Ba Historical Dev Modern Trade Theory Section 2 Internation Trade PDF

International Trade Theories
International Trade Theory and Policy (Econ 634)

MSc in Economics
Mengesha Yayo(Ph.D. in Economics)
AAU, Department of Economics
October , 2021
Mengesha.Y(Ph.D. in Economics) International Trade Theory and Policy (Ec

Historical Development of Modern Trade Theory
Modern trade theory is the product of an evolution of ideas in economic thought.

The writings of the mercantilists, physiocracy, and later those of the
classical economists— Adam Smith, David Ricardo, and John Stuart
Mill—have been instrumental in providing the framework of modern trade
theory.

Historical Development of Modern Trade Theory: Preclassical Economic Thought
The middle ages extends from the fall of the Roman Empire [476 AD] to
the late 15 Century [discovery of America by Columbus in 1492])
On the secular side, the Middle Ages are more or less synonymous
with the feudal system
The theory of feudalism in its essence implied a system in which
society was held together by mutual obligations and services so that
each one had his place assigned to him, and his tenure of that place
involved the giving and receiving mutually of support and assistance.

Historical Development of Modern Trade Theory: Preclassical Economic Thought
To complete the picture on the secular side, the Middle Ages inevitably lived to
a large extend in a ‘national economy’, which can be explained through the
following points:
The actual volume of trade was relatively small.
Men lived in small units, which to a large extent were virtually self
supporting.
Money transactions throughout Europe were limited (until the discovery
of silver mines in America, i.e., until after the passing of the Middle Ages).
Enterprise (as we understood today) presented few openings.

Mercantilism: Origin and Features
During the period 1500–1800, a group of writers ( called in group as

Mercantilism ) appeared in Europe who were concerned with the process of
nation building.
Representative Mercantilists
Antonio Serra – Italian Mercantilist
Jean Bodin – French Mercantilist
Thomas Mun – English Mercantilist (1571-1641)
Philipp W. Won Hornick – Austrian Mercantilist
Antoine de Montchretien (1576-1621) -French Mercantilist.
Jean Baptiste Colbert – French Mercantilist
Sir William Petty (1923-87) :Regarded by Marx as one of the Founder of
Political Economy

Mercantilism : 16th – 18th C

Between the mid-sixteenth century and late seventeenth century, a powerful
merchant class rose up in Europe as a result of the growth in international trade.
This merchant class was primarily concerned with the relationship
between a country’s wealth, identified by its stock of precious metals, and
its balance of trade.
The doctrine known as Mercantilism that evolved at this time represented
one of the earliest justifications for international trade.
Its basic idea was that wealth was necessary for national power.
This wealth was achieved by an interventionist philosophy that
advocated government regulation to achieve a surplus on the
balance of trade in order to accumulate precious metals.
Merchants saw no virtue in a large volume of trade per se but
recommended policies to maximize exports and minimize imports.
In this way, countries were able to amass holdings of gold and silver.
To achieve this objective, tariffs and other import restrictions were
enforced and exports were subsidized

According to the mercantilists, the central question was how a nation could
regulate its domestic and international affairs to promote its own interests.
The solution lay in a strong foreign trade sector.
If a country could achieve a favorable trade balance (a surplus of exports
over imports), it would realize net payments received from the rest of the
world in the form of gold and silver.
Such revenues would contribute to increased spending and a rise in
domestic output and employment.
To promote a favorable trade balance, the mercantilists advocated
government regulation of trade.
Tariffs, quotas, and other commercial policies were proposed by the
mercantilists to minimize imports in order to protect a nation’s
trade position

Mercantilism and the Transition to the Classical World of David Ricardo
Mercantilism was a highly nationalistic policy and ran into intense criticism in
the eighteenth and nineteenth centuries from the new laissez faire (classical)
school of economics.
At the time, however, the policy had some elements of rationality in the
following sense.
As a way of raising money to support armies and provide internal stability,
taxing the foreign sector was more attractive to the rulers than taxing the
landed gentry and peasantry.
Second, restrictions on imports of machinery and raw materials could be
thought of as a form of infant industry development policy.
Many of these ideas not only were spawned by events of the time but also
influenced history through their impact on government policies.
Geographical explorations that provided new opportunities for trade and
broadened the scope of international relations, the upsurge in population,
the impact of the Renaissance on culture, the rise of the merchant class,
the discovery of precious metals in the New World, changing religious
views on profits and accumulation, and the rise of nation-states
contributed to the development of Mercantilist thought.
Indeed, Mercantilism is often referred to as the political economy of state
building.

