Change of Relative prices for goods in the Ricardian model when trade occurs

The movement of relative prices under Ricardian model can be explained by taking two countries, say H and F initially. There are two goods say wine and cheese which are produced in sufficient quantities in both the countries. The quantities produced in both the countries are consumed in the countries themselves. So there is no trade between the countries initially. This situation is called Autarky under which each country is regarded as a closed economy and the situation is a closed economy equilibrium.

Let it be assumed that country H has a higher opportunity cost for cheese in terms of wine relative to country ‘F’. This means that country ‘H’ has to sacrifice more wine to produce one more unit of cheese than in country ‘F’.

Now let us presume that trade between ‘H’ and ‘F’ becomes possible because of certain development which reduce transportation costs. Businessmen notice that cheese is relatively cheap in ‘F’ and wine in ’H’. So buyers in ‘H’ opt for cheese in ‘F’ while buyers of wine in ‘F’ opt for purchase of wine from ‘H’. The situation leads to two developments.

1.)    The demand switch will lower the relative price of Cheese in ‘H’ and relative price wine ’F’. The relative prices in the two countries will then converge and are provided with free trade and negligible transport costs. There will be just one common international price.

2.)    The above price developments will cause manufacturers in ‘H’ to concentrate on wine production and manufacturers in ‘F’ to concentrate on cheese. They then trade with the two commodities to have a mix of the two. Thus Ricardian model separates production and consumption of commodities through relative price mechanism.

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