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

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

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

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

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

Consumption gains from trade: constant opportunity costs AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

Changing comparative advantage MRT = 0.67 MRT = 0.5 Autos

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

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