Download Basics of Two-Country Trade

Basics of Two-Country Trade:
The Standard Trade Model
Trade Between Two Countries
Japan
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
Trade Between Two Countries
• Assume a two-country world
• When these two countries begin trading…
– The price of the traded good
• decreases in the country with the higher autarky
price, and
• increases in the country with the lower autarky
price
– Eventually, the price becomes the same in
both countries
– This global price lies somewhere between the
two autarky prices
Trade Between Two Countries
• When two countries begin trading…
– the country with the higher autarky price
imports the good, and
– the country with the lower autarky price
exports the good
– global quantity demanded = global quantity
supplied
– exports = imports (in quantity and market
value)
Graphical analysis of two-country
trade
• Now, let us review our numerical analysis
using graphs!
– Economists love graphs!
This is how the worldwide free
trade price is determined. Note that
the free trade price ( ) must lie
between the two countries’ autarky
prices ( ).
Europe has the higher autarky price. Europe
becomes the importing country. Prices fall.
Production falls.
Japan has the lower autarky price. Japan
becomes the exporting country. Prices rise.
Production rises.
Note that Japan’s exports ( ) equal
Europe’s imports ( ).
Price
Europe
+
Japan
=
World
Quantity
Japan: The Exporting Country
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
Europe: The Importing Country
Price
of Steel
Domestic
supply
Price
before
trade
Price
after
trade
World
price
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
of Steel
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.
Price
Europe
+
Japan
=
World
Quantity
Prices: nominal and relative
• So far, I have been not been fully clear
about how prices are measured
• When the price of a good is measured in
currency units, it is called a nominal price
– Example: the nominal price of ice cream is
$4.00 per quart
– Example: the nominal price of coffee is $1.00
per cup
Prices: nominal and relative
• When the price of one good is measured in
units of another good, it is called a relative
price
– Example: suppose the nominal price of ice cream
is $4.00 per quart and the nominal price of coffee
is $1.00 per cup.
– Then the relative price of ice cream is 4 cups of
coffee per quart.
– And the relative price of coffee is ¼ quarts of ice
cream per cup
• In my lectures on international trade, when I
say “price” I mean “relative price”
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.
As we saw before, if the autarky
equilibrium price is not the same for
both countries, trade will occur when
trade is allowed. That is, dissimilarity =
trade.
Price
Europe
+
Japan
=
World
Quantity
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.
Effect of Trade on Consumption
• The effect of an increase in the price of
beef (relative to steel) on the consumption
of beef works through two channels:
– Substitution effect: buy less of whatever has
become more expensive and more of
whatever has become less expensive
– Income effect: if a change in a price makes
you richer, buy more of all things, across the
board; if a change in price makes you poorer,
buy less of all things, across the board
Effect of Trade on Consumption
• Consider an increase in the price of beef
(relative to steel)
– Substitution effect: buy less beef and more
steel
– Income effect:
• if you export beef, hooray, you are now richer! So
buy more of both beef and steel
• If you import beef, you are poorer. So, buy less of
both beef and steel
Effect of Trade on Consumption
Beef price ↑
Exports beef, imports steel
Imports beef, exports steel
beef
steel
beef
steel
Substitution effect
↓
↑
↓
↑
Income effect
↑
↑
↓
↓
ambiguous
↑
↓
ambiguous
Total effect
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”.