International Trade

Ch 2 Trade and Technology: The Ricardian Model

Introduction

One could say that the study of international trade and finance is where the discipline
of economics as we know it began. Historians of economic thought often describe the essay
“Of the Balance of Trade” by the Scottish philosopher David Hume (1711-1776) as the first
real exposition of an economic model. Hume published his essay in 1758, almost 20 years
before his friend, another Scottish philosopher, Adam Smith (1723-1790) published “The
Wealth of Nations”. And the debates over British trade policy in the early 19th century did
much to convert economics from a discursive, informal field to the model-oriented subject it
has been ever since.

Yet the study of international economics has never been as important as it is now. In
the early 21st century, nations are more closely linked than ever before through trade in goods
and services, flows of money, and investment in each other’s economies. And the global
economy created by these linkages is a turbulent place: Both policy makers and business
leaders in every country must now pay attention to what are sometimes rapidly changing
economic fortunes halfway around the world.

1. Reasons for Trade

Proximity
The closer countries are the lower the costs of transportation. For example, the largest trading
partner of most European countries is another European country.

Sometimes neighboring countries take advantage of their proximity by joining into a free-trade
area, in which the countries have no restrictions on trade between them. Say, Canada is the
largest trading partner of U.S.A, even though its population is one tenth of that of the U.S., 33
million against 303 million.

Distance between markets influences transportation costs and, therefore, the cost of imports
and exports.

Geography among nations such as oceans, harbors, and a lack of mountain barriers makes
transportation and trade easier.

Resources
Geography includes the natural resources (such as land and minerals) found in a country, as
well as its labor resources (labor of various education and skill levels) and capital (machinery
and structures).
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A country’s resources are often collectively called its factors of production, the land, labor,
and capital used to produce goods and services.
Economic size exemplified such as GDP plays a determined factor that sets the trade volume.
For example, 3 of the top 10 trading partners with the U.S were also the 3 largest European
economies: Germany, the United Kingdom, and France. In addition, Canada, China,
Mexico, and Japan make the list of largest trading partners with the U.S.
The size of an economy is directly related to the volume of imports and exports.
Larger economies produce more goods and services, so they have more to sell in the export
markets.
Larger economies generate more income from the goods and services sold, so they are able to
buy more imports.
Trade between any two countries is larger, the larger is either country.

The Gravity Model

The gravity model assumes that size and distance are important factors for international trade
in the following way: Assume there are two counties in the world, called country “i” and
country “j”.

𝐴∗ 𝑌𝑖 ∗ 𝑌𝑗
𝑇𝑖𝑗 =
𝐷𝑖𝑗

Where A is a constant term

𝑇𝑖𝑗 is the value of trade between country i and j
𝑌𝑖 is the GDP of country i,
𝑌𝑗 is the GDP of country j
𝐷𝑖𝑗 is the distance between country i and county j

Cultural Affinity
Close cultural ties, such as a common language, usually lead to strong economic ties. Good
example is the trade relationship between U.S.A and Republic of Ireland. Even though
small economic size and population, even far distance between two countries across the
Atlantic Ocean, Ireland has huge trading volume with the U.S.A. They speak same
language and share same cultural heritage and blood.
Most scholars agree that at least 30% of Americans are Irish descendants. For example, ex
U.S President John F. Kennedy and Bill Clinton are all Irish descendants.

Multinational Corporations (MNC)

Corporations spreading across different nations import and export many goods and services
among their divisions. These exports and imports among nations are considered
intercompany transfers from the Multinational Corporations’ point of view.

Brief Reviews of Thoughts on International Trade

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 Mercantilism: First Theory in International Trade

(1) Mercantilism refers to the economic policies adopted in Western Europe and the
ideas supported by them until modern capitalism was established by the
Industrial Revolution between the late 15th and early 18th century. Jean-
Baptiste Colbert (1619-1683), a French finance minister (1661-1683) under
King Louis XIV and Mirabeau (1715-1789) are most vocal supporters for
mercantilism.

(2) The core content of mercantilist policy is to protect the domestic market of
industrial capital and to promote the exploitation of foreign markets. In these
days international trade was settled by silver or gold. So one country exports
more than imports, that country could accumulate more precious metals. On
the other hand, one country imports more than exports that country loses
precious metals. England, for example, imported huge quantities of tea, black
pepper, spices, china (ceramic ware) and silk from China more than her exports
experienced huge losses of silver every year. In order to stop losing silver,
British merchants began exporting opium harvested in India to China. That
caused Opium War (1840) between England and China. Winning the Opium
War British government demanded more open trade relationship and expanded
trade volume. This was the beginning of economic colonization of China.
Many wars or historic events are economically motivated.