The laissez faire or classical school pointed out two major weaknesses in the
mercantilist arguments, and their criticisms influenced public policy in the
nineteenth
Mercantilism refers to the collection of economic thought that came into
existence in Europe during the period from 1500 to 1750.
It cannot be classified as a formal school of thought, but rather as a
collection of similar attitudes toward domestic economic activity and the
role of international trade that tended to dominate economic thinking and
policy during this period.
Many of these ideas not only were spawned by events of the time but also
influenced history through their impact on government policies.

The Mercantilist Economic System

Central to Mercantilist thinking was the view that national wealth was
reflected in a country’s holdings of precious metals.
In addition, one of the most important pillars of Mercantilist thought was
the static view of world resources.
Economic activity in this setting can be viewed as a zero-sum game in
which one country’s economic gain was at the expense of another.
(A zero-sum game is a game such as poker where one person’s
winnings are matched by the losses of the other players.)
Acquisition of precious metals thus became the means for increasing
wealth and well-being and the focus of the emerging European
nation-states.
In a hostile world, the enhancement of state power was critical to the
growth process, and this was another important Mercantilist doctrine.
A strong army, strong navy and merchant marine, and productive economy
were critical to maintaining and increasing the power of a nation-state.


Mercantilists saw the economic system as consisting of three components:
a manufacturing sector, a rural sector (domestic hinterland), and the
foreign colonies (foreign hinterland).
They viewed the merchant class as the group most critical to the
successful functioning of the economic system, and labor as the most
critical among the basic factors of production.
The Mercantilists, as did the Classical writers who followed, employed a
labor theory of value; that is, commodities were valued relatively in terms
of their relative labor content.
Not surprisingly, most writers and policymakers during this period
subscribed to the doctrine that economic activity should be regulated and
not left to individual prerogative.
Uncontrolled individual decision making was viewed as inconsistent with
the goals of the nation-state, in particular, the acquisition of precious
metals.


Finally, the Mercantilists stressed the need to maintain an excess of
exports over imports, that is, a favorable balance of trade or positive trade
balance.
This doctrine resulted from viewing wealth as synonymous with the
accumulation of precious metals (specie) and the need to maintain a
sizable war chest to finance the military presence required of a wealthy
country.
The inflow of specie came from foreigners who paid for the excess
purchases from the home country with gold and silver. This inflow was an
important source of money to countries constrained by a shortage in
coinage.
Crucial to this view was the implicit Mercantilist belief that the economy
was operating at less than full employment; therefore, the increase in the
money supply stimulated the economy, resulting in growth of output and
employment and not simply in inflation.
Hence, the attainment of a positive trade balance could be economically
beneficial to the country. Obviously, an excess of imports over exports—
an unfavorable balance of trade or a negative trade balance—would have
the opposite implications

The role of Goverment

The economic policies pursued by the Mercantilists followed from these
basic doctrines.
Governments controlled the use and exchange of precious metals, what is
often referred to as bullionism.
In particular, countries attempted to prohibit the export of gold, silver,
and other precious metals by individuals, and rulers let specie leave the
country only out of necessity.
Individuals caught smuggling specie were subject to swift punishment,
often death.
Governments also gave exclusive trading rights for certain routes or areas
to specific companies.
Trade monopolies fostered the generation of higher profits through the
exercise of both monopoly and monopsony market power.
Profits contributed both directly and indirectly to a positive trade balance
and to the wealth of the rulers who shared the profits of this activity.
The Hudson Bay Company and the Dutch East India Trading Company
are familiar examples of trade monopolies, some of which continued well
into the 19th century.

