International Trade Theory and Policy
by Steven M. Suranovic
Deriving the Autarky Terms of Trade
The Ricardian model assumes that all workers are identical or homogeneous in their productive capacities and that labor is freely mobile across industries. In autarky, assuming at least one consumer demands some of each good, the country will produce on the interior of its PPF. That is, it will produce some wine and some cheese.
Profit maximizing firms would never set a wage rate above the level set in the other industry. Why?
Suppose the cheese industry set a higher wage such that wC > wW. In this case all of the wine workers would want to move to the cheese industry for any wage greater than wW Since their productivity in cheese is the same as the current cheese workers and since it does not cost anything for them to move to the other industry, the cheese industry could lower their costs and raise profit by paying a lower wage. To maximize profit they must lower their wage. Thus only equal wage rates can be sustained between two perfectly competitive producing industries in the Ricardian model.
In autarky, then, wC = wW
Plugging in the relationships derived above yields,
This means that the autarky price ratio (cheese over wine) or terms of trade equals the opportunity cost of producing cheese. Another way to say the same thing, is that the price of cheese (in terms of wine) in autarky equals the opportunity cost of producing cheese (in terms of wine).
International Trade Theory and Policy - Chapter 40-7: Last Updated on 8/20/03