(3) In mercantilism, the precious metals are regarded as the original form of wealth,
and they are encouraged to exports, suppressed imports, and become more
prosperous if precious metals are pouring into the country. Remember at that
time currency is minted based on the amount of gold and silver reserved in
central bank. Spain and Portugal became the richest nations in Europe due to
the profuse inflow of gold and silver from their newly found territories in
America after Christopher Columbus found American continent in 1492.

(4) For this purpose, government imposes tariffs for the restraint of importing
foreign products and implements protective trade policies that promote
exporting domestic products.

(5) Mercantilists have recognized that trade is a kind of zero-sum game, and that
when one country becomes richer through trade, the other becomes poorer.

Adam Smith’s View on International Trade

(1) Adam Smith (1723-1790) argued that labor is the most fundamental form of
true wealth, not the precious metals such as gold or silver, but the products of
labor.

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 (2) In other words, the more the quantity of goods and services which are the
product of labor, the wealthier.

(3) To this end, it was argued that all countries could become wealthier if they put
their labors into production of goods with low production costs and then trade
them with another country.

(4) In contrast to mercantilism, which claimed to have protective trade for

accumulating national wealth, Adam Smith insisted that free trade should be
done to make each country richer.

Absolute Advantage: Adam Smith

When a country has the best technology for producing a good, that country has an absolute
advantage in the production of that good.

(1) One producer says he or she has an absolute advantage in producing a good
when it can produce a good with fewer resources than another producer. Or
the same amount of resources to produce more goods than other producers.

(2) Adam Smith applies the concept of absolute advantage to international trade.
"If each country exchanges goods which produced at full specialization with a low
production cost, both countries will benefit from free international trade."

Example:

1. Before trade:

(1) Assume that the labor input required for the production of 1 unit of good X and
good Y in Korea and the United States is given as shown in the following table,
and that the two countries have produced and consumed 10 units of X and Y
respectively.

(2) Since both countries produce and consume 10 units of X and Y goods, both
countries have 30 units of labor respectively. Once Korea produces and
consumes 10 units of X, Korea has 10 labors to produce 10 units of X and 20
labors to produce 10 units of Y. In total Korea has 30 labors. 10+20=30.

Korea U. S. A

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X 1 Labor/unit 2 Labor/unit

Y 2 Labor/unit 1 Labor/unit

Labor per unit table

2. After trade:

(1) In Korea, 30 units of X good are produced when all labor is put into X with low
absolute production cost. Because Korea needs only one labor required to
produce one unit of X compared U.S needs two labors to produce one unit of
good X. So we can say Korea has an absolute advantage in producing good X.

(2) The United States produces 30 units of Y good when all labor is put into Y
production with low absolute production costs. Because U.S needs only one
labor required to produce one unit of Y compared Korea needs two labors to
produce one unit of Y. So we can say U.S has an absolute advantage in
producing good Y.

(3) If the two countries exchange arbitrarily 15 units each of X good and Y good,
each country will be able to consume more 5 units of X and Y than the pre-trade
consuming amount. It is possible because Korea produces only 30 units of X
good, and no Y good, U.S produces 30 units of Y good and no X good. It is
beneficial to each country to consume half of their product domestically and
export the other half to another country. And imports same of other product.
Each country after trade consume 15 units of both X good and Y.good.
Consume more than before trade.

(4) Such free trade increases the welfare of both countries.

3. Contributions and Issues

(1) Absolute advantage was the first theory to suggest the basis of free
international trade.
(2) Absolute advantage cannot explain the phenomenon in which a trade occurs
even when a country is in absolute advantage of both goods or all in
absolute disadvantage in producing two goods. For example, the U.S
economy has absolute advantages in many areas, however, the U.S is the largest
importer in world trade.

David Ricardo (1772-1823) and Mercantilism

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 Mercantilists believed that exporting was good because it generated gold and silver for the
national treasury and that importing was bad because it drained gold and silver from the
national treasury.

To ensure that a country exported a lot and imported only a little, the mercantilists were in
favor of high tariffs (taxes on imports).

David Ricardo (1772-1823) was a British political economist, one of the most influential
of the classical economists along with Adam Smith, Thomas Malthus and James Mill. He
was also a politician, and a member of British Parliament, active in implanting his
economic theory in the real world. David Ricardo was interested in showing that
countries could benefit from international trade without having to use tariffs.

