Instructor’s Manual
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.
The principle of absolute advantage is explained. The discussion continues with an explanation of the principle
of comparative advantage in terms of a production possibilities table and also in terms of money. Trading under
conditions of constant opportunity cost and increasing opportunity cost are then discussed in detail. Attention
then shifts to the determination of the equilibrium terms of trade. The chapter emphasizes the theory of
reciprocal demand and offer curves in the determination of the equilibrium terms of trade. The effect of
Instructor’s Manual
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.
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
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
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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
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
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.
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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.
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.
