Trade Theories:
#1 - Mercantilism
Defining mercantilism …
Mercantilism
•The theory that a country should
accumulate financial wealth by amassing
as many inflows of “currency” as possible
Mercantilism: 16th – late 18th century
• A nation’s wealth depends on accumulated
treasure
• Gold and silver are the currency of trade
• Two means of increasing a country’s wealth are
colonialism and international trade.
Mercantilism
• A system of government institutions and
policies designed to restrict international trade
– Maximize exports through subsidies.
– Minimize imports through tariffs and quotas
• The theory therefore says that a country should
always have a trade surplus.
Mercantilism: Policies
•
•
•
•
•
Forbidding colonies to trade with other nations
Monopolizing markets with staple ports;
Forbidding trade to be carried in foreign ships;
Maximizing the use of domestic resources;
Also restricting domestic consumption with non-tariff
barriers to trade.
Mercantilism – 9-point plan
• That every inch of a country's soil be utilized for agriculture, mining or
manufacturing.
• That all raw materials found in a country be used in domestic
manufacture, since finished goods have a higher value than raw materials.
• That a large, working population be encouraged.
• That all export of gold and silver be prohibited and all domestic money be
kept in circulation.
• That all imports of foreign goods be discouraged as much as possible.
• That where certain imports are indispensable they be obtained at first
hand, in exchange for other domestic goods instead of gold and silver.
• That as much as possible, imports be confined to raw materials that can
be finished [in the home country].
• That opportunities be constantly sought for selling a country's surplus
manufactures to foreigners, so far as necessary, for gold and silver.
• That no importation be allowed if such goods are sufficiently and suitably
supplied at home.
Mercantilism: Flaws
• impaired economic growth
• Ignores living standards
• Ignores human development
Trade Theories:
#2 - Absolute Advantage
Adam Smith and the
Attack on Mercantilism and Economic
Nationalism
• In 1776, Adam Smith published the first modern statement of
economic theory, An Inquiry into the Nature and Causes of the
Wealth of Nations
– The Wealth of Nations attacked mercantilism—the system
of which dominated economic thought in the 1700s
– Smith proved wrong the belief that trade was a zero sum
game—that the gain of one nation from trade was the loss
of another
– On the other hand… Voluntary exchange (trade) is a
positive sum game —both nations can gain
Theory of absolute advantage
• Adam Smith ideas based on…
– The capability of one country to produce more
of a product with the same amount of input
than another country
– (same thing) The ability of a country to produce
a good using fewer resources than another
country (lower opportunity cost)
Theory of absolute advantage
• Adam Smith argued:
– A country should produce only goods where it
is most efficient …. and trade for those goods
where it is not efficient
• Trade between countries is, therefore, beneficial
Theory of absolute advantage
• … destroys the mercantilist idea since there
are gains to be had by both countries party to
an exchange
• … questions the objective of national
governments to acquire “wealth”: through
restrictive trade policies
• … also measures a nation’s wealth by the
living standards of its people
TRADE BASED ON
ABSOLUTE ADVANTAGE
• Consider this “simple” example involving the EU
and India
• Only two products are produced, machines and
cloth
• Labor is fixed, homogeneous within a country,
the only factor of production, and is fully utilized
• Technology and production costs are constant
• Transportation costs are zero and the countries
barter (trade) for goods
TRADE BASED ON
ABSOLUTE ADVANTAGE
Country
EU
India
One Person Per Day of Labor
Produces
Machines
Cloth
10 yards of
5 machines
cloth
15 yards of
2 machines
cloth
THE PRODUCTION POSSIBILITIES FRONTIER
AND CONSTANT COSTS
• The Production Possibilities Frontier (PPF) is a
curve showing the various combinations of two
goods that a country can produce when all of a
country’s resources are fully employed and used in
their most efficient manner
One Person Per Day of Labor Produces
Country
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
One Person Per Day of Labor Produces
Country
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
Production Possibilities Curves for the United States and India
Machines
5
2
Cloth
10
15
India
Cloth
Mach
15
0
7.5
1
0
2
EU
Cloth
10
8
6
4
2
0
Mach
0
1
2
3
4
5
“Opportunity Cost” also known as “Relative Price”
India - Opportunity Costs
EU - Opportunity Costs
Machine = 7.5 cloth
Cloth
= 0.133 machine
Machine
Cloth
= 2 cloth
= 0.5 machine
Same graph, drawn more to scale!
