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

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
United Kingdom

5 bottles 20 yards
15 bottles 10 yards

Comparative advantage: the US has an absolute

advantage in both goods
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom

Carbaugh, Chap. 2

40 bottles 40 yards
20 bottles 10 yards

Comparative advantage

Ricardos Comparative Advantage in

money prices
Nation

Labor

Wage

US
1 hr
UK
1 hr
UK
1 hr
(at $1.6 = 1)

$20/hr
5/hr
$8

Carbaugh, Chap. 2

Cloth (yards)
Quant. Price
40
10
10

$0.50
0.50
$0.80

Wine (bottles)
Quant. Price
40
20
20

$0.50
0.25
$0.40

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

Comparative advantage

Marginal Rate of Transformation

Carbaugh, Chap. 2

Comparative advantage

Production possibilities schedules:

constant opportunity costs

Carbaugh, Chap. 2

Comparative advantage

Supply schedules: constant opportunity

costs

Carbaugh, Chap. 2

Comparative advantage

Trading under constant opportunity

costs

Carbaugh, Chap. 2

Comparative advantage

Production gains from specialization:

constant opportunity costs
Before
Specialization

After
Specialization

Net Gain
(Loss)

Autos Wheat

Autos Wheat

Autos Wheat

US
Canada

40
40

40
80

120
0

0
160

80
-40

-40
80

World

80

120

120

160

40

40

Carbaugh, Chap. 2

10

Comparative advantage

Consumption gains from trade: constant

opportunity costs
Before
Trade

After
Trade

Net Gain
(Loss)

Autos Wheat

Autos Wheat

Autos Wheat

US
Canada

40
40

40
80

60
60

60
100

20
20

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
Specialization

After
Specialization

Net Gain
(Loss)

Autos Wheat

Autos Wheat

Autos Wheat

US
Canada

5
17

18
6

12
13

14
13

7
-4

-4
7

World

22

24

25

26

Carbaugh, Chap. 2

19

Increasing opportunity costs

Consumption gains from trade: increasing

opportunity costs
Before
Trade

After
Trade

Net Gain
(Loss)

Autos Wheat

Autos Wheat

Autos Wheat

US
Canada

5
17

18
6

5
20

21
6

0
3

3
0

World

22

24

25

27

Carbaugh, Chap. 2

20