International Trade Theory and Policy
by Steven M. Suranovic
The Motivation for International Trade
Suppose two countries, the US and France, are initially in autarky. Assume the US has a comparative advantage in cheese production relative to France. This implies,
This in turn implies:
This means that the autarky price of cheese in France (in terms of wine) is greater than the autarky price of cheese in the US. In other words you can buy more wine with a pound of cheese in the French market than you can in the US market.
Similarly, by rearranging the above inequality,
which means that the autarky price of wine is higher in the US (in terms of cheese) than it is in France. In other words, a gallon of wine can be exchanged for more cheese in the US than it will yield in the French market.
Next suppose barriers to trade which induced autarky are suddenly lifted and the US and France are allowed to trade freely. For simplicity we assume there are no transportation costs to move the products across borders.
Differences in price ratios between countries and the desire to make more profit is sufficient to generate international trade. To explain why, it is useful to incorporate some frictions in the trading process and to tell a dynamic story about how a new free trade equilibrium is reached.
First, note that the higher price of cheese in France means that cheese workers in the US could get more wine for their cheese in France than in the US. Suppose one-by-one over time cheese workers begin to take advantage of the opportunity for trade and begin to sell their cheese in the French market. We assume that some workers are more internationally adroit and thus move first. The motivation here is profit seeking. Workers want to get more for the goods they are selling. As the US cheese workers appear in the French market, there is an increase in the supply of cheese. This also represents exports of cheese from the US to France. The increased supply will reduce the price of cheese in the French market; meaning that over time, the quantity of wine obtained for a pound of cheese will fall. Thus falls once trade is opened.
Next consider French wine workers immediately after trade opens. Since the price of wine is higher in the US, French wine workers will one-by-one over time begin to sell their wine in the US market. This represents exports of wine from France to the US. The increased supply of wine to the US lowers its price on the US market. Thus each gallon of wine will trade for less and less cheese. This means falls which also means that its reciprocal, (PC/PW ), rises.
These shifts in supply will continue as long as the prices for the goods continue to differ between the two markets. Once the prices are equalized there will be no incentive to trade any additional amount. Equalized prices mean that a pound of cheese will trade for the same number of gallons of wine in both markets. The free trade prices will be those prices which equalize total supply of each good in the world with total demand for each good.
As a result of trade, the price ratio or terms of trade will lie in between the two countries autarky price ratios. In other words, the following inequality will obtain;
Whether the free trade price ratio will be closer to the US autarky price ratio or France's will depend on the relative demands of cheese to wine in the two countries. These demands in turn will depend on the size of the countries. If the US is a much larger country, in that it has a larger workforce, it will have a larger demand for both wine and cheese. When trade opens, the addition of France's supply and demand will have a relatively small effect on the US price. Thus, the free trade price ratio will be closer to the US autarky price ratio.
International Trade Theory and Policy - Chapter 40-8: Last Updated on 8/20/03