¿ What is the relationship between the relative prices in the two countries?

When there is no trade, (PC/PW= aLC/aLW) < (P*C/P*W= a*LC/a*LW)

Are there incentives for international trade? Yes, we export cheese, they
export wine, until relative prices equalise. We demonstrate it right now.

The determination of the relative price after trade

Let's assume that between the two countries free trade without any restriction
is established.

Analysis of general equilibrium (relationships between markets, wine and

cheese). Supply and demand in one of the markets are not enough in order
to develop the analisys.

How to determine the International (relative) price: with world relatives

demand and supply.

Firstly, we represent the world relative demand (hereafter DR) and world
relative supply (SR) as relations between the relative price Pc/Pw and the
world relative amount, defined in this way: (Qc+Q*c)/(Qw+Q*w) (number of
cheese offered or demanded, in relation to the number of liters offered or
demanded).
Let's reason form and logic of DR, and SR.

DR curve  "normal" form of a demand curve, representing the usual

substitution effects:

   
  Pc     Qc  Q *C  and viceversa.
 Pw   Qw  Q * w 

When you lower the relative price of cheese, it increases demand

for cheese in terms of wine

Y-axis: relative price on cheese

X-Axis: relative amount of cheese

DR
SR curve More complex, it has different sections depending on the
magnitude of the world price (Pc/Pw), as we will reason below. It is very
important to bear in mind that we assumed: aLC/aLW < a*LC/a*LW

- PC/PW < aLC/aLW

There is no global supply. Both specialize in wine. For my country,
wages in cheese are lower than in the other sector.

- PC/PW = aLC/aLW
Our workers earn exactly the same producing cheese than wine. Flat
section of the supply, till our full specialitation. Wine is only produced
by the other country.

- aLC/aLW < PC/PW < a*LC/a*LW

Our country is specialized in the production of cheese (L/aLC kilos
produced of cheese), and abroad in the wine (produce L*/a*LW). Thus,
the relative supply of cheese is fixed (perfectly inelastic) for that range
of prices.

- PC/PW = a*LC/a*LW
Us cheese, the foreigner is indifferent to produce cheese or wine.
Again the offer is flat, since we are ‘amount of cheese specialized'.

- PC/PW > a*LC/a*LW

All specialized in cheese.
 a*LC/a*LW SR

aLC/aLW

(L/aLC)/(L*/a*LW)

How to get the international price? Global general equilibrium between the
DR and the SR.

 PC 
 
 Pw 

SR
aLC/aLW < PC/PW < a*LC/a*LW

DR
 Qc  Q * c 
 
 Qw  Q * w 
(L/aLC)/(L*/a*LW)
Will there be specialization of countries? In the 'normal' section, each
specialize in the product in which it has comparative advantage. The normal
equilibrium is which occurs in the vertical section. But what if the
equilibrium takes place on a flat section of the SR?:

 PC 
 
 PW 

SR

aLC/aLW = PC/PW

DR  Qc  Q *C



 Qw  Q * 
Q´ < (L/aLC)/(L*/a*LW)  W 

Our economy is not specialized. Some cheese, some wine. Abroad,

specialized in wine.
The trading profits

Free trade between the two countries with an international price in the
"normal" part of the SR. Does it increase the welfare of the two countries?
Two forms of reasoning it:
1) analyzing the trade as an indirect method of production
2) possibilities for consumption (graphical method)

(We will use as an example "our country"; remember that we have

comparative adventage in cheese)

1) Trade as an indirect method of production

In order to get wine from abroad (good that import, according to the c.a.) we
have two options with 1 hour of work:

a) 1/aLW liters of wine

b) 1/aLC kilos of cheese and sell and swap them on the international
market at the relative Price: Pc/Pw. In this case we get (1/aLC)(PC/PW)
liters of wine.

(1/aLC)(PC/PW) > 1/aLW if Pc/Pw > aLC/aLw, condition that is met

(already shown) in the 'normal' stretch of SR.

Each country specialized in a good;for us better make cheese and

exchange it for wine, and the other viceversa.

Then… TRADE
2) Possibilities of consumption (graphical method)

a) The PPF gives the productive possibilities As we have seen, the

specialization is total in the good with c.a.
b) We can exchange according to the international price

the possibilities of consumption are given by the international price and the
point of production specialization ("consumption possibilities frontier",
CPF)

Qw Our country Q*w Abroad

Wine especialization

CPF>FPP
(under free trade)

CPF=FPP
(without trade)

Qc Q*c
Cheese especialization

Numerical example:
Our Country: aLC=1 hour/kg, aLW=2 hours/litre and L=100
Abroad: a*LC=6 hours/kg, a*LW=3 hours/litro

We are best in both products, but we have comparative advantage in cheese

aLC/aLW=1/2 (cheese oportunity cost) < a*LC/a*LW = 2 (cheese oportunity
cost*).