International Economics

By Robert J. Carbaugh
9th Edition

Chapter 2:
Foundations of Modern Trade
Theory

Copyright ©2004, South-Western College Publishing

Foundations of trade theory

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
Carbaugh, Chap. 2 2
Comparative advantage

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 10 yards

Comparative advantage: the US has an absolute

advantage in both goods
Output per labor hour
Nation Wine Cloth
United States 40 bottles 40 yards
United Kingdom 20 bottles 10 yards
Carbaugh, Chap. 2 3
Comparative advantage

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 40 $0.50
UK 1 hr £5/hr 10 £0.50 20 £0.25
UK 1 hr $8 10 $0.80 20 $0.40
(at $1.6 = £1)

Carbaugh, Chap. 2 4
Comparative advantage

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)

Carbaugh, Chap. 2 5
Comparative advantage

Marginal Rate of Transformation

Carbaugh, Chap. 2 6
Comparative advantage

Production possibilities schedules:

constant opportunity costs

Carbaugh, Chap. 2 7
Comparative advantage

Supply schedules: constant opportunity

costs

Carbaugh, Chap. 2 8
Comparative advantage

Trading under constant opportunity

costs

Carbaugh, Chap. 2 9
Comparative advantage

Production gains from specialization:

constant opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat
US 40 40 120 0 80 -40
Canada 40 80 0 160 -40 80
World 80 120 120 160 40 40

Carbaugh, Chap. 2 10
Comparative advantage

Consumption gains from trade: constant

opportunity costs
Before After Net Gain
Trade Trade (Loss)
Autos Wheat Autos Wheat Autos Wheat
US 40 40 60 60 20 20
Canada 40 80 60 100 20 20
World 80 120 120 160 40 40

Carbaugh, Chap. 2 11
Comparative advantage

Complete specialization under constant

opportunity costs

Carbaugh, Chap. 2 12
Comparative advantage

Changing comparative advantage

Carbaugh, Chap. 2 13
Comparative advantage

Trade restrictions and gains from trade

Carbaugh, Chap. 2 14
Increasing opportunity costs

Production possibilities schedule under

increasing costs

Carbaugh, Chap. 2 15
Increasing opportunity costs

Supply schedule under increasing costs

Carbaugh, Chap. 2 16
Increasing opportunity costs

Trading under increasing costs: US

Carbaugh, Chap. 2 17
Increasing opportunity costs

Trading under increasing costs: Canada

Carbaugh, Chap. 2 18
Increasing opportunity costs

Production gains from specialization:

increasing opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat
US 5 18 12 14 7 -4
Canada 17 6 13 13 -4 7
World 22 24 25 26 3 3

Carbaugh, Chap. 2 19
Increasing opportunity costs

Consumption gains from trade: increasing

opportunity costs
Before After Net Gain
Trade Trade (Loss)
Autos Wheat Autos Wheat Autos Wheat
US 5 18 5 21 0 3
Canada 17 6 20 6 3 0
World 22 24 25 27 3 3

Carbaugh, Chap. 2 20