Many of the major international institutions in the world today are founded at least in part
on the idea that free trade between countries brings gains for all trading partners.

2. Ricardian Model: beginning of modern international trade theory

Basic Assumptions of Ricardian Model:

(1) All economic agents, in particular firms and consumers, exhibit rational behavior.
(2) There are only two countries in the world. There are also only two goods in the world.
Each good is identical in its characteristics in the two countries, and some of each is always
consumed in each country. This is called “Two by Two Model”.
(3) There is no money illusion. In economics, money illusion, or price illusion, is the
name for the human cognitive bias to think of money in nominal, rather than real, terms. In
other words, the face value (nominal value) of money is mistaken for its purchasing power
(real value) at a previous point in time. Viewing purchasing power as measured by the
nominal value is false, as modern fiat currencies (paper money) have no intrinsic (underlying)
value, and their real value depends purely on the price level. The term was coined by a
great American Economist Irving Fisher (1867-1947) in his writing “Stabilizing the Dollar”.
It was popularized by a British economist John Maynard Keynes (1883-1946) in the early
twentieth century, and Irving Fisher wrote an important book on the subject, “The Money
Illusion”, in 1928.
(4) In each country, factor endowments are fixed and the set of technologies available to
each country is constant.
(5) Perfect competition prevails in both industries. In addition, there are no externalities
in production. Somewhat unrealistic hypothesis.
(6) Factors of production are perfectly mobile between the two industries within each
country.
(7) Preferences in consumption can be represented by a consistent set of indifference
curves.
(8) Factors of production cannot move between countries. No labor and capital movement
across borders assumed.
(9) There are no barriers to trade in goods.
(10) Exports must pay for imports.
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(11) Labor is the only relevant factor of production in terms of productivity analysis or
costs of production.
(12) Production exhibits constant returns to scale between labor and output.

The Home Country

To develop a Ricardian model of trade, we will use an example with two goods: 2x2 model.
• Wheat and other grains are major exports of the U.S. and Europe.
• Many types of cloth (fabric or apparel) are imported into these countries.
To simplify our example, we will ignore the role of land and capital and suppose that both
goods are produced with labor alone.
We will assume that labor is the only resource used to produce both goods.
The marginal product of labor (MPL) is the extra output obtained by using one more unit of
labor.
In Home Country, one additional worker produces 4 bushels (one bushel is approximately
equivalent to 36 liters) of wheat, so MPLW = 4. Alternatively, one additional worker can
produce 2 yards (one yard is equivalent to 91.44 centimeters) of cloth, so MPLC = 2. Home
country has total of 25 labors.

Assume an additional Foreign worker can produce one bushel of wheat or one yard of cloth.
Foreign country has total of 100 labors. Asterisk (* star) sign means foreign.

MPL*W = 1, MPL*C = 1

According to the MPL, home workers have absolute advantages in both Wheat and Cloth
production. In wheat production home workers are 4 times more efficient and in cloth
production home workers are 2 times more efficient than foreign workers.

Marginal Productivity of Labor Table (MPL)

Home Foreign

Wheat 4 bushels per labor 1 bushel per labor

Cloth 2 yard per labor I yard per labor

Labor Per Unit Table

Home Foreign

Wheat 1/4 Labor per bushel 1 labor per yard

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 Cloth 1/2 labor per yard 1 labor per yard

Opportunity Cost Table

Home Foreign

Wheat 1/2 yard of cloth 1 yard of cloth

Cloth 2 bushels of wheat 1 bushels of wheat

Opportunity Cost is, by definition, how much one should give up to gain some other product.
Or how much one can get by sacrificing something else.

Home Production Possibilities Frontier: Production Side or Supply Side

Using the marginal products for producing wheat and cloth, we can graph Home’s production
possibilities frontier (PPF) or production possibilities curve (PPC).
In economic analysis, the production possibility frontier (PPF) is a curve that illustrates the
possible quantities that can be produced of two products if both depend upon the same finite
resource (here, the labor) for their manufacture.

PPF also plays a crucial role in economics. It can be used to demonstrate the point that any
nation's economy reaches its greatest level of efficiency when it produces only what it is best
qualified to produce and trades with other nations for the rest of what it needs.

The PPF demonstrates that the production of one commodity may increase only if the
production of the other commodity decreases.

The PPF is a decision-making tool for managers deciding on the optimum product mix for the
economy.

