International Economics
By Robert J. Carbaugh
7th Edition
Chapter 2:
Foundations of modern trade
theory
Copyright ©2000, 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 8 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
Transformation schedules
 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
70
A
60
Wheat
50
Slope = MRT = 0.5
40
B
30
20
10
C
0
0
20
40
60
80
100
120
140
Autos
Carbaugh, Chap. 2
6
Comparative advantage
Transformation schedules: constant
opportunity costs
Canada
160
140
120
100
80
60
40
20
0
Slope = 0.5 = MRT
0
40
80
Autos
Carbaugh, Chap. 2
120
Wheat
Wheat
United States
160
140
120
100
80
60
40
20
0
Slope = 2.0 = MRT
0
40
80
120
Autos
7
Comparative advantage
3
3
S Canada
Autos per bushel of wheat
Bushels of wheat per auto
Supply schedules: constant opportunity
costs
2.5
2
1.5
S US
1
0.5
0
0
40
80
Autos
Carbaugh, Chap. 2
120
160
2.5
S US
2
1.5
1
0.5
S Canada
0
0 20 40 60 80 10 12 14 16
0 0 0 0
Wheat
8
Comparative advantage
Trading under constant opportunity
costs
Canada
United States
Trading
possibilities line
(terms of trade 1:1)
160
140
Wheat
100
80
C
60
20
D
0
B
20 40 60 80 10 12 14 16
0 0 0 0
Autos
Carbaugh, Chap. 2
120
100
D’
80
C’
A’
60
20
F
0
140
Trading
possibilities line
(terms of trade 1:1)
40
A
40
160
Wheat
E
120
B’
0
0
20 40 60 80 10 12 14 16
0 0 0 0
Autos
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
Specialization
After
Specialization
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
3
3
S Canada
Autos per bushel of wheat
Bushels of wheat per auto
Complete specialization under constant
opportunity costs
2.5
Aa’
2
1.5
S US
1
Aa
0.5
0
0
40
80
Autos
Carbaugh, Chap. 2
120
160
2.5
Aw
2
1.5
S US
S Canada
1
Aw’
0.5
0
0
40
80
120
160
Wheat
12
Comparative advantage
Changing comparative advantage
Japan
United States
Autos
Autos
100
MRT = 0.67
0
50
0
100
Computers
Carbaugh, Chap. 2
MRT = 0.5
MRT = 2.0
MRT = 1.0
0
80
150
0
40
80
120
160
Computers
13
Comparative advantage
Trade restrictions and gains from trade
tt’
350
tt
Crude oil
300
C
250
E
200
A
150
100
D
50
B
0
0
100
200
300
400
500
Manufactured goods
Carbaugh, Chap. 2
14
Increasing opportunity costs
Wheat
Transformation schedule under
increasing costs
160
140
120
100
80
60
40
20
0
A Slope 1A = 1W
Slope 1A = 4W
B
0
20
40
60
80
100
120
140
Autos
Carbaugh, Chap. 2
15
Increasing opportunity costs
Bushels of wheat per auto
Supply schedule under increasing costs
6
5
B
4
Supply curve of autos
3
2
A
1
0
0
20
40
60
80
100
120
140
Autos
Carbaugh, Chap. 2
16
Increasing opportunity costs
Trading under increasing costs: US
Trading possibilities line
25
C
Wheat
20
A
15
D
10
tUS (1A = 0.33W)
B
5
tt (1A =1W)
0
0
5
10
15
20
25
30
35
40
Autos
Carbaugh, Chap. 2
17
Increasing opportunity costs
Trading under increasing costs: Canada
Trading possibilities line
25
Wheat
20
tC (1A = 3W)
15
B’
10
5
D’ A’
C’
tt (1A =1W)
0
0
5
10
15
20
25
30
35
40
Autos
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
Specialization
After
Specialization
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