Chapter 2

CHAPTER 2 Why Countries Trade CHAPTER OUTLINE L Introduction 1L International Trade Versus Interregional Trade . international trade occurs for the same reasons as interregional trade . gains from technology and gains from trade III. Trade in an Individual Product VIL . trade in cloth (U.S./India) — Figure 2.1 . supply and demand . the effects on India and the U.S. Trade Based on Absolute Advantage A. Absolute Advantage . PASSPORT: Football Games, Rats, and Economic Theory . PASSPORT: Mercantilism . Table 2.1 B. The Gains from Specialization and Trade with Absolute Advantage . gains from trade — Table 2.2 . the labor theory of value Trade Based on Comparative Advantage A. Comparative Advantage . Table 2.3 . David Ricardo . Babe Ruth B. The Gains from Specialization and Trade with Comparative Advantage . PASSPORT: Principal Exports of Selected Countries — Table 2.4 . Change in world output — Table 2.5 Trade Based on Opportunity Costs A. Opportunity Costs . PASSPORT: Labor Costs as a Source of Comparative Advantage — Table 26 B. The Gains from Specialization and Trade with Opportunity Costs . Table 2.7 . Autarky The Production Possibilities Frontier and Constant Costs A. The Production Possibilities Frontier — Table 2.8 B. Production and Consumption Without Specialization and Trade — Figure 2.2 C. Production and Consumption with Specialization and Trade — Figure 2.3 20

'Why Countries Trade 21 VIIL. The Terms of Trade A. Changes in the Gains from Specialization and Trade . Table 2.9 . Figure 2.4 B. Demand Conditions and the Terms of Trade C. Distribution of the Gains from Trade . PASSPORT: The Commodity Terms of Trade . Table 2.10 IX. Trade Under Increasing Opportunity Costs A. Increasing Costs and the Production Possibilities Frontier — Figure 2.6 B. Production and Consumption without Specialization and Trade — Figure 2.7 C. Production and Consumption with Specialization and Trade — Figure 2.8 X. Dynamic Gains from Trade . economic growth . small country benefits . product variety . competition policy TEACHING NOTES AND TIPS L Introduction Notes The title of the chapter sets up the introduction. The purpose of the chapter is to start to explain the world pattern of trade — who imports what and who exports what. Next we briefly outline the subjects covered in the chapter: international vs. interregional trade, trade in an individual product, absolute advantage, comparative advantage, the gains from trade, and the dynamic gains from trade. Teaching Tip You already understand trade. You've been doing it all your life. We're just going to teach you what you "know" in more formal terms. 1L International Trade Versus Interregional Trade Notes This section starts out the discussion of trade by focusing on trade within a country. Teaching Tip Students, particularly if they are from a "large" country, know a lot more about trade at the start than they think they do. They are observing trade any time they drive on a major highway. It would be difficult for any state or province of a country to prosper without "trading" with other parts of the country. Ask the students to consider what would happen to their welfare if their state did not trade with other states. From there you can lead them to the thought that trade improves welfare. Now they just have to learn more precisely why.

22 Chapter 2 III. Trade in an Individual Product Notes The section begins the discussion of international trade by focusing on the effects of trade in an individual product. By initially focusing on one product, the price effects, production effects, and consumption effects of trade can clearly be developed for the student. Teaching Tip After developing the price effects, production effects, and consumption effects of international trade one can clearly discuss the benefits and costs associated with international trade. In addition, it is important that students understand Figure 2.1 as it will be used at several points throughout the book. IV. Trade Based on Absolute Advantage Notes This section goes through the standard explanation of mutually beneficial trade based on absolute advantage. A few extra points are worth touching on here. The theory is based on limiting assumptions. Discuss the material found in "PASSPORT: Football Games, Rats, and Economic Theory". We all use "theory", although most of the time the theory is not as "formal" as in economics. Table 2.2 shows that trade makes the world better off. The gains from trade are not just country specific. Also, discuss "PASSPORT: Mercantilism." Many students enter this course with the vague feeling that trading with other countries may not improve welfare. We aren't born with this bias so it must have come from somewhere. The boxed feature "PASSPORT: Mercantilism" is designed to show where this bias came from and why it is wrong. Teaching Tip It is a good idea to mention that absolute advantage is really important in another context. The average level of output per worker in a country roughly determines GDP per capita. Absolute advantage is not just important for international trade. One point to add is that the mercantilists had income and wealth confused. Ask the students what they would rather have: a gift of $1 million with the catch that they can never earn any more income or a job that guarantees them $75,000 per year for life. They'll get the point that income is more important than wealth. V. Trade Based on Comparative Advantage Notes Table 2.3 is the usual setup to make comparative advantage obvious. Table 2.4 is designed to put some "real world" feel into the concept of comparative advantage. Table 2.5 shows how trade increases world output. The Passport on "Labor Costs As A Source of Comparative Advantage" details the pitfalls of confusing low wages with comparative advantage. Teaching Tip Paul Samuelson once said that comparative advantage is one of few things in economics that is true but not obvious.