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 international
markets? (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
mercantilists, Adam Smith, and David Ricardo. Next, the deficiencies of mercantilism and Adam Smith’s principle of
absolute advantage are noted and attention shifts to David Ricardo’s principle of comparative advantage. This
principle is explained in terms of a production possibilities table and also in terms of money.
The principle of comparative advantage is then explained under conditions of constant opportunity cost and
increasing opportunity cost. The analysis concludes that international trade can provide economic gains for all
trading nations. The chapter then extends the principle of comparative advantage to more than two products and
two countries. The chapter concludes by examining the empirical evidence regarding comparative advantage.
Indifference curves are used to show the role of demand in the trading model. It is noted that a country in autarky
will maximize its well being at the point where its community indifference curve is tangent to its production
possibilities schedule. Similarly, a trading nation will maximize its welfare at the point where its community
indifference curve is tangent to its international terms of trade ratio.
After completing the chapter, students should be able to:
• Identify the trading ideas of the mercantilists, Adam Smith, and David Ricardo.
• Compare and contrast the principle of absolute advantage and the principle of comparative advantage.
• Identify the effects of comparative advantage under conditions of constant opportunity costs and increasing
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
3. Assume that by devoting all of its resources to the production of steel, France can produce 40 tons. By
4. Ignoring the role of demand’s impact on market prices, Smith and Ricardo maintained that a country’s
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
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
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
8. Under constant opportunity cost conditions, specialization is complete. A country can devote all of its
9. Production gains from trade refer to the increased output of goods and services made possible by the
10. The trade triangle includes a nation’s exports, its imports, and international terms of trade.
11. The free trade argument maintains that international trade permits international division of labor and
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 1 ½ 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
13. a. Concave production possibilities schedules 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.
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
17. The commodity terms of trade considers the direction of the gains from trade by measuring the