Copyright ©2002, South-Western College Publishing Chapter 2: Foundations of Modern Trade Theory (Jan )

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 bottles10 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 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) Comparative advantage

Carbaugh, Chap. 2 6 Marginal Rate of Transformation Comparative advantage

Carbaugh, Chap. 2 7 Production possibilities schedules: constant opportunity costs Comparative advantage

Carbaugh, Chap. 2 8 Supply schedules: constant opportunity costs Comparative advantage

Carbaugh, Chap. 2 9 Trading under constant opportunity costs Comparative advantage

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 TradeTrade(Loss)

Carbaugh, Chap Complete specialization under constant opportunity costs Comparative advantage

Carbaugh, Chap Changing comparative advantage Comparative advantage