ECO 364: International Trade Theory

Lecture 3
Instructor: Peter Morrow
Fall 2024

1
 Outline for Today
1. Review From Last Class
2. Ricardian Model: Equilibrium Prices
3. Ricardian Model: Three Cases
4. Ricardian Model: Equilibrium Conditions
5. Ricardian Model: Solving for Case with Specialization
6. Terms of Trade

• Tutorial: Ricardian Model

• Reading: FT Ch. 2 and Ch. 3 (specific factors)
2
 Lecture 3 Part 1:
Review from Last Class

3
 Suppose Free Trade Prices are
in Between Autarky Prices
𝑝!!"# 𝑝! 𝑝!!%#
!"# < < !%#
𝑝$ 𝑝$ 𝑝$
&! &$
𝑤!!"# = !"# = 𝑀𝑅𝑃!!"# > 𝑀𝑅𝑃$!"# = 𝑤$!"# = !"#
'! '$

&$ &!
𝑤$!%# = !%# = 𝑀𝑅𝑃$!%# > 𝑀𝑅𝑃!!%# = 𝑤!!%# = !%#
'$ '!

• Both countries maximize their value of production by

specializing in their comparative advantage good.
4
 𝐶$!"# , Q!"#
$
Canada: Autarky
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$

𝑄!"#$ = 𝐶!"#$

!"#
&!
𝑠𝑙𝑜𝑝𝑒 =- !"#
&$

𝑄""#$ = 𝐶""#$ 𝐿!"# 𝐶!!"# , Q!"#

!
𝑎!!"# 5
𝐶$!"# , Q!"#
$
Canada: Free Trade
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$

𝐶$!"#

𝑀$!"#

&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄$!"#
𝐶!!"# 𝑄!!"# = 𝐿!"# ⁄𝑎!!"# 𝐶!!"# , Q!"#
!
𝑋!!"# 6
 𝐶$!%# , Q!%#
$
China: Autarky
!%#
!%# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !%#
'$
𝑎!%#
$

𝑄!"%$ = 𝐶!"%$

!%#
&!
𝑠𝑙𝑜𝑝𝑒 =- !%#
&$

𝑄""%$ = 𝐶""%$ 𝐿!%# 𝐶!!%# , Q!%#

!
𝑎!!%# 7
𝐶$!%# , Q!%#
$
China: Free Trade
!%#
'!
𝑄!"#$ =
𝐿"#$ 𝑠𝑙𝑜𝑝𝑒 =- !%#
𝑎 "#$ '$
!

𝑋$!%#
&!
𝐶$!%# 𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄!!%# 𝐶!!%# 𝐿!%# ⁄𝑎!!%# 𝐶!!%# , Q!%#

!
𝑀!!%# 8
 Differences are Good
• If world relative prices are strictly in between autarky
relative prices, both countries gain from trade.

• The more “different" a country’s ratio of unit labor

requirements are from world relative prices, the more the
country gains from trade.

• Larger differences in prices (relative to autarky) mean

larger gains from specialization.

9
𝐶$!"# , Q!"#
$
Canada
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$
&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄!!"# = 𝐿!"# ⁄𝑎!!"# 𝐶!!"# , Q!"#

!
10
 Lecture 3 Part 2:
World Relative Supply
and Relative Demand

11
• To solve for prices, we create the world relative supply
and demand graph.
𝑝!
𝑝$

𝑄""#$ + 𝑄""%$
𝑄!"#$ + 𝑄!"%$ 12
 Free Trade
• Recall: the equilibrium relative prices lie weakly between
autarky relative prices/unit labor requirements.

• As before, assume that Canada has a comparative advantage in

computers and China in textiles:

𝑝!!"# 𝑝! 𝑝!!%#
!"# ≤ ≤ !%#
𝑝$ 𝑝$ 𝑝$

13
 𝑝!
𝑝$

𝑎""%$
𝑎 "%$
!

𝑎""#$
𝑎 "#$
!

𝑄""#$ + 𝑄""%$
𝑄!"#$ + 𝑄!"%$
14
• With a strict inequality

𝑝!!"# 𝑝! 𝑝!!%#
!"# < < !%#
𝑝$ 𝑝$ 𝑝$
Complete specialization with Canada specializing in
computers and China specializing in textiles.

• Any set of relative prices in the interval delivers this.

• The relative supply curve will be vertical at the relative

quantity supported by specialization.

15
• Why?

• Canada prefers specializing in computers:

𝐿!"#
𝑄!!"# = !"# 𝑄$!"# = 0
𝑎!

• China prefers specializing in textiles:

𝐿!%#
𝑄!!%# = 0 𝑄$!%# = !%#
𝑎$
&!"#
+,
*!!"#+*!!$# !"#
'! !$#
-!"#.%
= = !"# !$#
*%!"#+*%!$# &!$#
,+ !$# .! -
'% 16
 𝑝!
𝑝$

𝑎""%$
𝑎 "%$
!

