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1.
What are the basic questions that we seek to answer in this chapter? In what
way is the model presented in this chapter an abstraction or a simplification of the real
world? Can the model be generalized?
This chapter examined the development of trade theory from the mercantilists to Smith and
Ricardo and sought to answer two basic questions
•
What is the basis for and what are the gains from trade?
•
What is the pattern of trade?
The model is an abstraction for the real world since it could explain the pattern of trade and
gains from trade using the law of comparative advantage. That model can also be a
simplification for the real world by using 2 nations and 2 commodities, then generalizing to
trade in more than 2 commodities and among more than 2 nations.
The model could be generalized as the following: Assuming there are 2 nations 2
commodities, the law of comparative advantage will determine which commodities a
nation should export and import to gain from international
2.
What were the mercantilists’ views on trade? How does their concept of national
wealth differ from today’s view?
The mercantilists’ views on trade maintained that the way for a nation to become rich and
powerful was to export more than it imported
The mercantilists measured the wealth of a nation by the stock of precious metals it
possessed. In contrast, today we measure the wealth of a nation by its stock of human, manmade, and natural resources available for producing goods and services. The greater this
stock of useful resources, the greater the flow of goods and services to satisfy human wants,
and the higher the standard of living in the nation.
3.
Why is it important to study the mercantilists’ views on trade? How were their
views different from those of Adam Smith? What is the relevance of all this today?
It is important to study the mercantilists’ views on trade for 2 reasons:
• First, the ideas of Adam Smith, David Ricardo, and other classical economists can
best be understood if they are regarded as reactions to the mercantilists’ views on
trade and on the role of the government.
• Second, today there seems to be a resurgence of neo-mercantilism, as nations plagued
by high levels of unemployment seek to restrict imports in an effort to stimulate
domestic production and employment.
The mercantilists believed that a nation could gain in international trade only at the expense
of other nations. According to Adam Smith, trade is based on absolute advantage and
benefits both nations (the discussion assumes a two-nation, two-commodity world).
Today, though most nations claim to be in favour of free trade, most of them continue to
implement several restrictions on international trade (by using tariffs, quotas, etc…)
4.
What was the basis for and the pattern of trade according to Adam Smith? How
were gains from trade generated? What policies did Smith advocate in international
trade? What did he think was the proper function of government in the economic life
of the nation?
According to Adam Smith, trade between two nations is based on absolute advantage. Both
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nations can gain by specializing in the production of the commodity of its absolute
advantage and exchanging part of its output with the other nation for the
commodity of its absolute disadvantage
Resources are utilized in the most efficient way and the output of both commodities will
rise. This increase in the output of both commodities measures the gains from specialization
in production available to be divided between the two nations through trade.
He strongly advocated a policy of laissez-faire (as little government interference with the
economic system as possible.
The main function of government in the economic life of the nation was the protection of
industries important for national defence.
5.
In what way was Ricardo’s law of comparative advantage superior to Smith’s
theory of absolute advantage? How do gains from trade arise with comparative
advantage? How can a nation that is less efficient than another nation in the
production of all commodities export anything to the second nation?
Smith only discussed two nations which had its own absolute advantage. In the meantime,
Ricardo added the appearance of a nation that was less efficient in the production of two
commodities.
Gain from trade can arise with comparative advantage as long as the absolute disadvantage
that the first nation has with respect to the second is not in the same proportion in both
commodities.
The less efficient nation should specialize in the production and export of the commodity in
which its absolute disadvantage is smaller
6.
What is the exception to the law of comparative advantage? How prevalent is it?
The exception to the law of comparative advantage is that there is no comparative
advantage. This situation occurs when the absolute disadvantage that one nation has with
respect to another nation is the same in both commodities
Its occurrence is rare and a matter of coincidence. Additionally, natural trade barriers such
as transport costs can prevent trade even when some comparative advantage exists
7.
Why is Ricardo’s explanation of the law of comparative advantage
unacceptable? What acceptable theory can be used to explain the law?
Ricardo explained the law of comparative advantage in terms of the labour theory of value,
which is unacceptable. We will see that if we allow for different labour productivities in
various industries in different nations, the Ricardian trade model does a reasonably good job
of explaining the pattern of trade. Moreover, labour is not the only factor of production, nor
is it used in the same fixed proportion in the production of all commodities. In addition,
there is usually some possibility of substitution between labour, capital, and other factors in
the production of most commodities. Furthermore, labour is obviously not homogeneous but
varies greatly in training, productivity, and wages. At the very least, we should allow for
different productivity of labour.
