International Economics By Robert J. Carbaugh 9th Edition Chapter 2: Foundations of Modern Trade Theory

Historical development of trade theory Foundations of trade theory Historical development of trade theory Mercantilism Regulation to ensure a positive trade balance Critics: possible only for short term; assumes static world economy Absolute advantage (Adam Smith) Countries benefit from exporting what they make cheaper than anyone else But: nations without absolute advantage do not gain from trade Comparative advantage (David Ricardo) Nations can gain from specialization, even if they lack an absolute advantage Carbaugh, Chap. 2

Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour Nation Wine Cloth United States 5 bottles 20 yards United Kingdom 15 bottles 10 yards Comparative advantage: the US has an absolute advantage in both goods United States 40 bottles 40 yards United Kingdom 20 bottles 10 yards Carbaugh, Chap. 2

Ricardo’s Comparative Advantage in money prices Cloth (yards) Wine (bottles) Nation Labor Wage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1) Carbaugh, Chap. 2

Production possibilities schedule Comparative advantage Production possibilities schedule Generalizes theory to include all factors, not just labor Shows combinations of products that can be made if all factors are used efficiently Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) Carbaugh, Chap. 2

Marginal Rate of Transformation Comparative advantage Marginal Rate of Transformation Carbaugh, Chap. 2

Production possibilities schedules: constant opportunity costs Comparative advantage Production possibilities schedules: constant opportunity costs Carbaugh, Chap. 2

Supply schedules: constant opportunity costs Comparative advantage Supply schedules: constant opportunity costs Carbaugh, Chap. 2

Trading under constant opportunity costs Comparative advantage Trading under constant opportunity costs Carbaugh, Chap. 2

Production gains from specialization: constant opportunity costs Comparative advantage Production gains from specialization: constant opportunity costs Before After Net Gain Specialization Specialization (Loss) Autos Wheat Autos Wheat Autos Wheat US 40 40 120 0 80 -40 Canada 40 80 0 160 -40 80 World 80 120 120 160 40 40 Carbaugh, Chap. 2

Consumption gains from trade: constant opportunity costs Comparative advantage Consumption gains from trade: constant opportunity costs Before After Net Gain Trade Trade (Loss) Autos Wheat Autos Wheat Autos Wheat US 40 40 60 60 20 20 Canada 40 80 60 100 20 20 World 80 120 120 160 40 40 Carbaugh, Chap. 2

Complete specialization under constant opportunity costs Comparative advantage Complete specialization under constant opportunity costs Carbaugh, Chap. 2

Changing comparative advantage Carbaugh, Chap. 2

Trade restrictions and gains from trade Comparative advantage Trade restrictions and gains from trade Carbaugh, Chap. 2

Production possibilities schedule under increasing costs Increasing opportunity costs Production possibilities schedule under increasing costs Carbaugh, Chap. 2

Supply schedule under increasing costs Increasing opportunity costs Supply schedule under increasing costs Carbaugh, Chap. 2

Trading under increasing costs: US Increasing opportunity costs Trading under increasing costs: US Carbaugh, Chap. 2

Trading under increasing costs: Canada Increasing opportunity costs Trading under increasing costs: Canada Carbaugh, Chap. 2

Production gains from specialization: increasing opportunity costs Before After Net Gain Specialization Specialization (Loss) Autos Wheat Autos Wheat Autos Wheat US 5 18 12 14 7 -4 Canada 17 6 13 13 -4 7 World 22 24 25 26 3 3 Carbaugh, Chap. 2

Consumption gains from trade: increasing opportunity costs Before After Net Gain Trade Trade (Loss) Autos Wheat Autos Wheat Autos Wheat US 5 18 5 21 0 3 Canada 17 6 20 6 3 0 World 22 24 25 27 3 3 Carbaugh, Chap. 2