Copyright ©2000, South-Western College Publishing International Economics By Robert J. Carbaugh 7th Edition Chapter 2: Foundations of modern trade theory

Carbaugh, Chap. 2 2 Historical development of trade theory  Mercantilism  positive trade balance  Absolute advantage (Adam Smith)  Countries benefit from exporting what they make cheaper than anyone else  Comparative advantage (David Ricardo)  Nations can gain from specialization, even if they lack an absolute advantage Foundations of trade theory

Carbaugh, Chap. 2 3 Absolute & Comparative Advantage Comparative advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour NationWineCloth United States5 bottles20 yards United Kingdom15 bottles8 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour NationWineCloth United States40 bottles40 yards United Kingdom20 bottles10 yards

Carbaugh, Chap. 2 4 Ricardo’s Comparative Advantage in money prices Comparative advantage Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£5/hr10£0.5020£0.25 UK1 hr$810$0.8020$0.40 (at $1.6 = £1)

Carbaugh, Chap. 2 5 Transformation schedules  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) Comparative advantage

Carbaugh, Chap. 2 6 Marginal Rate of Transformation Comparative advantage A B C Slope = MRT = 0.5 Wheat

Carbaugh, Chap. 2 7 Transformation schedules: constant opportunity costs Comparative advantage Slope = 0.5 = MRT Slope = 2.0 = MRT Wheat

Carbaugh, Chap. 2 8 Supply schedules: constant opportunity costs Comparative advantage S Canada S US S Canada Bushels of wheat per auto Autos per bushel of wheat

Carbaugh, Chap. 2 9 Trading under constant opportunity costs Comparative advantage A B C D E F Trading possibilities line (terms of trade 1:1) A’ B’ C’ D’ Trading possibilities line (terms of trade 1:1) Wheat

Carbaugh, Chap Production gains from specialization: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

Carbaugh, Chap Consumption gains from trade: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

Carbaugh, Chap Complete specialization under constant opportunity costs Comparative advantage S Canada S US S Canada AwAw AaAa Aa’ Aw’ Bushels of wheat per auto Autos per bushel of wheat

Carbaugh, Chap Changing comparative advantage Comparative advantage MRT = 0.67 MRT = 0.5 Autos

Carbaugh, Chap Trade restrictions and gains from trade Comparative advantage A B C tt D E tt’ Crude oil

Carbaugh, Chap Transformation schedule under increasing costs Increasing opportunity costs A B Slope 1A = 1W Slope 1A = 4W Wheat

Carbaugh, Chap Supply schedule under increasing costs Increasing opportunity costs A B Supply curve of autos Bushels of wheat per auto

Carbaugh, Chap Trading under increasing costs: US Increasing opportunity costs A t US (1A = 0.33W) B C D tt (1A =1W) Trading possibilities line Wheat

Carbaugh, Chap Trading under increasing costs: Canada Increasing opportunity costs A’ t C (1A = 3W) B’ C’ D’ tt (1A =1W) Trading possibilities line Wheat

Carbaugh, Chap Production gains from specialization: increasing opportunity costs AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss) Increasing opportunity costs

Carbaugh, Chap Consumption gains from trade: increasing opportunity costs AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss) Increasing opportunity costs