International Trade Theory and Policy
by Steven M. Suranovic
Trade 301

A Pure Exchange EconomyThe simplest example of advantageous trade arising from differences in resources endowments can be shown with a pure exchange model. In this model we ignore the production process and assume that individuals are endowed with a stock of consumption goods. A Simple Example of Trade Suppose there are two individuals, Farmer Smith and Farmer Jones. Farmer Smith lives in an orange grove while Farmer Jones lives in an apple orchard. For years, these two farmers have sustained themselves and their families by collecting oranges and apples on their properties. One day these two farmers go out for a walk. Farmer Smith carries 10 oranges with him in case he becomes hungry. Farmer Jones carries 10 apples. Suppose these farmers meet. After a short conversation, they discover that the other farmer sustains his family with a different commodity, and the farmers begin to discuss the possibility of a trade. The first question worth asking is: what factors will determine the terms of trade? The terms of trade is defined as the quantity of one good that exchanges for a quantity of another. In this case, how many apples exchange for how many oranges? It is typical to express the terms of trade as a ratio. Thus, if one apple exchanges for four oranges, we can write the terms of trade as follows:
where ToT refers to terms of trade. It is immaterial whether the ratio is written apples over oranges or oranges over apples. The terms of trade is equivalent to the ratio of prices between two goods. Suppose P_{A} is the price of apples (measured in $/apple) and P_{O} is the price of oranges (measured in $/orange). Then
To demonstrate the equivalency, consider the units of this price ratio shown in brackets above. After some manipulation, we can see that the $'s cancel, and thus the price of oranges over the price of apples has units of apples per orange. We can refer to this price ratio as the price of oranges in terms of apples, i.e. how many apples one can get in exchange for every orange. Notice that the price of oranges over apples is in units of apples per orange. Similarly P_{A}/P_{O} has units of oranges per apple. [This model, and many others we will consider, are actually barter economies. This means that there is no money being exchanged between the agents. Instead one good is exchanged for another good. However, since we are accustomed to evaluating values in money terms, we will often write important expressions, like the terms of trade, in terms of their money equivalents as we have done above.] International Trade Theory and Policy  Chapter 301: Last Updated on 8/20/03 