability of
proper data of these countries. GDP per capita data that is arranged according to purchasing power
parity (PPP) is used for selected countries from IMF database. We use nominal values of export,
import and GDP levels from IMF database to determine the trade openness rates. In this study,
trade openness data is calculated as a ratio of international trade volumes (Exports + Imports) over
GDP levels for each country as mentioned above. Trade openness ratio that is greater than one
refers that the country has a greater international trade volume than its total GDP. Even though, the
scale of the trade openness ratios can be zero or greater than zero in mathematical sense, the trade
openness data of the selected countries in this study vary between 0.14 and 4.55.
In our model, GDP per capita is taken as a dependent variable, and trade openness and trend are
determined as independent variables. We add trend into our model to decontaminate the affect of
the ordinary changes in GDP per capita caused by the time impact. In order to make econometric
analysis we use the fixed effects model. Also, white cross-section method is employed to have
more significant coefficient variances in the regressions. First, we estimated the model for whole
dataset and then did the regression by dividing the data in two groups as advanced and developing
countries by using IMF classifications owing to idea that the different structure of economies reacts
differently for the changes in variables.
Our general structure of the model in regressions is determined as below;

Yi = α + βX1i + θX2i + εi
(1)

In this equation, Y refers to GDP per capita, X 1 refers to trade openness ratio, X2 is used to
illustrate trend effect and εi includes all other variables that we have neglected.
The result of the regression that is formed by using the whole dataset is shown below:

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Table 1. Trade Openness Regression Results
Variable Coefficient Std. Error

Intercept 8414.81* 581.49

Trade Openness 4646.40* 868.65

Trend 684.20* 48.11

R-squared Countries
Advanced 0.967 Developing Countries
Variable Coefficient Std. Error Variable Coefficient Std. Error

Intercept 14525.75* 594.99 Intercept 4112.77* 299.70

Trade Openness 4222.48* 727.53 Trade Openness 775.95*** 466.97

Trend 1108.21* 55.17 Trend 297.89* 37.77

R-squared 0.958 R-squared 0.957
* refers significance at 99%.

Table 1 shows us that there is a strong and positive relationship between trade openness and GDP
per capita. The coefficients are statistically significant at 99% confidence level that supports the
validity of each in the regression. One point increase in trade openness rate raises GDP per capita
by approximately 4646 U.S. dollar on average for whole countries in the model. Also there is a
positive connection between trend and income per head. On average, the time effect on GDP per
capita is 684 U.S. dollars between the years 1994 and 2007. As a brief interpretation, although
trend has a strong effect on GDP per capita, international trade is a key factor for higher prosperity
levels for countries and their citizens as generally accepted in theory.
When we separate countries in two groups to measure how international trade effects income levels
of countries in different structures, we find the results that are shown in Table 2 for both advanced
and developing countries:

Table 2. Trade Openness Regression Results

*, *** refer significance at 99%, 90%.

As it is seen from the Table 2, trade openness and GDP per capita have a positive correlation for
advanced countries. All coefficients are significant at 99% confidence level. In advanced countries,
one point increase in trade openness ratio raises GDP per capita by approximately 4222 U.S. dollar
on average. Also trend has a great influence on GDP per capita. One year increase indicates 1108
U.S. dollar higher GDP per capita on average between the years 1994 and 2007. This result shows
us that trade openness and GDP per capita show collateral pattern for high income countries.
The obtained result for developing countries also illustrates the positive linkage between trade
openness and GDP per capita. While the coefficient of trade openness is significant at 90%
confidence level, the other coefficients are significant at 99% level. The regression outcomes
confirm the benefits of internationalization for developing countries. One point increase in trade
openness ratio raises the GDP per capita about 775 U.S. dollars in developing countries. Also the
trend in GDP per capita is positive in these countries. Every year between 1994 and 2007, average
income of the citizens of developing countries ascended by 297 U.S. dollars.

II.1.2 Economic freedom

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To determine the correlation between economic freedom and GDP per capita, we use the data of 50
largest GDP producer nations in the year 2008 according to IMF. The panel data of economic
freedom and GDP per capita are composed by using the records between the years 1996 and 2007
in order to construct our regression. We again choose GDP per capita (PPP) data which is obtained
from IMF database as a dependent variable and index of economic freedom and trend as
independent variables in the model. As it is mentioned above, the economic freedom averages are
taken from the Index of Economic Freedom of Heritage Foundation. The index of economic
freedom is arranged by equally weighted composition of ten variables which are business freedom,
trade freedom, fiscal freedom, government size, monetary freedom, investment freedom, financial
freedom, property rights, freedom for corruption and labor freedom. It is unnecessary to express the
context of subtitles again as we have discussed the meaning of each broadly in previous sections.
The scale of the index changes between 0-100 and greater index values mean broader economic
freedom in a country. Trend is also added to regressions in order to separate the time effect on
dependent variable in the model. We use fixed effects model and white cross-section method in all
econometric analysis. We run three equations by using the data of whole countries and separately
grouped countries as advanced and developing. The general equation that is used in all regressions
is determined as below;

Yi = α + βX1i + θX2i + εi
(2)

In this model Y is used for GDP per capita, X 1 is used to refer the economic freedom index value,
X2 is showing the trend effect and εi includes all other factors that have disregarded.
We obtain the results that are shown in Table 3 for whole dataset:

Table 3. Economic Freedom Regression Results

Variable Coefficient Std. Error
Intercept 3248.08** 1448.19
Economic Freedom 149.74* 24.06
Trend 812.50* 57.05
R-squared 0.974
*, ** refer significance at 99%, 95%.