In any event, the theory of comparative advantage need not be based on the labour theory of
value but can be explained on the basis of the opportunity cost theory (which is acceptable)
8.
What is the relationship between opportunity costs and the production possibility
frontier (PPF) of a nation? How does the production possibility frontier look under
constant opportunity costs? What is the relationship between the opportunity cost of a
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commodity and the relative price of that commodity? How can they be visualized
graphically?
The production possibility frontier (PPF) represents the maximum combinations of two
goods or services that a nation can produce given its available resources and technology.
Opportunity cost is directly linked to the PPF, as it reflects the trade-off involved when
choosing to produce more of one good at the expense of the other. The slope of the PPF at
any point indicates the opportunity cost of one good in terms of the other. When resources
are shifted between goods, the PPF illustrates the increasing or constant opportunity costs
depending on the adaptability of resources. Thus, the opportunity cost is a fundamental
concept in understanding the trade-offs depicted by the PPF.
When opportunity costs are constant, the production possibility frontier (PPF) takes the form
of a straight line. This linear shape occurs because resources are perfectly adaptable for
producing both goods, leading to a consistent trade-off ratio. For example, if one unit of
good X always requires sacrificing the same number of units of good Y, the opportunity cost
remains unchanged regardless of the production mix. The slope of the straight-line PPF
represents this constant opportunity cost, and every point on the line reflects an efficient
allocation of resources between the two goods.
The opportunity cost of a commodity is closely related to its relative price, as both concepts
measure trade-offs. Opportunity cost is the amount of one good that must be forgone to
produce an additional unit of another good, while the relative price is the price of one good
expressed in terms of another. In a competitive and efficient market, the relative price aligns
with the opportunity cost because prices act as signals to allocate resources optimally. If the
relative price deviates from the opportunity cost, resources may be reallocated until
equilibrium is reached, ensuring that production and consumption are balanced.
Graphically, the PPF provides a clear visualization of opportunity costs and relative prices.
Under constant opportunity costs, the PPF is a straight line, and its slope represents the fixed
trade-off ratio between the two goods. With increasing opportunity costs, the PPF becomes
concave to the origin, reflecting the rising cost of reallocating resources. Relative prices can
be visualized as the slope of a tangent line to the PPF, which represents the trade-off ratio in
equilibrium. This tangent line shows the rate at which one good can be exchanged for
another in the market, illustrating how opportunity costs translate into relative prices.
9.
Why is a nation’s production possibility frontier the same as its consumption
frontier in the absence of trade? How does the nation decide how much of each
commodity to consume in the absence of trade?
In the absence of trade, a nation's production possibility frontier (PPF) is the same as its
consumption frontier because the country must rely solely on its own production to meet its
consumption needs. Without access to international markets, the nation cannot import goods
that it does not produce nor export surplus production. As a result, the quantities of goods
consumed are constrained by the quantities produced, which are limited by the resources
and technology available. Each point on the PPF reflects a combination of goods that the
nation can both produce and consume, making the PPF identical to the consumption frontier.
In the absence of trade, a nation determines how much of each commodity to consume based
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on the preferences of its population and the available production possibilities. The decision
involves finding a point on the PPF that maximizes overall satisfaction or utility. This point is
typically determined by the interaction of the nation’s production capabilities (as represented
by the PPF) and the community's indifference curves, which represent different levels of
collective preference or utility. The optimal consumption point is where the PPF is tangent to
the highest possible indifference curve, indicating the best achievable combination of goods
given the nation’s resources and technology
10.
What is meant by complete specialization? By incomplete specialization? Why do
both nations gain from trade in the first instance but only the small nation in the
second?
Complete specialization occurs when a nation focuses all its resources on the production of a
single good in which it has a comparative advantage and produces no units of the other
good. This happens under conditions where trade allows the nation to efficiently obtain the
other good from a trading partner at a lower opportunity cost than producing it domestically.
Complete specialization often arises when opportunity costs are constant and trade terms are
favorable, enabling both nations to maximize the gains from trade by producing only what
they are best at.
Incomplete specialization occurs when a nation produces more of the good in which it has a
comparative advantage but continues to produce some of the other good as well. This
typically happens under conditions of increasing opportunity costs or when trade
restrictions, transportation costs, or limited international demand prevent the nation from
fully specializing. In such cases, the nation optimizes its resource allocation by balancing
domestic production of both goods while still benefiting from trade.