The role of Goverment

Governments attempted to control international trade with specific
policies to maximize the likelihood of a positive trade balance and the
resulting inflow of specie.
Exports were subsidized and quotas and high tariffs were placed on
imports of consumption goods.
Tariffs on imports of raw materials that could be transformed by domestic
labor into exportables were, however, low or nonexistent, because the raw
material imports could be “worked up” domestically and exported as
high-value manufacturedgoods.
Trade was fostered with the colonies, which were seen as low-cost sources
of raw materials and agricultural products and as potential markets for
exports of manufactures from the parent country.
Navigation policies aimed to control international trade and to maximize
the inflow (minimize the outflow) of specie for shipping services.
The British Navigation Acts, for example, excluded foreign ships from
engaging in coastal trade and from carrying merchandise to Britain or its
colonies.
Trade policy was consistently directed toward controlling the flow of
commodities between countries and toward maximizing the inflow of
specie that resulted from international trade.

Mercantilism and Domestic Economic Policy

The regulation of economic activity also was pursued within the country
through the control of industry and labor.
Comprehensive systems of regulations were put into effect utilizing
exclusive product charters such as those granted to the royal
manufacturers in France and England, tax exemptions, subsidies, and the
granting of special privileges.
In addition to the close regulation of production, labor was subject to
various controls through craft guilds.
Mercantilists argued that these regulations contributed to the quality of
both skilled labor and the manufactures such labor helped
produce—quality that enhanced the ability to export and increased the
wealth of the country.


Finally, the Mercantilists pursued policies that kept wages low. Because
labor was the critical factor of production, low wages meant that
production costs would be low and a country’s products would be more
competitive in world markets.
It was widely held that the lower classes must be kept poor in order to be
industrious and that increased wages would lead to reduced productivity.
Note that, in this period, wages were not market determined but were set
institutionally to provide workers with incomes consistent with their
traditional position in the social order.
However, because labor was viewed as vital to the state, a growing
population was crucial to growth in production.
Thus, governments stimulated population growth by encouraging large
families, giving subsidies for children, and providing financial incentives for
marriage.


Mercantilist economic policies resulted from the view of the world
prominent at that time.
The identification of wealth with holdings of precious metals instead of a
nation’s productive capacity and the static view of world resources were
crucial to the policies that were pursued.
While these doctrines seem naive today, they undoubtedly seemed logical
in the period from 1500 to 1750. Frequent warfare lent credibility to
maintaining a powerful army and merchant marine.
The legitimization of and growing importance of saving by the merchant
class could easily be extended to behavior by the state, making the
accumulation of precious metals seem equally reasonable.
However, the pursuit of power by the state at the expense of other goals
and the supreme importance assigned to the accumulation of precious
metals led to an obvious paradox: rich nations in the Mercantilist sense
would comprise large numbers of very poor people.
Specie was accumulated at the expense of current consumption.
At the same time, the rich nations found themselves expending large
amounts of their holdings of precious metals to protect themselves against
other nations attempting to acquire wealth by force.


In the early 18th century, ideas regarding the nature of economic activity
began to change.
Bullionism and bullionists began to be thought of as naive.
National political units had already emerged under the pressure of peasant
wars and kingly conquest, and feudalism began to give way to centralized
monarchies.
Technological developments coupled with the strengthening of the profit
motive supported the development of market systems, and state
monopolies began to disappear.
New ideas and new philosophies (particularly the skeptical inquiry of the
humanist viewpoint), fostered in part by the Italian Renaissance,
contributed to the continuing spirit of change.
By the late 18th century, ideas concerning international trade began to
change when early Classical writers such as David Hume and Adam Smith
challenged the basic tenets of Mercantilism.

Critics over Mercantilism
By the eighteenth century, the economic policies of the mercantilists were under
strong attack.
According to David Hume’s price-specie-flow doctrine, a favorable trade balance
is possible only in the short run for over time it would automatically be
eliminated
. To illustrate, suppose England achieves a trade surplus that results in an
inflow of gold and silver.
Because these precious metals constitute part of England’s money supply,
their inflow increases the amount of money in circulation. This leads to a
rise in England’s price level relative to that of its trading partners.
English residents would therefore be encouraged to purchase
foreign-produced goods, while England’s exports would decline.
As a result, the country’s trade surplus would eventually be eliminated.
The price-specie-flow mechanism thus shows that mercantilist policies could
provide at best only short-term economic advantages.