What Determines the Slope of the PPC?
Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
This slope is also known as the … Marginal Rate of Transformation
Machines
EU: Slope = Opportunity Cost = -0.5
5
India: Slope = Opportunity Cost = -0.133
2
Cloth
10
15
Absolute Advantage: Production Conditions When
Each Country Is More Efficient in the
Production of One Commodity
• EU workers are more productive in producing
machines
• The EU has an absolute advantage in
machine production
• Indian workers are more productive in
producing cloth
• India has an absolute advantage in cloth
production
TRADE BASED ON
ABSOLUTE ADVANTAGE …
Yes, maybe that was obvious to you from the
beginning…
One Person Per Day of Labor Produces
Country
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
What does this mean?
What ???
Theory of absolute advantage
• Adam Smith: Wealth of Nations (again)
argued:
– A country should produce only goods
where it is most efficient, and trade for
those goods where it is not efficient
Assume TWO Persons per day, so that each product can be fully produced
Two Persons Per Day of Labor Produces
Country
Machines
EU
5 machines
India
2 machines
World Output
7 machines
Cloth
(and)
(and)
(and)
10 yards of cloth
15 yards of cloth
25 yards of cloth
This is a condition under Autarky: (The
complete absence of trade)
•Under Autarky all nations can only
consume the goods they produce at
home
Assume TWO Persons per day, so that each product can be fully produced
Two Persons Per Day of Labor Produces
Country
Machines
EU
5 machines
India
2 machines
World Output
7 machines
Cloth
(and)
(and)
(and)
10 yards of cloth
15 yards of cloth
25 yards of cloth
However, if each country produces to their absolute advantage …below…
Two Persons Per Day of Labor Produces
Country
Machines
EU
10 machines
India
0 machines
World Output
10 machines
Cloth
0 yards of cloth
30 yards of cloth
(and)
.
30 yards of cloth
.
TRADE BASED ON
ABSOLUTE ADVANTAGE
So there has obviously been an increase in World Output!!
Change in the Production of
Country
Machines
Cloth
EU
+5 machines
–10 yards of cloth
India
–2 machines
+15 yards of cloth
Change in World Output +3 machines
+5 yards of cloth
.
TRADE BASED ON
ABSOLUTE ADVANTAGE
• Both countries can benefit if trade
occurs
– EU produces machines and exports them
to India
– India produces cloth and exports it to the
EU
Two Persons Per Day of Labor Produces
Country
Machines
Cloth
EU
5 machines
(and)
10 yards of cloth
India
2 machines
(and)
15 yards of cloth
World Output
7 machines
(and)
25 yards of cloth
Two Persons Per Day of Labor Produces
Country
Machines
EU
10 machines
India
0 machines
World Output
10 machines
Cloth
0 yards of cloth
30 yards of cloth
(and)
30 yards of cloth
.
Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?
.
India - Opportunity Costs
EU - Opportunity Costs
Machine = 7.5 cloth
Cloth
= 0.133 machine
Machine
Cloth
= 2 cloth
= 0.5 machine
World Price
Back to our opportunity costs (above) Trade will
occur at a trading price … World Price …which
will occur between these respective “Relative
Prices”…
Also called the “Terms of Trade”
m
m
PIND
(7.5)  PWm  PEU
(2)
P (0.5)  P  P
c
EU
c
W
c
IND
(0.133)
Look…
Remember this graph?
Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
This slope is also known as the … Marginal Rate of Transformation
P (0.5)  P  P
c
EU
c
W
c
IND
(0.133)
Machines
EU: Slope = Opportunity Cost = -0.5
5
India: Slope = Opportunity Cost = -0.133
Pw
2
Cloth
10
15
Introduction: The Gains from Trade
• The improvement in national welfare (for
both countries) is known as the gains
from trade
One more quick example, just to be sure….
Output per Hour Worked
Bread
Steel
Output/hour worked
EU
Canada
2 loaves
3 loaves
3 tons
1 ton
What are the EU’s relative prices (opp. cost) … Bread? Steel?
What are Canada’s relative prices (opp. cost) … Bread? Steel?
Who has absolute advantage in Bread?
Who has absolute advantage in Steel?
Given 2 working hours per country… what is the maximum world output?
