Historical development of trade theoryMercantilismRegulation to ensure a positive trade balanceCritics: possible only for short term; assumes static world economyAbsolute advantage (Adam Smith)Countries benefit from exporting what they make cheaper than anyone elseBut: nations without absolute advantage do not gain from tradeComparative advantage (David Ricardo)Nations can gain from specialization, even if they lack an absolute advantageFoundations of trade theory

Carbaugh, Chap. 2

Absolute & Comparative AdvantageComparative advantageAbsolute advantage: each nation is more efficient in producing one goodOutput per labor hourNationWineClothUnited States5 bottles20 yardsUnited Kingdom15 bottles10 yards

Comparative advantage: the US has an absolute advantage in both goodsOutput per labor hourNationWineClothUnited States40 bottles40 yardsUnited Kingdom20 bottles10 yards

Carbaugh, Chap. 2

Ricardos Comparative Advantage in money pricesComparative advantageCloth(yards)Wine(bottles)NationLaborWageQuant. PriceQuant.PriceUS1 hr$20/hr40$0.5040$0.50UK1 hr5/hr100.50200.25UK1 hr$810$0.8020$0.40 (at $1.6 = 1)

Carbaugh, Chap. 2

Production possibilities scheduleGeneralizes theory to include all factors, not just laborShows combinations of products that can be made if all factors are used efficientlySlope, 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)Comparative advantage

Carbaugh, Chap. 2

Marginal Rate of TransformationComparative advantage

Carbaugh, Chap. 2

Production possibilities schedules: constant opportunity costsComparative advantage

Carbaugh, Chap. 2

Supply schedules: constant opportunity costsComparative advantage

Carbaugh, Chap. 2

Trading under constant opportunity costsComparative advantage

Carbaugh, Chap. 2

Production gains from specialization: constant opportunity costsComparative advantageAutosWheatAutos WheatAutosWheatUS4040120080-40Canada40800160-4080World801201201604040BeforeAfterNet GainSpecializationSpecialization(Loss)

Carbaugh, Chap. 2

Consumption gains from trade: constant opportunity costsComparative advantageAutosWheatAutos WheatAutosWheatUS404060602020Canada4080601002020World801201201604040BeforeAfterNet GainTradeTrade(Loss)

Carbaugh, Chap. 2

Complete specialization under constant opportunity costsComparative advantage

Carbaugh, Chap. 2

Changing comparative advantageComparative advantage

Carbaugh, Chap. 2

Trade restrictions and gains from tradeComparative advantage

Carbaugh, Chap. 2

Production possibilities schedule under increasing costsIncreasing opportunity costs

Carbaugh, Chap. 2

Supply schedule under increasing costsIncreasing opportunity costs

Carbaugh, Chap. 2

Trading under increasing costs: USIncreasing opportunity costs

Carbaugh, Chap. 2

Trading under increasing costs: CanadaIncreasing opportunity costs

Carbaugh, Chap. 2

Production gains from specialization: increasing opportunity costsAutosWheatAutos WheatAutosWheatUS51812147-4Canada1761313-47World2224252633BeforeAfterNet GainSpecializationSpecialization(Loss)Increasing opportunity costs

Carbaugh, Chap. 2

Consumption gains from trade: increasing opportunity costsAutosWheatAutos WheatAutosWheatUS51852103Canada17620630World2224252733BeforeAfterNet GainTradeTrade(Loss)Increasing opportunity costs

Carbaugh, Chap. 2