The mercantilists were also attacked for their static view of the world economy.
To the mercantilists, the world’s wealth was fixed.
This view meant that one nation’s gains from trade came at the
expense of its trading partners;
Not all nations could simultaneously enjoy the benefits of
international trade.
This view was challenged with the publication in 1776 of Adam Smith’s
The Wealth of Nations.
According to Smith (1723–1790), the world’s wealth is not a fixed
quantity.
International trade permits nations to take advantage of
specialization and the division of labor that increase the general
level of productivity within a country and thus increase world
output (wealth).
Smith’s dynamic view of trade suggested that both trading partners
could simultaneously enjoy higher levels of production and
consumption with trade.

Although the foundations of mercantilism have been refuted, mercantilism is

alive today.
However, it now emphasizes employment rather than holdings of gold and silver.
Neo-mercantilists contend exports are beneficial because they result in jobs for
domestic workers, while imports are bad because they take jobs away from
domestic workers and transfer them to foreign workers.
Trade is considered a zero-sum activity in which one country must lose for the
other to win.
There is no acknowledgment that trade can provide benefits to all countries,
including mutual benefits in employment as prosperity increases throughout the
world.

David Hume—The Price-Specie-Flow Mechanism

One of the first attacks on Mercantilist thought was raised by David
Hume (in his Political Discourses, 1752) with his development of the
price-specie-flow mechanism.
Hume challenged the Mercantilist view that a nation could continue to
accumulate specie without any repercussions to its international
competitive position.
He argued that the accumulation of gold by means of a trade surplus
would lead to an increase in the money supply and therefore to an
increase in prices and wages.
The increases would reduce the competitiveness of the country with a
surplus. Note that Hume is assuming that changes in the money supply
would have an impact on prices rather than on output and employment.


At the same time, the loss of gold in the deficit country would reduce its
money supply, prices, and wages, and increase its competitiveness (see
Concept Box 1). Thus, it is not possible for a nation to continue to
maintain a positive balance of trade indefinitely.
A trade surplus (or deficit) automatically produces internal repercussions
that work to remove that surplus (or deficit).
The movement of specie between countries serves as an automatic
adjustment mechanism that always seeks to equalize the value of exports
and imports (i.e., to produce a zero trade balance).
Today the Classical price-specie-flow mechanism is seen as resting on
several assumptions


Capsule Summary of the Price- Specie -Flow Mechanism
Given sufficient time, an automatic trade balance adjustment would take place
between a trade surplus country and a trade deficit country by means of the
following steps:


1. There must be some formal link between money and prices, such as
that provided in the quantity theory of money when full employment is
assumed:
MS V = PY
where: M=the supply of money; V= the velocity of money, or the rate at
which money changes hands; P= the price level; Y = the level of real
output
If one assumes that the velocity of money is fixed by tradition and
institutional arrangements and that Y is fixed at the level of full
employment, then any change in the supply of money is accompanied by a
proportional change in the level of prices.


2. Demand for traded goods is price elastic. This is necessary to ensure
that an increase in price will lead to a decrease in total expenditures for
the traded goods in question and that a price decrease will have the
opposite effect.
If demand is price inelastic, the price-specie-flow mechanism will
tend to worsen the disequilibrium in the trade balance. However,
demand elasticities tend to be greater in the long run than in the
short run as consumers gradually adjust their behavior in response
to price changes.
Hence, even though the price-specie-flow mechanism may be
“perverse” in the short run, Hume’s result is likely to occur as time
passes.