𝑎""#$
𝑎 "#$
!

!$#
-!"#.%
!"#-!$#
𝑄""#$ + 𝑄""%$
.!
𝑄!"#$ + 𝑄!"%$
17
• Now suppose that 𝑝!!"# 𝑝! 𝑝!!%#
!"# < = !%#
𝑝$ 𝑝$ 𝑝$

• Canada specializes in computers.

𝐿!"#
𝑄!!"# = !"# 𝑄$!"# = 0
𝑎!

• Chinese workers are indifferent between producing computers

and textiles. China produces some mix of both:
𝐿"#$ 𝐿"#$ 𝑄""#$
𝑄""#$ ∈ 0, 𝑄!"#$ ∈ 0, ⟹0≤ ≤∞
𝑎""#$ 𝑎 "#$
! 𝑄!"#$

• World relative supply at this relative price is a ray.

18
 𝑝!
𝑝$

𝑎""%$
𝑎 "%$
!

𝑎""#$
𝑎 "#$
!

!$#
-!"#.% 𝑄""#$ + 𝑄""%$
!"#-!$#
.! 𝑄!"#$ + 𝑄!"%$
19
• Now suppose that 𝑝!!"# 𝑝! 𝑝!!%#
!"# = < !%#
𝑝$ 𝑝$ 𝑝$

• China specializes in textiles.

𝐿!%#
𝑄$!%# = !%# 𝑄!!%# = 0
𝑎$
• Canadian workers are indifferent between producing
computers and textiles. Canada produces some mix of both:

𝐿"%$ 𝐿"%$ 𝑄""%$

𝑄""%$ ∈ 0, 𝑄!"%$ ∈ 0, ⟹0≤ ≤∞
𝑎""%$ 𝑎 "%$
! 𝑄!"%$

• The relative supply at this relative price is a segment.

20
 𝑝!
𝑝$ Relative Supply
𝑎""%$
𝑎 "%$
!

𝑎""#$
𝑎 "#$
!

!$#
-!"#.% 𝑄""#$ + 𝑄""%$
!"#-!$#
.! 𝑄!"#$ + 𝑄!"%$
21
• The familiar relative demand curve determines
equilibrium prices and quantities:

𝑀𝑈!( 𝑝!( 𝛼𝐶!)*+ 𝐶$+*) 𝑝!(

( = ( ) *) = (
𝑀𝑈$ 𝑝$ 1 − 𝛼 𝐶! 𝐶$ 𝑝$

)!$& &! !!& )&$

= → &=
+*) !!& &$ !$ +*) &!

22
𝑝!
𝑝$ Relative Demand

𝐶"&
𝐶!& 23
 Lecture 4 Part 3:
Equilibrium: Three Cases

24
• There are three general cases:

1. “Relatively even” demand for computers and textiles,

2. “Relatively high” demand for computers,

3. “Relatively high” demand for textiles.

25
 𝑝!
𝑝$ Case 1
𝑎""%$
𝑎 "%$
!

pC
pT
𝑎""#$
𝑎 '#$
!

𝐿"#$ 𝑎 "%$
! 𝐶"& 𝑄""#$ + 𝑄""%$
& , "#$
𝐿"%$ 𝑎""#$ 𝐶! 𝑄! + 𝑄!"%$
26
𝐶$!"# , Q!"#
$
Case 1: Canada
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$

𝐶$!"#

𝑀$!"#
&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄$!"#
𝐶!!"# 𝑄!!"# = 𝐿!"# ⁄𝑎!!"# 𝐶!!"# , Q!"#
!
𝑋!!"# 27
𝐶$!%# , Q!%#
$
Case 1: China
!%#
'!
𝑄!"#$ =
𝐿"#$ 𝑠𝑙𝑜𝑝𝑒 =- !%#
𝑎 "#$ '$
!

𝑋$!%#
&!
𝐶$!%# 𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄!!%# 𝐶!!%# 𝐿!%# ⁄𝑎!!%# 𝐶!!%# , Q!%#

!
𝑀!!%# 28
• Canada (China) specializes in computers (textiles).

• Canada (China) produces more computers (textiles) than

it consumes.

• Canada (China) exports computers (textiles) in return for

textiles (computers).

• Both countries attain a higher indifference curve than in

autarky⇒ both gain from trade.
• The ability to obtain comparative disadvantage good
better through trade than reallocating resources.
29
 𝑝!
𝑝$ Case 2
𝑝" 𝑎""%$
=
𝑝! 𝑎 "%$
!

𝑎""#$
𝑎 "#$
!

