1. 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

2. Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour NationWineCloth United States5 bottles20 yards United Kingdom15 bottles8 yards Comparative advantage: the US has an absolute advantage in both goods, but UK has comparative advantage in … Output/labor hour Oppty Cost NationWineCloth of Wine United States40 bottles40 yards 1 yd/bottle United Kingdom20 bottles10 yards ½ yd/bottle

3. Marginal Rate of Transformation A B C Slope = MRT = 0.5 Wheat

4. Transformation schedules: constant opportunity costs Comparative advantage Slope=0.5 bu/car=MRT Slope = 2.0bu/car = MRT Wheat

5. Trading under constant opportunity costs (terms of trade = 1:1) Comparative advantage A B C D E F Trading possibilities line (terms of trade 1:1) A’ B’ C’ D’ Trading possibilities line (terms of trade 1:1) Wheat

6. Consumption gains from trade: constant opportunity costs AutosWheatAutos WheatAutosWheat US404060602020 Canada4080601002020 World801201201604040 BeforeAfterNet Gain SpecializationSpecialization(Loss)

7. Changing comparative advantage MRT = 0.67 MRT = 0.5 Autos

8. Trading under increasing costs: US Increasing opportunity costs t US (1A = 0.33W) tt (1A =1W) Trading possibilities line Wheat

9. Trading under increasing costs: Canada Increasing opportunity costs A’ t C (1A = 3W) B’ C’ D’ tt (1A =1W) Trading possibilities line Wheat