In the case of complete specialization, both nations gain from trade because each country
can fully exploit its comparative advantage, leading to more efficient global resource
allocation and higher overall production. Both nations benefit from consuming combinations
of goods beyond what they could achieve without trade. However, under incomplete
specialization, only the small nation tends to gain from trade. This is because the larger
nation’s production and trade decisions can influence world prices due to its economic size,
potentially diminishing the trade benefits it receives. Conversely, the small nation is a price
taker, meaning it benefits from the terms of trade set by the larger nation, allowing it to
achieve gains even with limited specialization.
11.
What
is
meant
by
complete specialization?
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Salvatore, Chapter 2: Complete Problem Set Key
SUGGESTED ANSWERS TO PROBLEMS
1. Table 2.5 shows bushels of wheat and the yards of cloth that the
United States and the United Kingdom can produce with one hour of
labor time under four different hypothetical situations. In each case,
identify the commodity in which the United States and the United
Kingdom have an absolute advantage or disadvantage.
In case A, the United States has an absolute advantage in wheat and the United Kingdom in cloth.
In case B, the United States has an absolute advantage (so that the United Kingdom has an absolute
disadvantage) in both commodities.
In case C, the United States has an absolute advantage in wheat but has neither an absolute
advantage nor disadvantage in cloth.
In case D, the United States has an absolute advantage over the United Kingdom in both
commodities.
*2. With respect to Table 2.5, indicate in each case the commodity
in which each nation has a comparative advantage or disadvantage.
In case A, the United States has a comparative advantage in wheat and the United Kingdom in
cloth.
In case B, the United States has a comparative advantage in wheat and the United Kingdom in cloth.
In case C, the United States has a comparative advantage in wheat and the United Kingdom in cloth.
In case D, the United States and the United Kingdom have a comparative advantage in neither
commodity.
3. With respect to Table 2.5, indicate in each case whether or not
trade is possible and the basis for trade.
In case A, trade is possible based on absolute advantage.
In case B, trade is possible based on comparative advantage.
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In case C, trade is possible based on comparative advantage.
In case D, no trade is possible because the absolute advantage that the United States has over the
United Kingdom is the same in both commodities.
*4. Suppose that in Case B in Table 2.5 the United States exchanges
4W for 4C with the United Kingdom.
(a) How much does the United States gain in terms of cloth?
(b) How much does the United Kingdom gain in terms of cloth?
(c) What is the range for mutually beneficial trade?
(d) How much would each nation gain if they exchanged 4W for 6C
instead?
a) The United States gains 1C.
b) The United Kingdom gains 4C.
c) 3C < 4W < 8C.
d) The United States would gain 3C while the United Kingdom would gain 2C.
5. Use the information for Case B in Table 2.5 and assume that labor
is the only factor of production and is homogeneous (i.e., all of one
type).
(a) What is the cost in terms of labor content of producing wheat
and cloth in the United States and the United Kingdom?
(b) What is the dollar price of wheat and cloth in the United States if
the wage rate is $6?
(c) What is the pound price of wheat and cloth in the United
Kingdom if the wage rate is £1?
a) The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 in the
United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United
States and 1/2 in the United Kingdom.
b) In the United States, Pw=$1.50 and Pc=$2.00.
c) In the United Kingdom, Pw=£1.00 and Pc=£0.50.
6. Answer the following questions with reference to Problem 5.
(a) What is the dollar price of wheat and cloth in the United
Kingdom if the exchange rate between the pound and the dollar is
£1 = $2? Would the United States be able to export wheat to the
United Kingdom at this exchange rate? Would the United Kingdom
be able to export cloth to the United States at this exchange rate?
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(b) What if the exchange rate between the dollar and the pound
were £1 = $4?
(c) What is the exchange rate were £1 = $1?
(d) What is the range of exchange rates that will allow the United
States to export wheat to the United Kingdom and the United
Kingdom to export cloth to the United States?
a) With the exchange rate of £1=$2, Pw=2.00 and Pc=$1.00 in the United Kingdom, so that the
United States would be able to export wheat to the United Kingdom and the United Kingdom would
be able to export cloth to the United States.
b) With the exchange rate of £1=$4, Pw=$4.00 and Pc=$2.00 in the United Kingdom, so that the
United States would be able to export wheat to the United Kingdom, but the United Kingdom
would be unable to export any cloth to the United States.
c) With £1=$1, Pw=$1.00 and Pc=$0.50 in the United Kingdom, so that the United Kingdom
would be able to export both commodities to the United States.
d) $1.50 < £1.00 < $4.00
7. Assume that the data in Case B in Table 2.5 refer to millions of
bushels of wheat and millions of yards of cloth.
(a) Plot on graph paper the production frontiers of the United States
and the United Kingdom.
