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 nations wealth depends on
accumulated treasure
Gold and silver are the currency of trade

Two means of increasing a countrys

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 withstaple ports;
Forbidding trade to be carried in foreign
ships;
Maximizing the use of domestic resources;
Also restricting domestic consumption
withnon-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 mercantilismthe system
of which dominated economic thought in the 1700s
Smith proved wrong the belief that trade was a zero sum
gamethat 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 nations 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

EU

One Person Per Day of Labor

Produces
Machines
Cloth
10
yards
of
5 machines
cloth

India

2 machines

Country

15 yards of
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
countrys 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

10

15

Cloth

EU
India
Cloth
Cloth
Mach
Mach
10
0
15
0
8
7.5
1
6
0
2
4
2
Opportunity Cost also known0
as Relative Price
India - Opportunity Costs

EU - Opportunity Costs

Machine = 7.5 cloth

Cloth
= 0.133 machine

Machine
Cloth

1
2
3
4
5

= 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

India: Slope = Opportunity Cost = -0.133

2
10

15

Cloth

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
Also calledRelative
the Terms of Trade
Prices
m
IND

(7.5) P P (2)
m
W

m
EU

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

India: Slope = Opportunity Cost = -0.133

Pw

2
10

15

Cloth

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 EUs relative prices (opp. cost) Bread? Steel?
What are Canadas 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 Smiths

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 Smiths 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
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

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.

1
5

15

Cloth

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 products 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
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

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)
Indias 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

Food
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 dIvoire

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

TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for
Selected Sectors, 2000 (Ratios relative to the U.S.)
Country

Food
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

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

Output per hour of team
Country
Japan
Malaysia

Cars

Steel (tons)

0.5

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

One Person Per Day of Labor
Produces
Country
Japan
Malaysia

Cars

Steel (tons)

0.5

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

One Person Per Day of Labor

Produces
Country

Cars

Steel (tons)

Japan

Malaysia

World Output

+1

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
Japans Price

Malaysias Price

Terms of Trade and Gains from

Trade
The closer the terms of trade are to
one countrys 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.