Trade Theories: #1 - Mercantilism. Defining mercantilism … Mercantilism The theory that a country should accumulate financial wealth by amassing as many

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)


• 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


• … 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

• 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


One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines 10 yards of cloth

India 2 machines 15 yards of cloth

• 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

THE PRODUCTION POSSIBILITIES FRONTIER AND CONSTANT COSTS





Production Possibilities Curves for the United States and India





Machines

Cloth

2

1510

5

IndiaCloth Mach 15 07.5 1 0 2

EUCloth Mach

10 0 8 1 6 2 4 3 2 4 0 5

India - Opportunity Costs

Machine = 7.5 cloth Cloth = 0.133 machine

EU - Opportunity Costs

Machine = 2 cloth Cloth = 0.5 machine

“Opportunity Cost” also known as “Relative Price”

Machines

Cloth2

1510

5

What Determines the Slope of the PPC?

Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines

Same graph, drawn more to scale!

EU: Slope = Opportunity Cost = -0.5

India: Slope = Opportunity Cost = -0.133

This slope is also known as the … Marginal Rate of Transformation

• 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

Absolute Advantage: Production Conditions When Each Country Is More Efficient in the Production of One Commodity

TRADE BASED ON ABSOLUTE ADVANTAGE …

Yes, maybe that was obvious to you from the beginning…





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

Two Persons Per Day of Labor Produces




World Output 7 machines 25 yards of cloth

Assume TWO Persons per day, so that each product can be fully produced

(and)

(and)

(and)

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





World Output 10 machines 30 yards of cloth(and)

(and)

(and)

(and)

However, if each country produces to their absolute advantage …below…

.

.


Change in the Production of


EU +5 machines –10 yards of cloth

India –2 machines +15 yards of cloth

Change in World Output +3 machines +5 yards of cloth

.

So there has obviously been an increase in World Output!!

• Both countries can benefit if trade occurs

– EU produces machines and exports them to India

– India produces cloth and exports it to the EU











World Output 10 machines 30 yards of cloth(and)

(and)

(and)

(and)

.

.

Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?


Machine = 7.5 cloth Cloth = 0.133 machine

EU - Opportunity Costs

Machine = 2 cloth Cloth = 0.5 machine

World PriceBack to our opportunity costs (above) Trade will

occur at a trading price … World Price …which will occur between these respective “Relative Prices”…

)2()5.7( mEU

mW

mIND PPP

)133.0()5.0( cIND

cW

cEU PPP

Also called the “Terms of Trade”

Look…

Machines

Cloth2

1510

5

Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines

Remember this graph?

EU: Slope = Opportunity Cost = -0.5

India: Slope = Opportunity Cost = -0.133

This slope is also known as the … Marginal Rate of Transformation

)133.0()5.0( cIND

cW

cEU PPP

Pw

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

Output/hour workedEU Canada

Bread 2 loaves 3 loavesSteel 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

• 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



U.S. 5 machines 15 yards of cloth

India 1 machine 5 yards of cloth

U.S. has an Absolute Advantage in both goods.

Production Possibilities Curves for the United States and India





Machines

Cloth1

5 15

5

Graphically obvious … U.S. has an Absolute Advantage in both goods.

One country has Absolute Advantage in BOTH goods

• 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.

• 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

TRADE BASED ON COMPARATIVE ADVANTAGE


1 Machine = 5 cloth 1 Cloth = 0.2 machine

US - Opportunity Costs

1 Machine = 3 cloth 1 Cloth = 0.33 machine





Comparative Advantage: U.S. More Efficient in the Production of Both Commodities

U.S. has bigger Absolute Advantage in production of Machines

• 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


• 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

TRADE BASED ON OPPORTUNITY COSTS

One person Per Day of Labor Produces




Since we are dealing with Opp. Costs, we will compare across 15 yards of cloth

.

(per)



U.S. 5 machines -15 yards of cloth

India (3 days) -3 machines 15 yards of cloth

World Output +2 machines 0 cloth

Let us allow India to produce cloth up to the level that the U.S. can…

Change in World Output Resulting from Specialization According to Comparative Advantage


Change in the Production of


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.


Unit Labor Costs in 24 Developing Economies for Selected Sectors, 2000 (Ratios relative to the U.S.)

CountryFood Products Textiles Clothing

Electrical Machinery

Transport Equipment

Argentina 1.95 1.28 0.64 2.11 1.78

Bolivia 0.61 0.76 0.65 1.00 1.34

Brazil 0.74 0.65 0.47 0.81 0.53

Chile 0.80 0.89 0.51 0.90 0.74

Columbia 0.62 0.66 0.47 1.01 0.97

Cote d’Ivoire 1.50 1.06 1.02 1.34 1.69

Ecuador 0.88 0.30 0.34 1.20 0.55

Egypt 1.45 1.21 0.38 1.10 0.71

Ghana 0.82 0.96 0.60 0.39 1.63

India 1.29 1.57 0.47 0.98 1.43

Indonesia 1.71 0.42 0.45 0.62 0.26

Kenya 1.31 2.20 0.96 0.74 3.34


Unit Labor Costs in 24 Developing Economies for Selected Sectors, 2000 (Ratios relative to the U.S.)

CountryFood Products Textiles Clothing

Electrical Machinery

Transport Equipment

Malaysia 1.08 0.59 0.84 1.01 0.69

Mexico 0.90 0.88 0.64 1.06 0.43

Morocco 1.61 1.38 1.05 1.49 0.92

Nigeria 0.29 0.80 0.11 0.56 0.04

Peru 1.02 0.62 0.46 0.95 0.50

Philippines 0.65 0.67 0.59 0.80 0..40

Korea 0.73 0.63 0.62 0.56 0.71

Taiwan 1.93 1.45 0.80 1.81 1.17

Thailand 0.92 0.87 1.07 0.65 0.41

Turkey 1.09 0.96 0.43 0.97 0.65

Uruguay 1.64 0.74 0.69 1.52 1.22

Venezuela 0.93 0.72 0.49 0.68 0.17

• 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

DYNAMIC GAINS FROM TRADE

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, non-

transferable) • 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…

Output per hour of “team”

Country Cars Steel (tons)

Japan 2 2

Malaysia 0.5 1

Japan - Opportunity Costs

1 car = 1 steel1steel = 1 car

Malaysia - Opportunity Costs

1 car = 2 steel1steel = 0.5 car

Do you see any Absolute Advantages?

Do you see any Comparative Advantages?

Output per Hour Worked



Japan 2 2

Malaysia 0.5 1



Japan 2 2

Malaysia 1 2

World Output +1 0

Let us allow Malaysia to produce steel up to the level that Japan can…

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 low-wage 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.

Documents

Trade Theories: #1 - Mercantilism. Defining mercantilism … Mercantilism The theory that a country should accumulate financial wealth by amassing as many