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Draft Lecture 1 Leipzig University Faculty of Economics and Business Administration Institute for Economic Policy International Economics Kristoffer J. M. Hansen II. Trade Theory: Mercantilism, Smith and Ricardo 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 1 II. Trade Theory: Mercantilism, Smith and Ricardo 1. Mercantilism 2. Adam Smith and Absolute Advantage 3. David Ricardo and Comparative Advantage 4. Comparative Advantage under Increasing Costs 5. The Heckscher-Ohlin Theory 6. The Alchian-Allen Effect 7. Summary 8. References Pugel, International Economics, pp. 32-66 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 2 Russian and German Exports by Commodity in 2007 120 Agriculture Crude Materials Manufactured Products 100 80 What characteristics of production help to D S U explain patterns of world trade? n o i l 60 l i b 40 20 0 Exports Russia to Germany Exports Germany to Russia Source: UN Comtrade Statistics 2009. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 3 1. Mercantilism • Mercantilism is not so much an organized body of thought as a collection of ideas and policies used to interfere with international trade. • Especially prominent from the 16th to the 18th century in Europe. • The Montaigne fallacy: in trade, the gain of one person or country can only come at the loss of another person or country. • “No profit can possibly be made but at the expense of another.” • The assumption behind mercantilist policies: a nation’s wealth depends on its stock of precious metals (i.e., money). • Therefore, exports should be encouraged and imports discouraged. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 4 Mercantilist Practices To encourage exports: • Export subsidies, encourage manufacturing, subsidize national shipping (navigation acts). To discourage imports: • High tariffs on manufactured goods. • Colonies for raw materials (and later: captive markets). Other practices: • Chartered companies: Dutch East India Company, English East India Company. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 5 Critique of Mercantilism • Opposition to mercantilism was widespread, really took off in late 17th century. • Jean-Baptiste Colbert (1619-1683), minister to Louis XIV of France whose name became synonymous with mercantilism (colbertisme) thought he improved trade (and enriched the king!); in reality, France became impoverished. • Colbert once asked a group of merchants what he could do to help them. The answer was: “laissez faire, laisser passer, le monde va de lui même!” • Roughly translated: get out of our way and let commerce and industry develop freely! 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 6 Critique of Mercantilism • What’s so good about accumulating specie (i.e., precious metals)? As we saw earlier, people keep as much cash as they think good; an “adverse balance of payments” can only endure if people desire to reduce their cash holding and export specie. • Hume’s price-specie flow mechanism: if you import money, i.e., have a “positive” balance of trade, the money supply increases domestically → higher prices. Then the profit from exporting goods evaporates, foreign goods become relatively cheaper and merchants will import more foreign goods, reversing the “positive” balance of trade. • In the end, you’ve simply disturbed the patterns of trade with no gain. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 7 Critique of Mercantilism • Adam Smith’s Wealth of Nations was a sustained attack on mercantilism. Absolute advantage was the basis of the superiority of trade over autarky: • “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost… more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker… What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the product of our own industry, employed in a way in which we have some advantage.” 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 8 Implications of Mercantilism Distortions to Factor Allocation • Government imposed monopolies led to corruption and inefficient factor allocation. • Price ceilings (on food) favoured the rise of black markets. • As money in circulation increased relative to the amount of goods, inflationary pressure rose. Distribution Effects • The working population (farmers and workers) were to live at the “margins of subsistence”. • Merchants gained from the enforced monopolies, bans on foreign competition and poverty of workers. • Governments earned high tariffs and payments from merchants. • Almost all mercantilist writers were merchants or government representatives. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 9 Neo-Mercantilism • In the 20th century, mercantilism came back. The goal is no longer to increase the amount of specie in a country, but to create jobs through protectionism. • Jobs need to be protected from international competition, foreign workers “take” domestic jobs. • No recognition of mutual gains from trade or of comparative advantage. Examples • China is accused of pursuing a mercantilist policy by “flooding” international markets with exports. • West European trade unions oppose labour mobility, East European labourers 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 10 2. Adam Smith and Absolute Advantage Adam Smith (1723 – 1790) • response to mercantilism which prevailed at the time • absolute advantage as determinant of international trade • Smith compared nations to households. • Since every household finds it worthwhile to produce some of its needs and to buy others with products it can sell, the same should apply to nations. Assumptions • two countries and two goods • the hours of constituent labour determine the price/cost of goods. • fixed labour supply in each country • homogeneity of labour • perfect competition 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 11 Absolute Advantage: Numerical Example Absolute advantages: The foreign country (home country) has an absolute advantage in producing food (clothing). Foreign Country Home Country 1 unit of food 2 hours < 2.5 hours 1 unit of clothing 4 hours > 1 hour Relative commodity prices in autarky • Individuals trade equal labour values of food for clothing. • For example the price of 1 unit of clothing in the home country is 0.4 units of food that is 1 hour/2.5 hours. Foreign Country Home Country price of 1 unit of food 0.5 units of clothing 2.5 units of clothing price of 1 unit of clothing 2 units of food 0.4 units of food 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 12 Absolute Advantage: Numerical Example • After opening up to trade, both countries completely focus on their absolute advantages. • The foreign country´s (home country´s) labor completely shifts towards producing food (clothing), which has a higher value when exported abroad. The foreign country (home country) imports clothing (food) which is cheaper abroad. • Assuming that both countries completely specialize in their absolute advantage the international prices must be somewhere in the range: - 0.5 ≤ international price of 1 unit of food ≤ 2.5 and - 2 ≥ international price of 1 unit of clothing ≥ 0.4. • Both countries gain by trade and specialize according to their absolute advantages. The other commodity can be imported at a lower price than before trade. • Both countries gain by reaching a higher utility than in autarky. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 13 Absolute Advantage: Summary • A country will produce and export those goods in which is has an absolute advantage. • It will import those goods in which it has an absolute disadvantage. • This is in reality a special case of the the principle of comparative advantage! 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 14 3. The Principle of Comparative Advantage Absolute versus comparative advantage • The theory of absolute advantage showed that countries gain by free trade if each country has an absolute advantage. • David Ricardo demonstrated in the early 19th century that trade is beneficial whether or not countries have any absolute advantage. Comparative advantage and gains from trade • The Ricardian setting is based on the same assumptions as the theory of absolute advantage. • Here, the opportunity cost of producing another unit of one commodity is assumed to be constant. • A nation gains from trade by exporting goods in which it has its greatest comparative (relative) advantage in productivity and importing those in which it has the least comparative advantage. • Even if one nation has an absolute advantage at producing everything, both countries gain by trading with each other. 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 15 The Higher Productivity under Division of Labour • Recall the example of two persons from the introductory lecture • Let us say that person A is more productive than B in the production of both p and q. For the production of one unit of p A needs 3 hours compared to B’s 5 and for q 2 hours compared to B’s 4. • If each produce p for 60 hours and q for 60 hours, the total output is 32 p + 45 q. • If A concentrates on production of q and B on production of p, the total result is 24 p + 60 q. • Can we say that this is a preferable outcome? 26 Apr 2021 Kristoffer J. M. Hansen, Institute for Economic Policy 16 The Higher Productivity under Division of Labour • Yes we can! For A, p has a substitution ratio of 3/2 q and for B a substitution ratio of 5/4 q, which means that 24 p + 60 q signifies a higher output than 32 p + 45 q.
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