The World Price and Comparative Advantage

The first issue our economists take up is whether Isoland is likely to become a steel importer or a steel exporter. In other words if free trade is allowed will Isolandian end up buying or selling steel in world markets.

To answer this question the economists compare the current Isolandian price of steel to the price of steel in other countries. We call the price prevailing in world markets the world price. If the world price of steel is higher than the domestic price then Isoland will export steel once trade is permitted. Isolandian steel producers will be eager to receive the higher prices available abroad and will start selling their steel to buyers in other countries. Conversely if the world price of steel is lower than the domestic price then Isoland will import steel. Because foreign sellers offer a better price Isoland steel consumer will quickly start buying steel from other countries.

In essence comparing the world price and the domestic price before trade indicates whether Isoland has a comparative advantage in producing steel. The domestic price reflects the opportunity cost of steel: If tells us how much an Isolandian must give up to get one unit of steel . if the domestic price is low the cost of producing steel in Isoland is low suggesting that Isoland has a comparative advantage in producing steel relative to the rest of the world. If the domestic price is high then the cost of producing steel in Isoland is high suggesting that foreign countries have a comparative advantage in producing steel.

Trade among nations is ultimately based on comparative advantage. That is trade is beneficial because it allows each nation to specialize in doing what it does best. By comparing the world price and the domestic price before trade we can determine whether Isoland is better or worse at producing steel than the rest of the world.

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