Basics of Two-Country Trade: The Standard Trade Model Udayan Roy September 2009

Trade Between Two Countries JapanEuropeWorldTrade PDSDSDSJE

This is how the worldwide free trade price is determined. Note that the free trade price ( ) must lie between the two countries’ autarky prices ( ). Price EuropeJapanWorld+= Quantity The high-price country in autarky, Europe, becomes the importing country under trade. Prices fall. Production falls. The low-price country in autarky, Japan, becomes the exporting country under trade. Prices rise. Production rises. Note also that Japan’s exports ( ) equal Europe’s imports ( ) in the free trade equilibrium.

Japan: The Exporting Country Price of Steel 0 Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Domestic quantity demanded Domestic quantity supplied

Europe: The Importing Country Price of Steel 0 Quantity Price after trade World price of Steel Domestic supply Domestic demand Imports Domestic quantity supplied Domestic quantity demanded Price before trade

Price EuropeJapanWorld+= Quantity If the autarky equilibrium price is the same for both countries, no trade will occur even when trade is allowed. That is, similarity = no trade.

Similarity = No Trade If the pre-trade (or autarky) relative prices (of one good in terms of another) are the same for the two countries, no trade will occur. –On relative prices, see “Relative Prices and Supply” on page 31 of KO.

Price EuropeJapanWorld+= Quantity The high-price country in autarky, Europe, becomes the importing country under trade. Prices fall. Production falls. The low-price country in autarky, Japan, becomes the exporting country under trade. Prices rise. Production rises. If the autarky equilibrium price is not the same for both countries, trade will occur when trade is allowed. That is, dissimilarity = trade.

Dissimilarity = Trade Trade will occur if the pre-trade (or autarky) relative price of one good in terms of the other is not the same for the two countries. The free trade relative price will be neither higher than the two autarky prices, nor lower. Therefore, when the autarky relative prices are unequal, the free trade relative price must be different from the autarky relative price for at least one of the two countries.

Reasons For Dissimilarity Three theories that explain why autarky prices may be high in some countries and low in others: –Ricardian TheoryRicardian Theory –Specific Factors Theory –Heckscher-Ohlin TheoryHeckscher-Ohlin Theory

Effect of Trade on Prices When autarky ends and free trade begins, the relative price of any given good will – increase in the country where it used to be cheaper in autarky, and – decrease in the country where it used to be more expensive in autarky This follows from the fact that the free trade relative price of any traded good, in general, lies somewhere between the two autarky relative prices

Effect of Trade on Production If the price of good X (relative to good Y) increases, then, in a country that is otherwise unchanged, –the production of X will increase and –the production of Y will decrease See “Production Possibilities and Relative Supply” on page 89 and Figure 5-2 of KO.

Effect of Trade on Consumption If, under free trade, the price of good X (relative to good Y) increases, then, in a country that is otherwise unchanged, –the consumption of good X will decrease if it is the imported good and –may either decrease or increase if it is the exported good. Similarly, –the consumption of Y will increase if Y is the imported good and –may either increase or decrease if it is the exported good. See Figure 5-4 of KO.

Trade Reflects Comparative Advantage When autarky ends and free trade begins, each country –increases its production of the good in which it has a comparative advantage andcomparative advantage –exports that good. In other words, free trade follows the principle of comparative advantage.

Comparative Advantage A country is said to have a comparative advantage in the production of a good if, in autarky, the opportunity cost of the good is smaller in that country. –The opportunity cost of good X is the amount of good Y that will have to be sacrificed when an additional unit of X is produced –In a perfectly competitive economy, the opportunity cost of good X equals the relative price of good X. –See “The Concept of Comparative Advantage” on page 28 of KO for more on “opportunity cost” and “comparative advantage”.