THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.2
The GE solution to the classical model.
Suppose we have the PPFs from figure 3.1.
In the test the two PPFs are not drawn to the same scale.
Figure 3.2 adds the CICs that are at a tangency with the PPFs.
If we allow trade to occur what will happen?
There will be only one would price. This price will be between the two autarky prices.
How much specialization will occur?
If we know what the new equilibrium will be we can say.
Comparative advantage determines specialization and trade.
Figure 3.3 illustrates an equilibrium.
The new world price is in between the autarky prices.
Suppose the new price is 3/4. This represents the ‘terms of trade’.
A will produce more S
B will produce more T
A will produce only S because this allows A to reach the highest CCI.
Similarly B will only produce T and reach its highest CCI.
How do we know that the new price is feasible? I.e. why should supply and demand be matched perfectly at that price? Because the price adjusts until it is at the equilibrium value (choosing ¾ is just a guess for illustration only).
This price is called the terms of trade: ‘TOT’
HIJ in Figure 3.3 is the ‘trade triangle’.
The trade triangle tells us how much S country A will export (J – H) and how much T it will import (all of its T consumption).
The trade triangles for the two countries must be congruent since the horizontal sections are equal and the hypotenuse has the same slope.
Walras Law
If there are n markets in a GE economy and (n-1) are in equilibrium then the last market must be in equilibrium.