The outcome of the regression implies that there is a powerful connection between economic
freedom and GDP per capita. One point increase in the economic freedom index ascended GDP per
capita about 150 U.S. dollars in selected countries. While the coefficient of the intercept is
significant at 95% confidence level, the coefficients of economic freedom and trend are significant
at 99% confidence level. Also trend shows a positive correlation with GDP per capita during the
period between 1996 and 2007. One point increase in trend supports 812.5 U.S. dollar raise in GDP
per capita.
If we did the same regression for advanced countries and developing countries separately, we
obtain the table below:

Table 4. Economic Freedom Regression Results

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*, ** refer significance at 99%, 95%.

For advanced countries, there is a positive relationship between economic freedom and GDP per
capita. One point increase in the index of economic freedom stimulates 126 U.S. dollar rise in GDP
per capita. By the way, trend has also impact on income during the period in advanced countries.
One year increase reflects as 1204 U.S. dollar rise on GDP per capita.
The obtained result for developing countries that we observe from Table 4, have no econometric
meaning because of the low confidence level of the main coefficient. This result constraints us to
make any inference about the relation between economic freedom and prosperity level in
developing countries.

II.2 Results

According to regressions that include all selected countries within the determined time interval, we
can conclude that both trade openness and economic freedom have positive correlation with
income per capita of countries. That means participation in international trade and movements
towards freer economic environment have positive impact on generating income for nations as
defined in liberal theories.
When we inspect the effect of trade openness by its own, the regression results illustrate that
international trade is beneficial for both advanced and developing countries. These results are
consistent with neo-liberal international trade theories which predict that trade creates external
benefits for countries as mentioned in previous sections of this paper. On the other hand, it is
observed that although trade openness rates and income per head levels are jointly increases for
both of the groups, advance economies have more gains respectively with increases in openness
rate. Thus, we can conclude that international trade theories are more appropriate to advance
countries’ economic forms that enjoy producing high value-added and relatively advantageous
goods owing to their innovative economic structure. Furthermore, while the coefficient of trade
openness rates of advance countries show approximately same pattern with general regression’s
openness coefficient, the developing countries’ coefficient of trade openness is far from general
regression’ openness quotient which implies that advance countries has dominance in our
aggregate dataset. It can be said that the studies using higher number of advanced countries may
overestimate the effect of trade openness on GDP per capita for different economic structures.
In economic freedom case, our regression with aggregate dataset proves that economic freedom
and income per head levels are positively correlated. Thus, we can express that the consequence is
viable with the laissez faire belief in liberal doctrine. By the way, it should be mentioned that the
results of regressions are only true for overall economic freedom score. So, interpreting the
conclusions of the regression as all components of economic freedom is positively correlated with
Advanced Countries Developing Countries
Variable Coefficient Std. Error Variable Coefficient Std. Error

Intercept 10879.75* 3210.01 Intercept 6520.71* 714.22

Econ. Freedom 126.11** 50.80 Econ. Freedom -16.47 14.61

Trend 1204.56* 76.21 Trend 377.03* 45.04

R-squared 0.960 R-squared 0.972
income per capita levels will be misleading. There is a need for further investigation to make any
comment on the individual effects of subcomponents of economic freedom on economic wealth.
Thereto, while advance countries’ income per capita levels react positively with the changes in
economic freedom scores, we cannot make any inference about developing countries specifically
because of the insignificant coefficient. Thus, likewise in trade regression, we can conclude that
advance countries dominate the aggregate model with their developed steady-state economic

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structures. On the other hand, even though the coefficient of freedom in developing countries’
regression is a confusing result, it can be explained with the incomplete transformation of the
market structures. Due to developing countries have been changing their economic structures since
1990s, they have not reached the adequate level of efficient market form in comparison with
advance countries. In addition, some of the developing countries such as Poland, Ukraine, and
Czech Republic are transition economies which are evolving into market economy. These countries
shift up their economic structure after mid-90s and our econometric analysis are affected by those
countries’ economic fluctuations.

III. Conclusion

In this study, we try to address the arguments of free trade and free market theories of liberal
doctrine by econometric analysis. Theoretically, participating in international trade and economic
freedom are beneficial for countries and have positive effects on allocation of sources,
specialization, and productivity. Our econometrical results prove that trade openness and economic
freedom variables have significant and noteworthy positive effects on income per head. Both
advanced and developing countries’ GDP per capita values are positively related with trade
openness rates. So it can be said that, as theory defines, international trade is one of the most
crucial factor in increasing production and income. Thus, we can suggest that protectionist policies
against trade should be abolished to increase overall welfare of countries and their citizens. On the
other hand, as we expected, advanced countries gain more than developing countries from
international trade. The major reason behind this conclusion can be their comparative advantages
on high value-added products and strong structures of their economies which raise their profit from
international trade. However, although developing countries have lower returns than advanced
countries, they also have benefits from trade which are crucial for sustaining their economic
development. But, in contrast to the liberal theories, these results imply divergence of advanced
and developing countries rather than convergence by trade.
In economic freedom case, we found that GDP per capita level of countries have positively
changed with their overall freedom scores in general regression that uses whole dataset. The result
verifies that economic actors increase their efficiencies in free economic environment and thereby
raises total welfare of countries. The advanced countries’ regression also proves that prosperity
level is related with economic freedom and confirms the theoretical belief about the benefits of free
market on economy. Per contra, the regression of developing countries shows insignificance for
economic freedom coefficient that constraint us making comparison between advance and
developing countries.
To sum up, we can conclude that international trade and economic freedom are effectual on
prosperity level of countries. But free trade and laissez faire phenomenon that is originated in
developed world is more suitable for advanced economic structures rather than developing
economies. Benefits of liberalization are higher for advanced countries and the gap between
countries is widening by the freer economic environment.

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