3. Perfect competition in both product and factor markets is assumed in
order to establish the necessary link between price behavior and wage
behavior, as well as to guarantee that prices and wages are flexible in both
an upward and a downward direction.
4. Finally, it is assumed that a gold standard exists.
Under such a system, all currencies are pegged to gold and hence to
each other, all currencies are freely convertible into gold, gold can
be bought and sold at will, and governments do not offset the
impact of the gold flows by other activities to influence the money
supply.
This is sufficient to establish the link between movements of specie and
changes in a nation’s money supply. If all of these assumptions are
satisfied, the automatic adjustment mechanism will, allowing time for
responses to occur, restore balanced trade anytime it is disrupted.
Balance-of-payments adjustment mechanisms and the gold standard are
still prominent in discussions of international monetary economics.


Concept Review- Price Elasticity and Total Expenditure
You learned in previous economics courses that price elasticity of demand
refers to the ratio between the percentage change in quantity demanded
of a given product and the percentage change in its price, that
is, △Q
△P
∗QP
). (Because quantity demanded varies inversely with price,
price elasticity of demand will have a negative sign.
Economic convention often ignores the negative sign, but it is understood
that ’s value will be less than 0, that is, negative.) When this ratio
(ignoring the negative sign) is greater than 1.0, indicating that the
percentage change in quantity demanded for a given price change is
greater than the percentage change in price, demand is said to be elastic.
When the ratio has a value of 1.0, demand is said to be unit-elastic,and
when the ratio is less than 1.0, demand is said to be inelastic. Because
the relative change in quantity is greater than the relative change in price
when demand is elastic, total expenditures on the product will increase
when the price falls (quantity demanded increases) and fall when the price
increases (quantity demanded falls).
When demand is inelastic, the exact opposite happens: Total expenditures
rise with a price increase and decline with a price decrease.
In the case of unit elasticity, total expenditures are invariant with changes
in price. Thus, for trade balances to change in the appropriate manner in
the price-specie-flow mechanism, it is sufficient to assume that demand
for traded goods is price elastic.
Physiocracy: A Link between Mercantilism and the Classical School
The physiocrats appeared in France towards the end of the mercantilist epoch.
The beginning of this school can be dated at 1756, when Francois
Quesnay published his first article on economics in the Grande
Encyclopede.
The school may be said to have ended in 1776 with the publication
of Adam Smith’s Wealth of Nations and the downfall of Anne
Robert Jacques Turgot 1727-81 from his high office as Finance
Minister.
But the influence of the physiocrats lasted well beyond the two
decades during which they led the world in economic thinking.

To subscribe to physiocracy become the fashion of the day and important

personalities like
Empress Catherine of Russia,
King Stanislaus of Poland,
King Gustavus III of Sweden,
Emperor Joseph II of Austria,
Grand Duke Leopold of Juscany, together with a large number of other
political personalities tried to understand its principles.

Physiocracy was not just a furthering and refinement of the mercantilist

doctrine or a modification of it.
It was basically a reaction against mercantilism and was offering an
alternative political and social system.
All sorts of restrictions, controls and regulations characterized
mercantilism==>In contrast to that, physiocracy was claiming to be a
natural system, based upon a belief that there existed natural laws, which
ought to be followed for stability and all round benefit.
It is true that inspite of its theoretical advancement, the economic and
social system which it was offering could not stand the test of time and
was soon discredited and abandoned.
But during its period of currency, physiocracy had a wide following
and was commanding almost a religious fervor.

The Margrave of Baden, Karl Frieldrich, even tried to apply these principles in
his realm.
Physiocrats are credited with the creation of the earliest school of thought in
proper sense of the term.
Physiocracy marked the rise of the first school of economic thought.
The physiocrats preferred to be called (or called themselves) “economists” but
posterity has agreed to call them ‘physiocrats’.

