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Basics of Two-Country Trade:
The Standard Trade Model
Udayan Roy
http://myweb.liu.edu/~uroy/eco41
September 2009
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
This is how the worldwide free
trade price is determined. Note that
the free trade price ( ) must lie
between the two countries’ autarky
prices ( ).
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.
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
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.
If the autarky equilibrium price is not
the same for both countries, trade will
occur when trade is allowed. That is,
dissimilarity = trade.
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.
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.
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”.