The slope of the PPF is also the opportunity cost of wheat (what is shown on x-axis), the
amount of cloth that must be given up to obtain one more unit of wheat.

Assume there are 25 workers in Home Country. If all the workers were employed in wheat
production, the country could produce 100 bushels of wheat. If they were all employed in
cloth production, they could produce 50 yards of cloth. The PPF connects these two points.

The Home PPF is a straight line between 50 yards of cloth and 100 bushels of wheat. Any
point on the curve shows the combination of production quantity between wheat and cloth.
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The slope of the PPF equals the negative of the opportunity cost of wheat (what is shown on
x-axis).

But why is the PPF a straight line?

A straight line occurs if the opportunity cost remains constant. In this scenario, the
opportunity cost of producing two goods is projected as being equal regardless of where you
are along the line.

This is highly unrealistic simple hypothesis. In the real world opportunity cost keeps
changing depending on the production quantity of each good.
You must learn how to walk before learning how to run. Even you must learn how to crawl
before learning how to walk.

Equivalently, the magnitude of the slope can be expressed as the ratio of the marginal
products of labor for the two goods. See Fig 2-1

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 Home Indifference Curve: Consumption Side or Demand Side
There are several ways to represent demand in the Home economy, but we will start by
using indifference curves.
(1) All points on an indifference curve have the same level of utility.
(2) Points on higher indifference curves have higher utility.
(3) Indifference curves are often used to show the preferences of an individual or a
community.
(4) Each indifference curve shows the combinations of two goods, such as wheat and cloth,
that a person or a community can consume and be equally satisfied.

Home Equilibrium with No Trade (See Fig 2-2) closed economy or autarky or self-
sufficiency
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Points A and B lie on the same indifference curve and give the Home consumers the level of
utility U1.
The highest level of Home utility on the PPF is obtained at point A, which is the no-trade
equilibrium.
Point D is also on the PPF, but would give lower utility.
Point C represents a higher utility level, but is off of the PPF, so it is not attainable in the
absence of international trade.

Opportunity Cost and Prices

Whereas the slope of the PPF reflects the opportunity cost of producing one more bushel of
wheat (what is on x-axis), under perfect competition the opportunity cost of wheat
(MPLc/MPLw) should also equal the relative price of wheat (Pw/Pc, price of one bushel of
wheat divided by price of one yard of cloth). Price reflects the opportunity cost of a good.

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 Wages
• In competitive markets firms hire workers up to the point at which the hourly wage
equals the value of one more hour of production. Maximum Wage depends on the
worker’s marginal productivity.
• The value of one more hour of labor (VMPL) equals the amount of goods produced in
that hour (MPL) times the price of the good.
• Labor hired up to the point where wage equals P • MPL for each industry.

• We can use the equality of the wage across industries to obtain the following
equation:
Wage = PW • MPLW = PC • MPLC
By rearranging terms, we see that

PW/PC = MPLC/MPLW
• The right-hand side of this equation is the slope of the production possibilities frontier
(the opportunity cost of obtaining one more bushel of wheat, the product of x-axis).
• The left-hand side of the equation is the relative price of wheat against price of cloth
(Pw/Pc).

The Foreign Country

Assume an additional Foreign worker can produce one bushel of wheat or
one yard of cloth.

MPL*W = 1, MPL*C = 1

Assume there are 100 workers available in Foreign Country.

If all workers were employed in wheat production, they could produce 100
bushels of wheat.

If all workers were employed in cloth production, they could produce 100
yards of cloth.

Foreign Production Possibilities Frontier (See Fig 2-3)

The Foreign PPF is a straight line between 100 yards of cloth and 100 bushels of wheat.
The slope of the PPF equals the negative of the opportunity cost of wheat (the product on x-
axis), that is, the amount of cloth that must be given up (1 yard) to obtain 1 more bushel of
wheat.

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 Comparative Advantage: Opportunity Cost Table

A country has a comparative advantage in a good when it has a lower opportunity cost of
producing than another country does.
By looking at the chart we can see that Foreign has a comparative advantage in producing
cloth. Home has a comparative advantage in producing wheat.

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 Foreign Equilibrium with No Trade
*
The highest level of Foreign utility on the PPF is obtained at point A , which is the
no-trade equilibrium. See Fig 2-4

Determining the Pattern of International Trade

International Trade Equilibrium

What happens when goods are traded between Home and Foreign?

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We will see the country’s no-trade relative price determines which product it will export and
which it will import.
The no-trade relative price equals its opportunity cost of production when in equilibrium.
The pattern of exports and imports will be determined by the opportunity costs of production
in each country—their comparative advantage.