𝐿"#$ 𝑎 "%$
! ⎛ QCW ⎞ 𝐶"& 𝑄""#$ + 𝑄""%$
& , "#$
⎜ W⎟
𝐿"%$ 𝑎""#$ ⎝ QT ⎠ 𝐶! 𝑄! + 𝑄!"%$
30
𝐶$!"# , Q!"#
$
Case 2: Canada
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$

𝐶$!"#

𝑀$!"#
&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄$!"#
𝐶!!"# 𝑄!!"# = 𝐿!"# ⁄𝑎!!"# 𝐶!!"# , Q!"#
!
𝑋!!"# 31
𝐶$!%# , Q!%#
$
Case 2: China
!%#
!%# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !%#
'$
𝑎!%#
$

𝐶!"#$

&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝐶""#$ 𝐿!%# 𝐶!!%# , Q!%#

!
𝑎!!%# 32
 QT
Case 2: China
Production somewhere along here.
CHN
Q
T
Exports

CHN
C T

QCCHN CCCHN QC
Imports 33
• Canada specializes in computers .
• China produces both computers and textiles.

• Canada (China) produces more computers (textiles) than

it consumes.
• Canada (China) exchanges computers (textiles) in return
for textiles (computers).

• Canada cannot produce enough computers to satisfy high

World demand for computers. China satisfies for the rest.
• Relative prices for China are the same as in autarky.
China does not gain from trade but does not lose. Canada
gains. 34
 𝑝!
𝑝$ Case 3
𝑎""#$
𝑎"#$
!

𝑝' 𝑎'')*
= ')*
𝑝( 𝑎(

⎛ QCW ⎞ 𝐿"#$ 𝑎 "%$

! 𝐶"& 𝑄""#$ + 𝑄""%$
& , "#$
⎜ W⎟
⎝ QT ⎠ 𝐿"%$ 𝑎""#$ 𝐶! 𝑄! + 𝑄!"%$
35
𝐶$!"# , Q!"#
$
Case 3: Canada
!"#
!"# '!
𝐿 𝑠𝑙𝑜𝑝𝑒 =- !"#
'$
𝑎!"#
$

𝐶$!"# Production somewhere along here.

𝑀$!"#
&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝐶!!"# 𝐿!"# 𝐶!!"# , Q!"#

!
𝑋!!"# 𝑎!!"# 36
𝐶$!%# , Q!%#
$
Case 3: China
!%#
'!
𝑄!"#$ =
𝐿"#$ 𝑠𝑙𝑜𝑝𝑒 =- !%#
𝑎 "#$ '$
!

𝑋$!%#
&!
𝐶$!%# 𝑠𝑙𝑜𝑝𝑒 =-
&$

𝑄!!%# 𝐶!!%# 𝐿!%# ⁄𝑎!!%# 𝐶!!%# , Q!%#

!
𝑀!!%# 37
• China specializes in textiles
• Canada produces both computers and textiles.

• Canada (China) produces more computers (textiles) than

it consumes.

• Canada exchanges computers in return for textiles.

• China cannot produce enough textiles to satisfy high
World demand for textiles. Canada satisfies the rest.
• Because prices for Canada are the same as in autarky,
Canada does not gain from trade but does not lose. China
does gain.
38
 Lecture 3 Part 4:
Equilibrium Conditions

39
 Equilibrium Conditions
• With a taxonomy of cases, what must always be true with
free trade?

1. Consumers maximize utility.

2. Producers maximize profits.

3. Goods and labor markets clear.

40
 Utility Maximization
• Utility maximization
!%& "#'
&=
!' $%" #%
• Budget constraint with labor income
& &
𝑝! 𝐶! + 𝑝' 𝐶' = 𝑤 & 𝐿&
𝑤 & 𝐿& = 𝑝! 𝑄!& + 𝑝' 𝑄'&
• Total consumption expenditure equals total income
& & & &
⟹ 𝑝! 𝐶! + 𝑝' 𝐶' =𝑝! 𝑄! + 𝑝' 𝑄'
41
 Profit Maximization
• For each good produced:

& #(
𝑤 =
((&

• Does not hold for a good that it not produced.

42
 Markets Clear
• Labor markets clear in each country c

& & &

𝐿 = * 𝑎) 𝑄)
)

• Goods markets clear globally. For each good j

𝐶)& + 𝐶)&* = 𝑄)& + 𝑄)&*

43
 Lecture 3 Part 5:
Solving for Equilibrium
with Complete Specialization
by Both Countries

44
 𝑝!
𝑝$

𝑎""#$
𝑎"#$
!
𝑝!
𝑝$
𝑎"")$
𝑎")$
!

𝐿")$ 𝑎"#$
!
𝐶"& 𝑄""#$ + 𝑄""%$
& , "#$
𝐶! 𝑄! + 𝑄!"%$
𝐿"#$ 𝑎"")$ 45
 Equilibrium with Specialization

• The easy part

𝐿!+, 𝑄'!+, = 0
𝑄!!+, = !+,
𝑎!

