PART II HOW MARKETS WORK. Ch 4: The Market Forces of Demand and Supply Udayan Roy uroy
Basics of Two-Country Trade: The Standard Trade Model Udayan Roy uroy/eco41 September 2009.
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Transcript of Basics of Two-Country Trade: The Standard Trade Model Udayan Roy uroy/eco41 September 2009.
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”.