1. International Economics By Robert J. Carbaugh 7th Edition
Chapter 2:
Foundations of modern trade theory

2. Historical development of trade theory
Foundations of trade theory
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
Carbaugh, Chap. 2

3. 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 8 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

4. 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
UK 1 hr £5/hr 10 £ £0.25
UK 1 hr $8 10 $ $0.40
(at $1.6 = £1)
Carbaugh, Chap. 2

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

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

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

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

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

10. 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
Canada
World
Carbaugh, Chap. 2

11. Consumption gains from trade: constant opportunity costs
Comparative advantage
Consumption gains from trade: constant opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World
Carbaugh, Chap. 2

12. Complete specialization under constant opportunity costs
Comparative advantage
Complete specialization under constant opportunity costs
S Canada
S US
Aa’ Aw
Bushels of wheat per auto
S US
Autos per bushel of wheat
S Canada Aa
Aw’
Carbaugh, Chap. 2

13. Changing comparative advantage
MRT = 0.67
Autos
Autos
MRT = 0.5
Carbaugh, Chap. 2

14. Trade restrictions and gains from trade
Comparative advantage
Trade restrictions and gains from trade D E
tt’ tt C A
Crude oil B
Carbaugh, Chap. 2

15. Transformation schedule under increasing costs
Increasing opportunity costs
Transformation schedule under increasing costs A
Slope 1A = 1W
Slope 1A = 4W
Wheat B
Carbaugh, Chap. 2

16. Supply schedule under increasing costs
Increasing opportunity costs
Supply schedule under increasing costs B
Supply curve of autos
Bushels of wheat per auto A
Carbaugh, Chap. 2

17. Trading under increasing costs: US
Increasing opportunity costs
Trading under increasing costs: US B C D
tt (1A =1W)
Trading possibilities line A
tUS (1A = 0.33W)
Wheat
Carbaugh, Chap. 2

18. Trading under increasing costs: Canada
Increasing opportunity costs
Trading under increasing costs: Canada B’ C’ D’
tt (1A =1W)
Trading possibilities line
tC (1A = 3W)
Wheat A’
Carbaugh, Chap. 2

19. Production gains from specialization: increasing opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World
Carbaugh, Chap. 2

20. Consumption gains from trade: increasing opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World
Carbaugh, Chap. 2