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What Should Be The Equilibrium Price Ratio?

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Tariq Habib answered
Once trade opens up, some set of prices must hold in the world marketplace depending upon the overall market supplies and demands. Without further information we cannot specify the exact price ratio, but we can determine what the price range will be. The prices must lie somewhere between the prices of the two regions. That is, we know that the relative price of food and clothing must lie somewhere in the range between ½ and ¾.

The final price ratio will depend upon the relative demands for food and clothing. If food were very much in demand, the food price would be relatively high. If food demands were so high that Europe produced food as well as clothing, the price ratio would be at Europe's relative prices, or ¾. On the other hand, if clothing demands were so strong that America produced clothing as well as food, the terms of trade would equal America's price ratio of ½.

If each region specializes completely in the area of its comparative advantage, with Europe producing only clothing and America producing only food, the price ratio will lie somewhere between ½ and ¾. The exact ratio will depend on the strength of demand.

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