1. Foundations of Modern Trade Theory: Comparative Advantage
Chapter 2
Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

2. Mercantilists popular from 1500-1800 in Europe
assumption that a trade surplus (exports > imports) would lead to a nation obtaining more gold which would lead to increased domestic production and employment
policy implication was for domestic government to limit trade through tariffs, import quotas, and other methods

3. Price-Specie-Flow Doctrine
David Hume
counter argument to mercantilism
trade surplus possible only in short run
inflow of gold or other form of wealth will lead to an increase in the price of domestic goods
higher prices for domestic goods will eventually lead to increased imports and decreased exports

4. Absolute Advantage Adam Smith – Wealth of Nations
cost differences determine the patterns of international trade
based on natural and acquired resources
labor theory of value – amount of labor required determines the cost of any good
principle of absolute advantage – trade is beneficial when each country is a least cost producer of one of the goods being traded

5. Absolute Advantage - Example
Since the U.S. can produce more cloth, we should produce cloth and trade it to the U.K. for wine, for which the U.K. has greater capacity.

6. Comparative Advantage
David Ricardo
trade as mutually beneficial even if one country is more efficient than another
principle of comparative advantage – each nation should specialize in production of those goods for which it is relatively more efficient with a lower opportunity cost
not possible for one country to have a comparative advantage in everything

7. Comparative Advantage - Example
The U.S. can produce twice as much wine as the U.K. but four times as much cloth. Therefore the U.S. should specialize in producing cloth while the U.K. specializes in producing wine.

8. Production Possibilities Schedule (PPS)
PPS - various combinations of two goods that a nation can produce using all available factor inputs

9. Marginal Rate of Substitution (MRT)
amount of one good a country must sacrifice to get one more unit of another good
synonymous with opportunity cost
equal to the absolute value of the slope of the production possibilities schedule
∆ good Y
∆ good X
MRT =

10. MRT (cont.)
In this graph the MRT equals 0.5 because wheat output falls by 20 when auto rises by 40

11. Basis for Trade
The MRT or opportunity cost for each nation will indicate the direction of trade.
The MRT or opportunity cost can also indicate the potential gains from trade.
We begin with an assumption of constant opportunity costs.
Benefits will be measured in terms of both improved production and consumption.

12. Gains from Specialization
1 additional auto in the U.S. => loss of 0.5 bushel of wheat
1 additional auto in Canada => loss of 2 bushels of wheat

13. Gains from Specialization (cont.)
Since the U.S. has a lower opportunity cost of auto production, it will be mutually beneficial for the U.S. to produce autos and trade them to Canada for wheat.

14. Production Gains
Without trade or specialization, world production is 80 autos and 120 bushels of wheat.
If both nations specialized based on their comparative advantages, world production would increase to 120 autos and 160 bushels of wheat.

15. Consumption Gains
If the U.S. trades 60 autos for 60 bushels of wheat, then consumption will increase in each country.

16. Consumption Gains (cont.)
Graphically consumption could increase from A to C for the U.S. and A to C  for Canada or elsewhere along the Trading Possibilities Lines.

17. Distributing Gains from Trade
comparative advantage => only outer limits for the terms of trade
based on domestic cost ratios
form no-trade boundaries and region of mutually beneficial trade

18. Equilibrium Terms of Trade
John Stuart Mill – Theory of Reciprocal Demand
terms of trade determined by the relative strength of each nation’s demand for the other nation’s product
nations of roughly equal size => gains from trade distributed roughly equally
one nation larger => smaller nation attains most of the gains from trade because trade occurs closer to the larger nation’s existing price ratio – “importance of being unimportant”

19. Terms of Trade Estimates
export price index
import price index
terms of trade = × 100
prices of exports rise in relation to imports shows improvement
2006 terms of trade data using 2000 as the base year

20. Dynamic Gains from Trade
increased income leads to increased savings which leads to increased investment
greater options in supply chain
increased output level can lead to benefits from economies of scale
improved competition can lead to lower prices for consumers and a greater variety of products offered to consumers

21. Changes in Comparative Advantage
Thus far our analysis has assumed comparative advantage did not change.
However, if productivity changed at different rates, comparative advantage could shift from one nation to another.

22. Increasing Opportunity Costs
result of diminishing marginal productivity
cost of producing one good increases as more of that good is produced
production possibilities schedule has concave shape
MRT will increase as we move around the curve towards the intercepts

23. Trade with Increasing Opportunity Costs
specialize until relative costs are equal
line tt becomes terms of trade for both the U.S. and Canada

24. Gains – Increasing Cost Case
If the U.S. specializes and trades 7 autos for 7 bushels of wheat, consumption would increase in each country.

25. Impact of Trade on U.S. Jobs
little to no impact on overall employment
will impact mix of jobs and specific industries

26. Many Products
Various products have different comparative costs resulting in different degrees of comparative advantage.
Each nation will produce and export the goods for which it has the greatest comparative advantage subject to supply and demand constraints.

27. Many Countries multilateral trade
implies bilateral trade balance is unlikely result

28. Outsourcing – Pros & Cons
reduced costs and increased competitiveness for domestic companies
increased exports to countries in which new jobs are created
higher level of repatriated earnings reinvested into domestic economy
Cons
reduced employment in specific industries
lower wages, particularly for unskilled workers