(b) What is the relative price of wheat (i.e., PW/PC in the United
States and in the United Kingdom in autarky (no trade)?
(c) What is the relative price of cloth (i.e., PC/PW in the United States
and in the United Kingdom in autarky?
a) See Figure 1.
b) In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.
c) In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.
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8. Using the United States and United Kingdom production frontiers
from Problem 7, assume that the no-trade or autarky point is 3W
and 3/4C (in million units) in the United States and 1/2W and 1C in the
United Kingdom. Also assume that with the opening of trade the
United States exchanges 1W for 1C with the United Kingdom. Show
graphically for the United States and the United Kingdom the
autarky (or no-trade) point of production and consumption, the
point of production and consumption with trade, and the gains from
trade.
See Figure 2. The autarky points are A and A' in the United States and the United Kingdom,
respectively. The points of production with trade are B and B' in the United States and the United
Kingdom, respectively. The points of consumption are E and E' in the United States and the United
Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E' > A' for the
U.K.
9. (a) What would be the equilibrium-relative commodity price of
wheat if DW(US+UK) shifted up by one-third in the left panel of Figure
2.3? How much wheat and cloth would the United States and the
United Kingdom then produce?
(b) What does the answer to part (a) imply for DC(UK+US) in the right
panel of Figure 2.3?
a) If DW(US+UK) shifted up in Figure 2.3, the equilibrium relative commodity price of wheat would
also rise by 1/3 to PW/PC=4/3. Since the higher DW(US+UK) would still intersect the vertical portion of
the SW(US+UK) curve, the United States would continue to specialize completely in the production of
wheat and produce 180W, while the United kingdom would continue to specialize completely in the
production of cloth and produce 120C.
b) Since the equilibrium relative commodity price of cloth is the inverse of the relative commodity
price of wheat, if the latter rises to 4/3, then the former falls to ¾. This means that DC(UK+US) shifts
down by 1/3 in the right panel of Figure 3.
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*10. What would happen if DW(US+UK) intersected the horizontal
portion of SW(US+UK) at PW/PC = 2/3 and 120W in the left panel of
Figure 2.3? What would this imply for specialization in production
and the distribution in the gains from trade between the two
nations?
If DW(US+UK) intersected SW(US+UK) at PW/PC=2/3 and 120W in the left panel of Figure 2.3, this would
mean that the United States would not be specializing completely in the production of wheat.
The United Kingdom, on the other hand, would be specializing completely in the production
of cloth and exchanging 20C for 30W with the United States. Since the United Kingdom trades at
U.S. the pre-trade relative commodity price of PW/PC=2/3 in the United States, the United Kingdom
receives all of the gains from trade.
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11. Draw a figure similar to Figure 2.2 showing that the United
Kingdom is now a small country, half the size shown in the right
panel of Figure 2.2, and trades 20C for 30W with the United States
at PW/PC = 2/3.
See Figure 2.3 on page 15 and the discussion in the last paragraph of Section 2.6b in the text.
12. (a) How was the Ricardian trade model tested empirically?
(b) In what way can the results be said to confirm the Ricardian
model?
(c) Why do we then need other trade models?
a) The Ricardian model was tested empirically by showing the positive correlation between relative
productivities and the ratio of U.S.to U.K. exports to third
countries and by the negative
correlation between relative unit labor costs and relative exports
b) The Ricardian trade model was confirmed by the positive relationship found between the relative
labor productivity and the ratio of U.S. to U.K. exports to third countries, as well as by the negative
relationship between relative unit labor costs and relative exports.
c) Even though the Ricardian model was more or less empirically confirmed we still need other
models because the former assumes rather than explains comparative advantage (i.e., it does not
explain the reason for the different labor productivities in different nations) and cannot say much
regarding the effect of international trade on the earnings of factors of production.
13. How would you counter the argument that the United States
needs to restrict textile imports in order to save American jobs?
The United States has a comparative disadvantage in the production of textiles. Restricting textile
imports would keep U.S. workers from eventually moving into industries in which the United States
has a comparative advantage and in which wages are higher.
*= Answer provided at www.wiley.com/college/salvatore.
SUGGESTED ANSWER TO PROBLEM IN APPENDIX 2
The numbers in the following table refer to the cost or price of commodities X, Y, and Z in nations
A, B, and C in terms of the same currency. Thus, nation A exports commodity X to nations B and
C; nation B exports commodity Y to nations A and C; nation C exports commodity Z to nations A
and B.
Commodity
X
Y
Z
A
1
3
4
Nation
B
2
1.5
3
C
3
2
2
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