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
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
3
Comparative advantage
Ricardo’s 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
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
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
3
3
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
3
3
Carbaugh, Chap. 2
20