Implications of Adam Smith’s Theory
• Access to foreign markets helps create wealth
– If no nation imports, every company will be limited by
the size of its home country market
– Imports enable a country to obtain goods that it cannot
make itself or can make only at very high costs
– Trade barriers decrease the size of the potential
market, hampering the prospects of specialization,
technological progress, mutually beneficial exchange,
and, ultimately, wealth creation
Adam Smith and Trade Barriers
• Smith was highly critical of trade barriers (Tariffs,
Quotas, Subsidies…)
• Trade barriers decrease
- Specialization
- Technological progress
- Wealth creation
• The modern view of trade shares Smith’s dislike
for trade barriers
TRADE BASED ON
ABSOLUTE ADVANTAGE
• Labor Theory of Value
– Assumes that labor is the only relevant
factor of production
– This implies that the pre-trade price of a
good is determined by the amount of labor
it took to produce it.
2-Country Scenario
Country
One Person Per Day of Labor
Produces
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
U.S. has an Absolute Advantage in both goods.
One Person Per Day of Labor Produces
Country
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Production Possibilities Curves for the United States and India
Machines
Graphically obvious …
U.S. has an Absolute Advantage in both goods.
5
1
Cloth
5
15
One country has Absolute Advantage
in BOTH goods
One Person Per Day of Labor Produces
Country
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
• In this scenario, there is obviously no
opportunity to trade… especially not for U.S.
• NO… No … No!!! This is not correct. We need
to introduce the concept of:
Comparative Advantage
Trade Theories:
#3 - Comparative Advantage
Theory of Comparative Advantage
• David Ricardo: Principles of Political Economy (1817)
– Extended free trade argument
– Should import even if the country is more efficient in
the product’s production than country from which it
is buying.
– Look to see how much more efficient. If only
comparatively efficient, then import.
TRADE BASED ON
COMPARATIVE ADVANTAGE
• Why would trade occur if one country had an
absolute advantage in both goods?
• Comparative Advantage is the ability of a country
to produce a good at a lower opportunity cost
than another country
• We compare the degree of absolute advantage or
disadvantage in the production of goods
Comparative Advantage: U.S. More Efficient
in the Production of Both Commodities
Country
One Person Per Day of Labor
Produces
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
U.S. has bigger Absolute Advantage in production of Machines
US - Opportunity Costs
India - Opportunity Costs
1 Machine = 3 cloth
1 Cloth
= 0.33 machine
1 Machine = 5 cloth
1 Cloth = 0.2 machine
TRADE BASED ON
COMPARATIVE ADVANTAGE
• The U.S. has a greater absolute advantage in
producing machines than is does in
producing cloth (5x more efficient in
machines … only 3x more efficient in cloth)
• India’s absolute disadvantage is smaller in
producing cloth than in producing machines
• Thus the U.S. has a comparative advantage
in machines and India has a comparative
advantage in cloth
TRADE BASED ON
OPPORTUNITY COSTS
• Even though U.S. has an absolute
advantage in both goods, India has a
comparative advantage in cloth
production
• Even if U.S. has an absolute advantage in
both goods, beneficial trade is possible
• If both countries specialize according to
their comparative advantage, they both
can gain from this specialization and trade
Since we are dealing with Opp. Costs, we
will compare across 15 yards of cloth
One person Per Day of Labor Produces
Country
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Let us allow India to produce cloth up to the level that the U.S. can…
One Person Per Day of Labor Produces
Country
Machines
Cloth
U.S.
5 machines
-15 yards of cloth
India (3 days)
-3 machines
World Output
+2 machines
(per)
15 yards of cloth
0 cloth
.
TRADE BASED ON
COMPARATIVE ADVANTAGE
Change in World Output Resulting from Specialization According to Comparative
Advantage
Change in the Production of
Country
Machines
Cloth
U.S.
+5 machines
–15 yards of cloth
India
–3 machines
+15 yards of cloth
Change in World Output
+2 machines
0 yards of cloth
Trade in the Ricardian Model
(cont.)
• A country can be more efficient in
producing both goods, but it will have a
comparative advantage in only one good.
• Even if a country is the most (or least)
efficient producer of all goods, it still can
benefit from trade.
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for Selected Sectors,
2000 (Ratios relative to the U.S.)
