Trade Theories:

1. Trade Theories: #1 - Mercantilism

2. Defining mercantilism … • Mercantilism • The theory that a country should accumulate financial wealth by amassing as many inflows of “currency” as possible

3. 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.

4. 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 tradesurplus.

5. 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.

6. 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.

7. Mercantilism: Flaws • impaired economic growth • Ignores living standards • Ignores human development

8. Trade Theories: #2 - Absolute Advantage

9. 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

10. Theory of absolute advantage • Adam Smith ideas based on… • The capability of one country to produce moreof 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)

11. 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

12. 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

13. 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

14. TRADE BASED ON ABSOLUTE ADVANTAGE

15. 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

16. Production Possibilities Curves for the United States and India Machines 5 2 Cloth 10 15

17. EU ClothMach 10 0 8 1 6 2 4 3 2 4 0 5 India ClothMach 15 0 7.5 1 0 2 “Opportunity Cost” also known as “Relative Price” India - Opportunity Costs Machine = 7.5 cloth Cloth = 0.133 machine EU - Opportunity Costs Machine = 2 cloth Cloth = 0.5 machine

18. 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 5 2 Cloth 10 15

19. 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

20. TRADE BASED ON ABSOLUTE ADVANTAGE … Yes, maybe that was obvious to you from the beginning… What does this mean?

21. 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

22. 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

23. Assume TWO Persons per day, so that each product can be fully produced (and) (and) (and) However, if each country produces to their absolute advantage …below… . (and) .

24. TRADE BASED ON ABSOLUTE ADVANTAGE So there has obviously been an increase in World Output!! .

25. 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

26. (and) (and) (and) (and) . Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth? .

27. India - Opportunity Costs Machine = 7.5 cloth Cloth = 0.133 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…

28. Remember this graph? 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 5 Pw 2 Cloth 10 15

29. Introduction: The Gains from Trade • The improvement in national welfare (for both countries) is known as the gains from trade

30. One more quick example, just to be sure….Output per Hour Worked 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?

31. 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

32. 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

33. 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.

37. 2-Country Scenario U.S. has an Absolute Advantage in both goods.

38. 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

39. 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

40. Trade Theories: #3 - Comparative Advantage

41. 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.

42. 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

43. Comparative Advantage: U.S. More Efficient in the Production of Both Commodities U.S. has bigger Absolute Advantage in production of Machines India - Opportunity Costs 1 Machine = 5 cloth 1 Cloth = 0.2 machine US - Opportunity Costs 1 Machine = 3 cloth 1 Cloth = 0.33 machine

44. 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

45. 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

46. Since we are dealing with Opp. Costs, we will compare across 15 yards of cloth Let us allow India to produce cloth up to the level that the U.S. can… (per) .

47. TRADE BASED ON COMPARATIVE ADVANTAGE Change in World Output Resulting from Specialization According to Comparative Advantage

48. 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.

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

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