Basics of Two-Country Trade: The Standard Trade Model

Udayan Roy

http://myweb.liu.edu/~uroy/eco41

September 2009

Trade Between Two CountriesJapan Europe World Trade

P D S D S D S J E

10 0 11 0 9 0 20 11 9

9 0 10 2 8 2 18 10 6

8 0 9 4 7 4 16 9 3

7 0 8 6 6 6 14 8 0

6 0 7 8 5 8 12 7 -3

5 0 6 10 4 10 10 6 -6

4 1 5 12 3 13 8 4 -9

3 2 4 14 2 16 6 2 -12

2 3 3 16 1 19 4 0 -15

1 4 2 18 0 22 2 -2 -18

0 5 1 20 0 25 1 -4 -20

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

Europe Japan World+ = 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

Priceof Steel

0Quantityof Steel

Domesticsupply

Priceaftertrade World

price

DomesticdemandExports

Pricebeforetrade

Domesticquantity

demanded

Domesticquantitysupplied

Europe: The Importing Country

Priceof Steel

0 Quantity

Priceafter

trade

Worldprice

of Steel

Domesticsupply

Domesticdemand

Imports

Domesticquantitysupplied

Domesticquantity

demanded

Pricebeforetrade

Price

Europe Japan World+ = 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

Europe Japan World+ = 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 Theory– Specific Factors Theory– Heckscher-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 and – 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”.