Lecture Slides Chapter 02.pptVIP

Foundations of Modern Trade Theory:Comparative Advantage Chapter 2 Copyright ? 2009 South-Western, a division of Cengage Learning. All rights reserved. Mercantilists popular from 1500-1800 in Europe assumption that a trade surplus (exports imports) would lead to a nation obtaining more gold which would lead to increased domestic production and employment policy implication was for domestic government to limit trade through tariffs, import quotas, and other methods Price-Specie-Flow Doctrine David Hume counter argument to mercantilism trade surplus possible only in short run inflow of gold or other form of wealth will lead to an increase in the price of domestic goods higher prices for domestic goods will eventually lead to increased imports and decreased exports Absolute Advantage Adam Smith – Wealth of Nations cost differences determine the patterns of international trade based on natural and acquired resources labor theory of value – amount of labor required determines the cost of any good principle of absolute advantage – trade is beneficial when each country is a least cost producer of one of the goods being traded Absolute Advantage - Example Since the U.S. can produce more cloth, we should produce cloth and trade it to the U.K. for wine, for which the U.K. has greater capacity. Comparative Advantage David Ricardo trade as mutually beneficial even if one country is more efficient than another principle of comparative advantage – each nation should specialize in production of those goods for which it is relatively more efficient with a lower opportunity cost not possible for one country to have a comparative advantage in everything Comparative Advantage - Example The U.S. can produce twice as much wine as the U.K. but four times as much cloth. Therefore the U.S. should specialize in producing cloth while the U.K. specializes in producing wine. Production Possibilities Schedule (PPS) PPS - various combinations of two goods that