CHAPTER 2
FOUNDATIONS OF MODERN TRADE THEORY: COMPARATIVE ADVANTAGE
CHAPTER OVERVIEW
This chapter introduces students to the foundations of modern trade theory, which seeks to answer three
questions: (1) What constitutes the basis for trade? (2) At what terms of trade are products exchanged in the
world market? (3) What are the gains from trade in terms of production and consumption?
The chapter first examines the historical development of modern trade theory by introducing the ideas of the
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BRIEF ANSWERS TO STUDY QUESTIONS
1. Modern trade theory addresses the following questions: (1) What constitutes the basis for trade? (2) At
what terms of trade do nations export and import certain products? (3) What are the gains from trade
in terms of production and consumption?
2. The mercantilists maintained that government should stimulate exports and restrict imports so as to
increase a nation’s holdings of gold. A nation could only gain at the expense of other nations because
not all nations could simultaneously have a trade surplus. Smith maintained that with free trade,
3. Assume that by devoting all of its resources to the production of steel, France can produce 40 tons. By
devoting all of its resources to televisions, France can produce 60 televisions. Comparable figures for
4. Ignoring the role of demand’s impact on market prices, Smith and Ricardo maintained that a country’s
competitive position is underlaid by supply conditions. Smith’s trade theory is based on absolute costs,
5. The principle of comparative advantage can be explained in opportunity cost, which indicates the
amount of one product that must be sacrificed in order to release enough resources to be able to
produce one more unit of another product. The slope of the production possibilities curve (i.e., the
6. Constant opportunity costs refer to a situation where the cost of each additional unit of one product in
terms of another product remains the same. Constant costs occur when resources are completely
adaptable to alternative uses. Under increasing cost conditions, a nation must sacrifice more and more
7. Where a nation produces along its production possibilities curve in autarky affects the nation’s
comparative costs under increasing cost conditions. This is because the slope of a bowed-out
production possibilities curve, which indicates the marginal rate of transformation, varies at each point
8. Under constant opportunity cost conditions, specialization is complete. A country can devote all of its
resources to the production of a good without losing its comparative advantage. Under increasing cost
9. Production gains from trade refer to the increased output of goods and services made possible by the
international division of labor and specialization. Consumption gains from trade refer to the increased
10. The trade triangle includes a nation’s exports, its imports, and international terms of trade.
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11. The free trade argument maintains that international trade permits international division of labor and
specialization and results in resources being transferred to their highest productivity. World output thus rises
12. a. Canada’s MRT of steel into aluminum equals 1/3 ton of steel per ton of aluminum while
France’s MRT of steel into aluminum equals 1½ tons of steel per ton of aluminum. Canada
specializes in the production of aluminum while France specializes in the production of steel.
Complete specialization occurs in each country. The production gains from trade for the two
countries total 500 tons of aluminum and 300 tons of steel.
13. a. Concave production possibilities frontiers are explained by increasing opportunity costs.
b. Japan’s MRT of steel into autos equals 1/6 ton of steel per auto; South Korea’s MRT of steel
into autos equals 6 tons of steel per auto.
c. Japan specializes in the production of autos while South Korea specializes in steel.
14. Japan’s commodity terms of trade improved to 107. Canada’s commodity terms of trade remained
constant at 100. Ireland’s commodity terms of trade worsened to 88.
15. The gains a country enjoys from free trade depend on the equilibrium terms of trade, which is
determined by world supply and demand conditions. By recognizing only the role of supply, Ricardo
16. The theory of reciprocal demand suggests that if we know the domestic demands expressed by both
17. The commodity terms of trade considers the direction of the gains from trade by measuring the
relationship between the prices a country gets for its exports and the prices it pays for its imports, over