Country
Argentina
Bolivia
Brazil
Chile
Columbia
Cote d’Ivoire
Ecuador
Egypt
Ghana
India
Indonesia
Kenya
Food
Products
1.95
0.61
0.74
0.80
0.62
1.50
0.88
1.45
0.82
1.29
1.71
1.31
Textiles
1.28
0.76
0.65
0.89
0.66
1.06
0.30
1.21
0.96
1.57
0.42
2.20
Clothing
0.64
0.65
0.47
0.51
0.47
1.02
0.34
0.38
0.60
0.47
0.45
0.96
Electrical
Machinery
2.11
1.00
0.81
0.90
1.01
1.34
1.20
1.10
0.39
0.98
0.62
0.74
Transport
Equipment
1.78
1.34
0.53
0.74
0.97
1.69
0.55
0.71
1.63
1.43
0.26
3.34
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for Selected Sectors,
2000 (Ratios relative to the U.S.)
Country
Malaysia
Mexico
Morocco
Nigeria
Peru
Philippines
Korea
Taiwan
Thailand
Turkey
Uruguay
Venezuela
Food
Products
1.08
0.90
1.61
0.29
1.02
0.65
0.73
1.93
0.92
1.09
1.64
0.93
Textiles
0.59
0.88
1.38
0.80
0.62
0.67
0.63
1.45
0.87
0.96
0.74
0.72
Clothing
0.84
0.64
1.05
0.11
0.46
0.59
0.62
0.80
1.07
0.43
0.69
0.49
Electrical
Machinery
1.01
1.06
1.49
0.56
0.95
0.80
0.56
1.81
0.65
0.97
1.52
0.68
Transport
Equipment
0.69
0.43
0.92
0.04
0.50
0..40
0.71
1.17
0.41
0.65
1.22
0.17
DYNAMIC GAINS FROM TRADE
• Static Gains from trade are gains in word
output that result from specialization
and trade
• Dynamic gains from trade are gains from
trade over time that occur because
trade induces greater efficiency in the
use of existing resources
Assumptions and limitations
• Driven only by maximization of production
and consumption
• Only 2 countries engaged in production and
consumption of just 2 goods?
• What about the transportation costs?
• Only resource – labor (that too, nontransferable)
• No consideration for ‘learning theory’
Absolute and Comparative
Productivity Advantage Contrasted
• Absolute productivity advantage: Held by a
country that produces more of a certain good per
hour worked than another
• Comparative productivity advantage (or
comparative advantage): Held by a country that
has lower opportunity costs of producing a good
than its trading partners do
• Comparative advantage allows a country that
lacks absolute advantage to sell its products
abroad
One more time for practice…
Country
Japan
Malaysia
Output per hour of “team”
Cars
Steel (tons)
2
2
0.5
1
Do you see any Absolute Advantages?
Do you see any Comparative Advantages?
Japan - Opportunity Costs
Malaysia - Opportunity Costs
1 car = 1 steel
1steel = 1 car
1 car = 2 steel
1steel = 0.5 car
Output per Hour Worked
Country
Japan
Malaysia
One Person Per Day of Labor
Produces
Cars
Steel (tons)
2
2
0.5
1
Let us allow Malaysia to produce steel up to the level that Japan can…
Country
One Person Per Day of Labor
Produces
Cars
Steel (tons)
Japan
2
2
Malaysia
1
2
World Output
+1
0
Gains from Trade with
Summation …
• Japan has an absolute advantage in both cars (2>0.5)
and steel (2>1), yet it can still gain from trade, as can
Malaysia
• Once trade opens, the world price of cars will be
between one and two tons of steel per car
Japan’s Price…
… Malaysia’s Price
Terms of Trade and Gains from Trade
• The closer the terms of trade are to one
country’s pre-trade price ratio, the greater the
gain for the other country.
• Importance of being unimportant—when
small countries trade with big countries, the
small countries are likely to enjoy most of the
mutual gains from trade.
Evaluation of the Classical Model
• The model does not explain why differences in productivity
levels between countries exist.
• It makes extreme and unrealistic predictions such as countries
will completely specialize in the production of exportables
only.
• It maintains that the gains from trade are greater between
countries of dissimilar production technologies (despite the
fact that most trade occurs between DCs with similar
technology and income levels).
Evaluation (cont.)
• The classical model is a useful tool because:
– It provides a motive for trade between developed
and developing countries
– It explains why high-wage countries may still
benefit from trade even when faced with lowwage competing countries
Summary of the Comparative Advantage
Model
• It is not necessary for a country to possess absolute
advantage in order to participate in trade. What is
required is comparative advantage in production.
• A country will specialize in and export that good in
which its has comparative advantage, i.e., has a lower
pre-trade relative price than in the other country.
• The terms of trade or world price will settle between
the autarky prices of the two countries and is
determined by reciprocal demand.