The relative price of cloth to price of wheat in Foreign is PC/PW = 1. Or Pw/Pc=1

The relative price of cloth to price of wheat in Home is PC/PW = 2. Or Pw/Pc=1/2
Therefore, Foreign would want to export their cloth to Home—they can make it for $1 and
export it for more than $1. This is just example $1 or $2. We don’t know the unit price of
wheat or cloth. We can only calculate the relative price using equilibrium wage under
perfect competitive market assumption.
The opposite is true for wheat.
Home will export wheat and Foreign will export cloth.
Both countries export the good for which they have the comparative advantage (the lower
relative price).

How Trade Occurs

As Home exports wheat, quantity of wheat sold (consumed) at Home falls (declines).
Farmers can sell wheat in foreign market more expensive than domestic market.

The price of wheat at Home is bid up (going up).

More and more wheat goes into Foreign market. Even though home wheat price
goes up, the wheat price is still cheap in foreign market compared to home market.

The price of wheat in Foreign falls. Because cheap foreign imports will decline
domestic price.

As Foreign exports cloth, the quantity sold in Foreign falls, and the price in Foreign
for cloth rises.

The price of cloth at Home falls. This is completely opposite story.

The two countries are in an international trade equilibrium when the relative price of wheat or
cloth is the same in the two countries. After a period of adjustment both markets approach
equilibrium price.
• This means that the relative price of cloth is also the same in both countries.
To fully understand the international trade equilibrium, we are interested in two issues:
• Determining the relative price of wheat (or cloth) in the trade equilibrium
• Seeing how the shift from the no-trade equilibrium to the trade equilibrium affects
production and consumption in both Home and Foreign.

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The relative price of wheat in the trade equilibrium will be between the no-trade price in the
two countries. Such as 1/2<Pw/Pc<1 or 1<Pc/Pw<2
For now we will assume arbitrarily the free-trade price of PW / PC is 2/3. This is between the
price of ½ in Home and 1 in Foreign.
We can now take this price and see how trade changes production and consumption in each
country.
The world price line shows the range of consumption possibilities that a country can achieve
by specializing in one good and engaging in international trade.

Change in Production and Consumption (See Fig 2-5)

2
With an arbitrary world relative price of wheat of /3, Home production will occur at point B.
Through international trade, Home is able to export each bushel of wheat it produces in
2
exchange for /3 yard of cloth. That means one bushel of wheat export from home country is
to be paid by two-third (2/3) yard of cloth. On the other hand, one yard of cloth export from
foreign country is to be paid by three over two (3/2) bushel of wheat. Look at the reciprocal
relationship between two countries.

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As wheat is exported, Home moves up the world price line BC. Home consumption occurs
at point C, at the tangent intersection with indifference curve U2, since this is the highest
possible utility curve on the world price line.

Given these levels of production and consumption, we can see that total exports are 60
bushels of wheat in exchange for imports of 40 yards of cloth and also that Home consumes
10 fewer bushels of wheat and 15 more yards of cloth relative to its pre-trade levels.
Here we assume once free trade is allowed each country engages in full specialization of
product which has comparative advantage.

International Trade

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Home obtains a higher utility with international trade than in the absence of international
trade (U2 is higher than U1); the finding that Home’s utility increases with trade is our first
demonstration of the gains from trade, by which we mean the ability of a country to obtain
higher utility for its citizens under free trade than with no trade.

Pattern of Trade and Gains from Trade (See Fig 2-6)

With a world relative price of wheat of 2/3, Foreign production will occur at point B*.

Through international trade, Foreign is able to export 2/3 yard of cloth in exchange for 1 bushel
of wheat, moving down the world price line. This is equivalent expression of exporting 1
yard of cloth in exchange for 3/2 bushels of wheat.

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 *
Foreign consumption occurs at point C , and total exports are 40 yards of cloth in exchange
for imports of 60 bushels of wheat. Relative to its pre-trade wheat and cloth consumption
*
(point A ), Foreign consumes 10 more bushels of wheat and 10 more yards of cloth.

• Each country is exporting the good for which it has the comparative
advantage.
• This confirms that the pattern of trade is determined by comparative
advantage.
• This is the first lesson of the Ricardian model.
• There are gains from trade for both countries.
• This is the second lesson of the Ricardian model.

