Prices in an Open Economy

  1. Absolute vs. Relative Prices
Goal Lay the groundwork for two trade theories
   Cutting off external trade relations causes a dramatic change in the prices of traded goods. Policies that restrict international trade such as tariffs and quotas also significantly affect the prices of traded goods. To lay the basis for our discussion through the course, we first consider how foreign prices are converted into domestic prices so that home consumers can compare the prices of imported and domestic goods.
 Conversion of foreign prices  Domestic price of a commodity (p$) = $/unit

Foreign price of a commodity (p) = €/unit (or yuan/unit)

Exchange Rate e (dollar price of a foreign currency) = $/€ (or $/yuan)

Domestic price of an imported good

= p$ = e × p (or e ×pyuan)

= ($/€)(€/unit) = $/unit.

 The Law of One Price

One price prevails, provided No Transportation Costs + No Trade Restrictions.

Given the exchange rates, one can obtain the dollar price of any good.

If p > p*, then import the good. Imports lower p until p = p*

If p < p*, then export the good. This raises p until p = p*

when t > 0

If transportation cost t is positive, the law of one price does not prevail.

p = p* + t.


 Absolute prices Assume N goods: 1, 2,...,N.

(p1, p2,..., pN). N absolute prices.

 Relative Prices

(p1/pN, p2/pN,...,1). (N-1) relative prices.

You may use another good as a standard instead of good N.

 2- good case



AP: p1, p2.

RP: p1/p2.

HDTV = $2,000. Corn price = $4 per bushel.

p1/p2 = 500. Relative price changes over time. Now HDTV = $1,000, p1/p2 = 250.

One HDTV costs 250 bushels of corn.

oil price = $80 per barrel. p1/p2 = 20 (i.e., one barrel of oil costs 20 bushels of corn.)


  2. Equilibrium in a Closed Economy
 Gains from Trade

 Equilibrium is established when supply = demand for each good.

 autarky price

 The autarky price of a good is the market clearing price in a closed economy.

Autarky price = pA; = (p¹/p²)A; at autarky.

At this price X = M = 0.

(domestic) market clearing price = autarky price

because domestic and foreign markets are not connected.

Domestic market is insulated from foreign shocks.

 export or import  If p* > pA, then export.

Export supply: X = X(p1/p2), +

(The export supply curve is positively sloped)

Import Demand: M = M(p1/p2), -

(The import demand curve is negatively sloped)

 Finding Commodity trade occurs because of differences in autarky prices between countries.

Goods flow from a low-price country from a high-price country. (add two demand and supply curves)


  3. Equilibrium Price in the World Market
Assume: there are two countries: US + Japan


  4. Tariffs and Domestic Prices

If a tariff is imposed, domestic price does not fall to the free trade level p*.

Thus, the price gap (p and p*) indicate the degree of protection in the importing country.


 Equilibrium price occurs at the intersection of world demand and supply curves.

World demand = horizontal sum of demand curves of all counries.

world supply = horizontal sum of supply curves of all countries

 Higher prices  High domestic prices indicate some sort of trade restriction or undervaluation of one currency.
High prices in Japan

Watermelon, ¥2980(about $30) each

Cantaloupes, ranging from ¥10,000 to ¥20,000 per box. That is, ¥5,000 to ¥10,000 each (or $50 - $100)

Augustus the Strong

Augustus der Starke (king of Poland) "sold" 600 horsemen to Friedrich Wilhelm I of Prussia and in return received 151 porcelain vessels.

  4. Doha Round is not for Free Trade (Choi's opinion)

 WTO was established in 1995. Doha Development Round was supposed to have started in Seattle in 1999, and was going to be called the "Seattle Round," but such efforts were stymied by vehment demonstrations in Seattle. Doha conference began in Doha, Qatar in 2001.

In these trade negotions, member countries send their representatives to negotiate the terms with others. They weigh the benefits and costs of their concessions, which are measured by consumer surplus and producer surplus resulting from the proposed concessions or agreements.

Developing countries

low income countries < $1026

lower middle income countries ($1026 < $4036)

World Bank: LDCs = low income + lower middle income countries. China ($6800 in 2013)

Developing countries grew at the rate of 4.2%, while developed economies grew at 3.2% over the 1965-99 period.

Africa's per capita GDP = $2,300 in 2013. The growth rates of one third of African countries is greater than 6% per year. Africa's GDP = $2.4 trillion = France's GDP (growth rate of F is 1%.)

 Failure At the WTO meeting in Nairobi in 2015, 160 countries ended the negotiations. Developing countries want more concessions in terms of reduced trade barriers from developed economies, especially in agriculture, whereas EU is against them.
India and China want to protect their poor farmers (not import foodstuff from the US).
EU's strategy Perception: Make EU a self-sufficient economy.
Block imports from the US (e.g., ban genetically modified products such as corn, soybeans.)
 US strategy

Choi's opinion: Give up on WTO.
Multilateral trade negotiations are time-consuming. Too much talking.

focus on bilateral trade agreements.

The US withdrew from Trans-Pacific Partnership.

TTIP is uncertain; talks may resume.

Likely to withdrew from NAFTA.

 China's strategy

the low yuan policy to reduce unemployment and increase trade surplus. (Large and persistent trade surpluses are harmful to China's economy.)

China jumps on the bandwagon to negotiate bilateral trade agreements. (e.g., China + ASEAN free trade agreement)


Qianmen street


Starbucks in Qianmen street

   A tailor's shop in Qianmen street
6. Transatlantic Trade and Investment Partnership (TTIP)

Doha round has been time consuming.

Bilateral FTAs are easier.

Developing countries do not want to import ag products from the US or EU.

Reaction to limited access to Asian markets.

Possible Impacts

US + EU output shares = 45% of Gross World Product

Integration US + Developing country: yields more benefits (due to wage disparity) but more difficult to achieve , because it requires a drastic adjustment in the labor markets.

Integration of US + EU is easier, but benefits are smaller than with developing countries.

 TPP Started in Feb 2013. China is not a participant.
 Concerns  blue color workers suffered from NAFTA.