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: 16 th – late 18 th 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

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 CountryMachinesCloth EU5 machines 10 yards of cloth India2 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 One Person Per Day of Labor Produces CountryMachinesCloth EU5 machines10 yards of cloth India2 machines15 yards of cloth

Production Possibilities Curves for the United States and India One Person Per Day of Labor Produces CountryMachinesCloth EU5 machines10 yards of cloth India2 machines15 yards of cloth Machines Cloth

India ClothMach EU ClothMach India - Opportunity Costs Machine = 7.5 cloth Cloth = machine EU - Opportunity Costs Machine = 2 cloth Cloth = 0.5 machine “Opportunity Cost” also known as “Relative Price”

Machines Cloth 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 = 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… One Person Per Day of Labor Produces CountryMachinesCloth EU 5 machines 10 yards of cloth India2 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

Two Persons Per Day of Labor Produces CountryMachinesCloth EU5 machines10 yards of cloth India2 machines15 yards of cloth World Output7 machines25 yards of cloth Assume TWO Persons per day, so that each product can be fully produced (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

Two Persons Per Day of Labor Produces CountryMachinesCloth EU5 machines10 yards of cloth India2 machines15 yards of cloth World Output7 machines25 yards of cloth Assume TWO Persons per day, so that each product can be fully produced Two Persons Per Day of Labor Produces CountryMachinesCloth EU10 machines 0 yards of cloth India 0 machines 30 yards of cloth World Output10 machines30 yards of cloth (and) However, if each country produces to their absolute advantage …below…..

TRADE BASED ON ABSOLUTE ADVANTAGE Change in the Production of CountryMachinesCloth 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 TRADE BASED ON ABSOLUTE ADVANTAGE

Two Persons Per Day of Labor Produces CountryMachinesCloth EU5 machines10 yards of cloth India2 machines15 yards of cloth World Output7 machines25 yards of cloth Two Persons Per Day of Labor Produces CountryMachinesCloth EU10 machines 0 yards of cloth India 0 machines 30 yards of cloth World Output10 machines30 yards of cloth (and).. Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?

India - Opportunity Costs Machine = 7.5 cloth Cloth = machine EU - Opportunity Costs Machine = 2 cloth 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” Look…

Machines Cloth Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines Remember this graph? EU: Slope = Opportunity Cost = -0.5 India: Slope = Opportunity Cost = This slope is also known as the … Marginal Rate of Transformation PwPw

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 worked EUCanada Bread2 loaves3 loaves Steel3 tons1 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. TRADE BASED ON ABSOLUTE ADVANTAGE

2-Country Scenario One Person Per Day of Labor Produces CountryMachinesCloth U.S.5 machines15 yards of cloth India1 machine 5 yards of cloth U.S. has an Absolute Advantage in both goods.

Production Possibilities Curves for the United States and India One Person Per Day of Labor Produces CountryMachinesCloth U.S.5 machines15 yards of cloth India1 machine 5 yards of cloth Machines Cloth 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 One Person Per Day of Labor Produces CountryMachinesCloth U.S.5 machines15 yards of cloth India1 machine 5 yards of cloth

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

India - Opportunity Costs 1 Machine = 5 cloth 1 Cloth = 0.2 machine US - Opportunity Costs 1 Machine = 3 cloth 1 Cloth = 0.33 machine One Person Per Day of Labor Produces CountryMachinesCloth U.S.5 machines15 yards of cloth India1 machine 5 yards of cloth 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 TRADE BASED ON COMPARATIVE ADVANTAGE

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 CountryMachinesCloth U.S.5 machines15 yards of cloth India1 machine 5 yards of cloth Since we are dealing with Opp. Costs, we will compare across 15 yards of cloth. (per) One Person Per Day of Labor Produces CountryMachinesCloth U.S.5 machines-15 yards of cloth India (3 days) -3 machines15 yards of cloth World Output+2 machines0 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 TRADE BASED ON COMPARATIVE ADVANTAGE Change in the Production of CountryMachinesCloth 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 Food ProductsTextilesClothing Electrical Machinery Transport Equipment Argentina Bolivia Brazil Chile Columbia Cote d’Ivoire Ecuador Egypt Ghana India Indonesia Kenya

TRADE BASED ON OPPORTUNITY COSTS Unit Labor Costs in 24 Developing Economies for Selected Sectors, 2000 (Ratios relative to the U.S.) Country Food ProductsTextilesClothing Electrical Machinery Transport Equipment Malaysia Mexico Morocco Nigeria Peru Philippines Korea Taiwan Thailand Turkey Uruguay Venezuela

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” CountryCarsSteel (tons) Japan22 Malaysia0.51 Japan - Opportunity Costs 1 car = 1 steel 1steel = 1 car Malaysia - Opportunity Costs 1 car = 2 steel 1steel = 0.5 car Do you see any Absolute Advantages? Do you see any Comparative Advantages?

Output per Hour Worked One Person Per Day of Labor Produces CountryCarsSteel (tons) Japan22 Malaysia0.51 One Person Per Day of Labor Produces CountryCarsSteel (tons) Japan22 Malaysia12 World Output+10 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.