𝐿!-,
𝑄!!-, =0 𝑄'!-, = !-,
𝑎'

46
 Equilibrium with Specialization

• Demand
!%%*+ "#' !%%,+ "#'
= =
!'%*+ $%" #% !'%,+ $%" #%

• Define
!%-./01 !%%*+ .!%%,+
=
!'-./01 !'%*+ .!'%,+

!%-./01 "#'
⟹ =
!'-./01 $%" #%

47
 Equilibrium with Specialization

• World relative production equals relative demand

𝑄!!+, + 𝑄!!-, 𝐶!!+, + 𝐶!!-,

!+, !-, = !+,
𝑄' + 𝑄' 𝐶' + 𝐶'!-,

• Therefore, you know world relative prices

*, + .-!"# + .-,./ !"#

+ /,./ 0,
= =
*- !"#
,-+ ., + .,
,./ ,./
,-+ / !"# 0-

48
 Equilibrium with Specialization

• Canada
𝑝! 𝐶!!+, + 𝑝' 𝐶'!+, =𝑝! 𝑄!!+, + 𝑝' 𝑄'!+,

#% !+, !+, #% !+,

𝐶! + 𝐶' = 𝑄!
#' #'

• China
#% !-,
𝐶! + 𝐶'!-, =𝑄'!-,
#'
49
Four Equations, Four Unknowns

#% !+, !+, #% !+,

𝐶! + 𝐶' = 𝑄!
#' #'

#%
𝐶!!-, + 𝐶'!-, =𝑄'!-,
#'

!%%*+ "#' !%%,+ "#'

= =
!'%*+ $%" #% !'%,+ $%" #%

50
 Lecture 3 Part 6:
Terms of Trade : World Prices and
Country Welfare

51
 World Prices and Country Welfare
• Trade can make countries better off than autarky and no
worse off.

• However, changes in prices with trade can make countries

better off or worse off.
– Different than comparing free trade with autarky.

52
 World Prices and Country Welfare
• Suppose that Canada and China specialize in their
comparative advantage good….
– Canada in computers and China in textiles.

• …and the world relative price of computers increases

(e.g. trade policy).

• How does this affect welfare in each country?

53
𝐶$!"# , Q!"#
$
Canada

𝐶$!"#
𝐶$!"#

&!
𝑠𝑙𝑜𝑝𝑒 =-
&$
+,-
&!
𝑠𝑙𝑜𝑝𝑒 =- +,-
&$

𝑄!!"#
𝐶!!"# 𝐶!!"# 𝑄!!"# 𝐶!!"# , Q!"#
!
54
𝐶$!%# , Q!%#
$
China
𝐿"#$
𝑄""#$ =
𝑎 "#$
!
&!
𝑠𝑙𝑜𝑝𝑒 =-
&$

𝐶$!%#
𝐶$!%#
+,-
&!
𝑠𝑙𝑜𝑝𝑒 =- +,-
&$

𝐶!!%#𝐶!!%# 𝐶!!%# , Q!%#

𝑄!!%# !
55
 Terms of Trade
• If the relative price of a country’s comparative advantage good
increases, consumers in that country become better off.

• If the relative price of a country’s comparative advantage good

falls, consumers in that country become worse off.

56
 Terms of Trade
• Terms of trade: the price of a country’s exports divided by the
price of its imports.

• With two goods: the price of the exported good divided by the
price of the imported good.

• With more than two goods: the price of a basket of exported

goods divided by the price of a basket of imported goods.

57
 Terms of Trade

• If the price of exports relative to imports goes up, this is a

terms of trade appreciation. This makes a country better off.

• If the price of exports relative to imports goes down, this is a

terms of trade depreciation. This makes a country worse off

58
 Canada
• Canada consumes and produces commodities but
produces more than it consumes, exporting them.

• If the relative price of commodities increases, Canada is

better off.

• If the relative price of commodities falls, Canada is worse

off.

59
 Canada’s Terms of Trade (black)
and World Commodity Prices
2.5

1.5

0.5

0
Sep-99

Sep-06

Sep-13

Sep-20
May-97

May-04

May-11

May-18
Nov-00

Mar-03

Nov-07

Mar-10

Nov-14

Mar-17

Nov-21
Jul-98

Jul-05

Jul-12

Jul-19
Jan-02

Jan-09

Jan-16

Jan-23
Canada's Terms of Trade Commodity Price Index

Source: Statistics Canada and Federal Reserve Bank of Saint Louis. All values
60
normalized to 100 in May 1997.
 Quinoa

Source
61
 Quinoa

Source
62
 Quinoa

Source
63