Chapter 2:
Foundations of Modern Trade
Theory (Jan.28.2016)
Copyright ©2002, South-Western College Publishing
Foundations of trade theory
Historical development of trade theory
 Mercantilism
 positive trade balance
 Absolute advantage (Adam Smith)
 Countries benefit from exporting what they
make cheaper than anyone else
 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