1. Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 2: Foundations of Modern Trade Theory

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

3. 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

4. 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)

5. 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

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

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

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

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

10. Carbaugh, Chap. 2 10 Production gains from specialization: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US4040120080-40 Canada40800160-4080 World801201201604040 BeforeAfterNet Gain SpecializationSpecialization(Loss)

11. Carbaugh, Chap. 2 11 Consumption gains from trade: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US404060602020 Canada4080601002020 World801201201604040 BeforeAfterNet Gain TradeTrade(Loss)

12. Carbaugh, Chap. 2 12 Complete specialization under constant opportunity costs Comparative advantage

13. Carbaugh, Chap. 2 13 Changing comparative advantage Comparative advantage

14. Carbaugh, Chap. 2 14 Trade restrictions and gains from trade Comparative advantage

15. Carbaugh, Chap. 2 15 Production possibilities schedule under increasing costs Increasing opportunity costs

16. Carbaugh, Chap. 2 16 Supply schedule under increasing costs Increasing opportunity costs

17. Carbaugh, Chap. 2 17 Trading under increasing costs: US Increasing opportunity costs

18. Carbaugh, Chap. 2 18 Trading under increasing costs: Canada Increasing opportunity costs

19. Carbaugh, Chap. 2 19 Production gains from specialization: increasing opportunity costs AutosWheatAutos WheatAutosWheat US51812147-4 Canada1761313-47 World2224252633 BeforeAfterNet Gain SpecializationSpecialization(Loss) Increasing opportunity costs

20. Carbaugh, Chap. 2 20 Consumption gains from trade: increasing opportunity costs AutosWheatAutos WheatAutosWheat US51852103 Canada17620630 World2224252733 BeforeAfterNet Gain TradeTrade(Loss) Increasing opportunity costs