In this chapter, we present the building blocks for trade policy analysis using a computable general equilibrium (CGE) model. We begin by reviewing the trade data in the Social Accounting Matrix (SAM). Next, we introduce two concepts, the real exchange rate and terms of trade, and explain how they are represented in standard CGE models. We then focus on trade theory as we simulate and interpret the results of two types of shocks: A change in endowment that changes comparative advantage, and a change in world prices that changes industry structure, trade and factor returns. We study an example of “Dutch Disease,” a problem that illustrates the links between a change in world prices, the real exchange rate, and industry structure. We conclude with an explanation of the role of trade and transport costs in international trade.
Since David Ricardo first developed the theory of comparative advantage, showing that nations gain from specializing in the goods that they produce at relatively lower cost, most students of economics have learned that all countries can gain from trade. Yet, many countries are reluctant to move too far or too fast toward free trade. Their reasoning is not inconsistent with Ricardo's theory. Trade and specialization lead to changes in a country's industry's structure and, in turn, to changes in the wages and rents of factors used in production. Therefore, although trade confers broad benefits on a country, it can also create winners and losers.