Deck 2: Foundations of Modern Trade Theory: Comparative Advantage

Question 1

Identify the basic questions with which modern trade theory is concerned.

Answer 1

The modern trade theory concerns with the following questions:
(1) What is the basis of international trade?
(2) What are the terms of trade at which the nations are ready to export and import?
(3) What are gains from international trade in terms of consumption and production?

Question 2

How did Smith's views on international trade differ from those of the mercantilists?

Answer 2

Mercantilists believed that a nation's government should regulate trade in order to promote a favorable trade balance, where exports exceed imports and there would result net payments in the form of gold and silver. They believed that this excess revenue increase domestic expenditures and decrease unemployment. By minimizing imports from others, a nation could regulate its domestic and international affairs to promote its own interests. Mercantilists also believed that imports have adverse effects on a nation because they take jobs away from domestic workers and transfer them to foreign workers. To them, international trade was a zero-sum activity in which one nation must lose for another to benefit.
In contrast to the mercantilists' view of international trade, classical economist Adam Smith believed that all nations can take advantage of the division of labor and their abilities to specialize in the production of certain goods. This would result in increased efficiency for each nation and increase the global productivity level. International trade, Smith believed, was necessary to benefit all trading parties because specialization allowed nations to consume more than it could without trade.

Question 3

Develop an arithmetic example that illustrates how a nation could have an absolute disadvantage in the production of two goods and could still have a comparative advantage in the production of one of them.

Answer 3

Answers may vary for this question.
Suppose that the United States and France only produce two goods: soda and donuts. American workers can produce 50 bottles of soda or 100 donuts in an hour. In the same amount of time, French workers can produce 25 bottles of soda or 25 donuts. The French clearly has an absolute disadvantage in the production of both goods because overall, they are only capable of producing 25 bottles of soda or 25 donuts in an hour as compared to the United States' capability to produce 50 bottles of soda or 100 donuts in the same amount of time.
In order to produce 1 bottle of soda, American workers must forgo the production of 2 donuts (50 bottles: 100 donuts = 1:2 ratio). For the French, the opportunity cost for producing 1 bottle of soda is only 1 donut (25 bottles: 25 donuts = 1:1 ratio). Therefore, the French has a comparative advantage in the production of soda even when it has an absolute disadvantage in the production of both goods because its opportunity cost of soda production is lower than that of the United States'. This means that French workers should specialize in the production of soda, making 25 bottles and 0 donuts, while American workers specialize in the production of donuts, using their time to make 100 donuts and 0 bottles of soda in an hour.

Question 4

Both Smith and Ricardo contended that the pattern of world trade is determined solely by supply conditions. Explain.

Question 5

How does the comparative-cost concept relate to a nation's production possibilities schedule? Illustrate how differently shaped production possibilities schedules give rise to different opportunity costs.

Question 6

What is meant by constant opportunity costs and increasing opportunity costs? Under what conditions will a country experience constant or increasing costs?

Question 7

Why is it that the pre-trade production points have a bearing on comparative costs under increasing- cost conditions but not under conditions of constant costs?

Question 8

What factors underlie whether specialization in production will be partial or complete on an international basis?

Question 9

The gains from specialization and trade are discussed in terms of production gains and consumption gains. What do these terms mean?

Question 10

What is meant by the term trade triangle?

Question 11

With a given level of world resources, international trade may bring about an increase in total world output. Explain.

Question 12

The maximum amount of steel or aluminum that Canada and France can produce if they fully use all the factors of production at their disposal with the best technology available to them is shown (hypothetically) in Table 2.8. Assume that production occurs under constant-cost conditions. On graph paper, draw the production possibilities schedules for Canada and France; locate aluminum on the horizontal axis and steel on the vertical axis of each country's graph. In the absence of trade, assume that Canada produces and consumes 600 tons of aluminum and 300 tons of

steel and that France produces and consumes 400 tons of aluminum and 600 tons of steel. Denote these autarky points on each nation's production possibilities schedule.
a. Determine the MRT of steel into aluminum for each nation. According to the principle of comparative advantage, should the two nations specialize? If so, which product should each country produce? Will the extent of specialization be complete or partial? Denote each nation's specialization point on its production possibilities schedule. Compared to the output of steel and aluminum that occurs in the absence of trade, does specialization yield increases in output? If so, by how much?
b. Within what limits will the terms of trade lie if specialization and trade occur? Suppose Canada and France agree to a terms-of-trade ratio of 1:1 (1 ton of steel = 1 ton of aluminum). Draw the terms-of-trade line in the diagram of each nation. Assuming that 500 tons of steel are traded for 500 tons of aluminum, are Canadian consumers better off as the result of trade? If so, by how much? How about French consumers?
c. Describe the trade triangles for Canada and France.

Question 13

The hypothetical figures in Table 2.9 give five alternate combinations of steel and autos that Japan and South Korea can produce if they fully use all factors of production at their disposal with the best technology available to them. On graph paper, sketch the production possibilities schedules of Japan and South Korea. Locate steel on the vertical axis and autos on the horizontal axis of each nation's graph.

a. The production possibilities schedules of the two countries appear concave, or bowed out, from the origin. Why?
b. In autarky, Japan's production and consumption points along its production possibilities schedule are assumed to be 500 tons of steel and 600 autos. Draw a line tangent to Japan's autarky point and from it calculate Japan's MRT of steel into autos. In autarky, South Korea's production and consumption schedule are assumed to be 200 tons of steel and 800 autos. Draw a line tangent to South Korea's autarky point and from it calculate South Korea's MRT of steel into autos.
c. Based on the MRT of each nation, should the two nations specialize according to the principle of comparative advantage? If so, in which product should each nation specialize?
d. The process of specialization in the production of steel and autos continues in Japan and South Korea until their relative product prices, or MRTs, become equal. With specialization, suppose the MRTs of the two nations converge at MRT = 1. Starting at Japan's autarky point, slide along its production possibilities schedule until the slope of the tangent line equals 1. This becomes Japan's production point under partial specialization. How many tons of steel and how many autos will Japan produce at this point? In like manner, determine South Korea's production point under partial specialization. How many tons of steel and how many autos will South Korea produce? For the two countries, do their combined production of steel and autos with partial specialization exceed their output in the absence of specialization? If so, by how much?
e. With the relative product prices in each nation now in equilibrium at 1 ton of steel equal to 1 auto (MRT 5 1), suppose 500 autos are exchanged at this terms of trade.
(1) Determine the point along the terms-of-trade line at which Japan will locate after trade occurs. What are Japan's consumption gains from trade?
(2) Determine the point along the terms-of-trade line at which South Korea will locate after trade occurs. What are South Korea's consumption gains from trade?

Question 14

Table 2.10 gives hypothetical export price indexes and import price indexes (1990 5 100) for Japan, Canada, and Ireland. Compute the

commodity terms of trade for each country for the period 1990-2006. Which country's terms of trade improved, worsened, or showed no change?

Question 15

Why is it that the gains from trade could not be determined precisely under the Ricardian trade model?

Question 16

What is meant by the theory of reciprocal demand? How does it provide a meaningful explanation of the international terms of trade?

Question 17

How does the commodity terms-of-trade concept attempt to measure the direction of trade gains?