International Trade

Ricardo Model - Edgeworth Box

Facts

From the Model, we can derive that, by trade:

  • / <= / <= /
  • Both countries completely specialise in the areas where they have comparative advantages (labour productivity).
  • Both countries reach a higher level of utility.

    • How is / determined?

    This is the price that each country agrees on. For more details, let's look at the following section.

    Ricardo and Edgeworth Box

    AUTARKY

    We create [1] the World Edgeworth Box in the same way we did previously for the General Equilibrium Model:

    As H produces at C and F produces at C', the Edgeworth Box is OHFOFG.

    TRADE

    Under trade, H and F will specialise [1] in the good they have the comparative advantage in. As H produces X only (i.e. produces at B) and F produces Y only (i.e. produces at A'), the Edgeworth Box will be OHBOFJ:

    (It is clear that the Edgeworth Box under free trade is greater than that under Autarky.)

    PRICE DETERMINATION

    If we draw the offer curve [1] (price expansion curve) of H from its production point B, and the offer curve of F [2] from its production point A', they will intersect at some point [3] (here E or E'). At that point, H's and F's desires to trade coincide, i.e. both countries agree on the terms of trade (how many of X and Y should be traded).

    As the ratio of X and Y traded is XEE/XEB, the straight line connecting E and B [4] (or E' and A') is the World Equilibrium Price.
    H:
  • produces at B (X only);
  • consumes OHXE and exports BXE;
  • by exporting BXE of X, imports BYE of Y; and, as a result,consumes at E.
    		•  F:
  • produces at A' (Y only);
  • consumes OFYE and exports A'YE ( = BYE);
  • by exporting BYE of X, F imports BXE of X; and, as a result,consumes at E'.
    • WELFARE ANALYSIS USING THE EDGEWORTH BOX

    Before trade, H and F produce and consume at C and C', respectively. Their utility levels are represented by IH and IF. By trade, H specialises in producing X (at B) and consumes at E (by exporting X and importing Y). H's utility level [1] at E is shown by I'H, which is higher than IH.

    F specialises in producing Y (at A') and consumes at E' (by exporting Y and importing X). F's utility level [2] at E' is I'F, which is greater than IF.

    Both countries gain by trade.



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