International Trade Theory & Policy - Essay Example

The model further assumes that all markets conducting trade are perfectly competitive; hence goods are priced according to costs within the countries that produce them where there is a competitive wage in each country. Another assumption is that labor is present in fixed supply in both countries and is static between countries yet perfectly mobile within each country. Modern formulations of the Ricardian model specify for both countries utility functions that the consumers represented maximize on the basis of budget constraints.

According to the model, each country specializes in producing goods for which it has comparative advantage. This allows both countries to export goods for which it can gain profits (Bowen, Hollander & Viane, 1998). With such specialization, productivities and labor endowments determine food outputs; hence world prices are dictated by the countries’ demands, which is equal to the supply amount of one country in free and frictionless trade. Both countries gain from such trade as trade allows for the expansion of exports production and labor is reallocated to exports from importing industries.

Additionally, trade under the Ricardian model increases the relative price of both countries’ exports. . The model assumes that both trading countries have similar production technologies, thus producing identical output of any commodity can be attained with an equal capital and labor level in both countries (Suranovic, 2010). The model also assumes that output product has constant return to scale in order to produce equilibrium. Additionally, technologies utilized in the production of both commodities differ substantially and labor is costless in terms of mobility within countries.

The model also assumes that commodities produced in the countries have similar prices everywhere and countries operate in perfectly competitive markets internally thus labor and capital do not affect prices or production factors. It also assumes that trade is free of government interference in market functioning. When labor becomes more expensive than capital, labor-intensive products are at a disadvantage and become quite expensive compared to products that are not labor-intensive. Under free trade, assumed in the Heckscher- Ohlin model of trade the price of goods in both countries is similar; hence the wage-rent ratio is also the same in both countries.

However, when labor becomes expensive, more capital in needed to produce products that are labor intensive and those that are not (Krugman & Obstfeld, 1988). When machine use per worker is similar in both countries, these factors will falsify the equality of wage-rent ratio. Effects of tariffs imposed by “small” countries A small country refers to a country whose trading partner is big enough to meet its imports supply. Tariffs imposed by small countries increase the price of imports above world prices by the value of the tariff (Jonathan & Kortum, 2002). This