Solving for Wages across Countries

Absolute Advantage
As our example shows, wages are determined by absolute advantage. In contrast, the
pattern of trade is determined by comparative advantage. It is because labor cannot move
across country. Labor only can move freely within a nation.
• As stated before, in competitive labor markets, firms will pay workers the
value of their marginal product to the most.
• Since Home produces and exports wheat, they will be paid in terms of that
good—the real wage is MPLW = 4 bushels of wheat.
• The workers sell the wheat on the world market at a relative price of
• PW/PC = 2/3.
• We can use this to calculate the real wage in terms of cloth:
• (PW/PC)MPLW = (2 yards of cloth=MPLc/3 bushels of wheat=MPLw) * 4
bushels of wheat = 8/3 yards of cloth. Remember in free trade PW/PC =
MPLc/MPLw= 2 yards of cloth/3 bushels of wheat.
•

• We can do this for Foreign as well and summarize:

• Home real wage is: Home market equilibrium
• 4 bushels of wheat: Home’s comparative advantage MPLw=4
bushels per labor
• 8/3 yards of cloth.: (PW/PC)MPLW = (2/3)4 = 8/3 yards of cloth.
• Foreign real wage is:
• 3/2 bushels of wheat: (Pc/Pw)MPLc=(3 bushels of
wheat=MPLw/2 yards of cloth=MPLc) * 1 yard of cloth = 3/2
bushels of wheat
• 1 yard of cloth: Foreign’s comparative advantage MPLc=1 yard
of cloth

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 • Foreign workers earn less than Home workers as measured by their ability to
purchase either good. Because remember wage is determined by absolute
advantage.
•
• This fact reflects Home has absolute advantage in the production of both
goods. Because labor cannot move between countries, only allow move in
domestic industries. So Home country’s workers earn higher wages than
Foreign.

4 Solving for International Prices

Home exports wheat, so we will derive a Home export supply curve, which shows the
amount it wants to export at various relative prices.
Foreign imports wheat, so we will derive a Foreign import demand curve, which shows the
amount of wheat that it will import at various relative prices.

Home Export Supply Curve (See Fig 2-9)

Home Export Supply Panel (a) repeats Figure 2-5 showing the trade equilibrium for Home
with production at point B and consumption at point C.
Panel (b) shows the Home export supply of wheat.
1
For relative prices above /2, Home exports more than 50 bushels, along the segment B C.
2
For example, at the relative price of /3, Home exports 60 bushels of wheat.

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 Foreign Import Demand Curve (See Fig 2-10)

Foreign Import Demand Panel (a) repeats Figure 2-6.

Panel (b) shows Foreign import demand for wheat. When the relative price of wheat is 1,
*
Foreign will import any amount of wheat between 0 and 50 bushels, along the segment A B*
of the Foreign import demand curve.

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For relative prices below 1, Foreign imports more than 50 bushels, along the segment B*C*.
2
For example, at the relative price of /3, Foreign imports 60 bushels of wheat.

International Trade Equilibrium (See Fig 2-11)

World Market for Wheat Putting together the Home export supply curve and the Foreign
import demand curve for wheat, the world equilibrium is established at point C, where the
2
relative price of wheat is /3.

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 The Terms of Trade (ToT)
The price of a country’s exports divided by the price of its imports is called the terms of
trade.
• Because Home exports wheat, (PW /PC) is its terms of trade. Before free trade home
country’s ToT is ½.
• Foreign exports cloth, so (Pc /Pw) is its terms of trade. Before free trade foreign
country’s ToT is 1.
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 • In this case, having a higher price for cloth (Foreign’s export) or a lower price for
wheat (Foreign’s import) would make the Foreign country better off. Because
foreign country has higher ToT than home country, free trade brings more benefit to
foreign country than home country.

Key Points

1. A country has comparative advantage in producing a good when the country’s

opportunity cost of producing the good is lower than the opportunity cost of
producing the good in another country.

2. The pattern of trade between countries is determined by comparative advantage.

This means that even countries with poor technologies can export the goods in which
they have comparative advantage.

3. All countries experience gains from trade. That is, the utility of an importing or
exporting country is at least as high as it would be in the absence of international
trade.

4. The level of wages in each country is determined by its absolute advantage, that is, by
the amount the country can produce with its labor. This result explains why
countries with poor technologies are still able to export: their low wages allow them
to overcome their low productivity.

5. The equilibrium price of a good on the world market is determined at the point where
the export supply of one country equals the import demand of the other country.

6. A country’s terms of trade equal the price of its export good divided by the price of its
import good. A rise in a country’s terms of trade makes it better off because it is
exporting at higher prices or importing at lower prices.

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