Factors which gave rise to physiocracy

The socioeconomic conditions prevailing in France were largely responsible for
the rise of phyiocracy in that country:
i. The forces of regulation, which had been adopted under mercantilism
(Colbertism), had exhausted their resourcefulness and there was a need to
rejuvenate the economy.
Industry and trade were given preference at the cost of agriculture
Agriculture was in a miserable (wretched) condition and the
agricultural workers bore the heavy burden of taxes.
Agriculture was in a state of stagnation as compared with its
increasing usefulness and profitability in England where the fruits of
agricultural revolution were being reaped.
Mercantilism had outlived its usefulness and was heading towards
its decline.


ii. France (during the period preceding the French Revolution) experienced a
degenerated and corrupt court life.
The king was the center about which every thing in the state revolved.
He believed in the authoritarian maxim ‘I am the state’ and himself led an
extremely luxurious life.
The life of the political administrators, from the kind down-wards, was
very luxurious and corrupt.
Public expenditure was very extravagant and wasteful.
The result was an increasing indebtedness of the government and the
need to levy extra taxes to finance the public expenditure.


iii. To replenish state treasury, heavy taxes were imposed. But the taxes were
inequitable and unjust.
The nobility and clergy owned about two thirds of the country’s land, but
they were hardly paying any taxes,
While the poor peasants were being crushed under all sorts of levies in
addition to the extortionist land rents.
These taxes further added to the miseries of the poor people.

The undisputed leader of the physiocratic school was Francois Quesnary (1694-
1774).
He came from a peasant family, studied medicine and rose to be
appointed as the court physician to Madame de Pompadour and later to
King Louis XV.
With a record of medical dissertations on such subjects as suppuration,
gangrene and fevers, he burgeoned as an economist at the age of 62 and
died at the age of 80.
He lived to be the acknowledged head of the most compact of any of the
schools of economists.

Let us investigate the main ideas of the physiocratic school through F. Quesnay.
For Quesnay and all the physiocrats their economics in corollary to their
social philosophy which stipulates that these is a Natural Order (or
Natural Law) which governs human actions, not less than the rest of the
field of nature.
The problem is therefore to find the structure of society which will accord
with this natural law.
Natural laws are of two types:
natural physical laws and natural moral laws.
The natural physical laws govern the physical universe. These laws
bring with them both good and bad events.
Using Quesnay’s example:
The rain storm which inconveniences the traveler waters the field.’
The point is that the benefit from the physical laws are far greater
than the evils they produce.

The natural moral laws, which rule human societies, also produce beneficial
results in the some manner as the natural physical laws do.
They are the laws of human actions, the consequences of which are ‘as
favorable as possible to the happiness’ of all individuals of the human
society.
The natural physical laws explain the inevitable ‘what is’ while the natural moral
laws give the ideal ‘what ought to be’.
The physiocrats were concerned with the natural moral laws and emphasized the
following points regarding the nature of these laws:
a) they include rules of prudent individual conduct;
b) they include the rules of justice to be followed by individuals while
dealing among themselves.

Human society is thus subject to two kinds of laws:

the natural laws (Lois naturelles) and the positive laws (Lois positives).
The natural law has been defined by the physiocrats as the providential
order decreed by God for the welfare of mankind.
It is universal and unchangeable.
The natural laws are the expression of the will of God.
They belong to the ‘essence of the matter and the soul of
humanity’ and are irrevocable to discover and to understand these
laws is man’s first duty and to live according to them is the second.

The knowledge of the natural laws is obtained not by external observations but
through introspection (i.e., by directing ones mind, thought into oneself).
Though the natural order is a Devine light, a self-evident principle, within every
man, but only rational human beings become aware of it.
Positive laws are of human origin and they are therefore strictly subordinate.
Indeed, the primary function of the positive laws should be to ‘declare’ the
natural laws.
Positive laws are thus essentially subordinate, and should only be
introduced in so far as they are in conformity with, and rigorously subject
to, the natural laws.
They are therefore not of arbitrary institution, and ‘the legislator cannot
render them just by his authority, except in so far as they are just in their
essence.’

The economic contributions of the Physiograts can be summarized as follows:

i. According to the physiocrats, the natural order reveals itself through
the principles of private property and individual liberty.
The institution of private property, for them, is the fundamental
institution on which all other institutions of the society depend.
The most important natural right is the right to acquire private
property.
ii. The physiocrats are credited for their famous decline of ‘laissez-faire,
laissez-passer’ which was principally directed to attack the protectionist
principle of the mercantilists.
It was also an attack on the greater government action of the
mercantilists.
The physiocrats underlined that the positive law should not go
beyond the point of protection against invasion, restraint of the
wicked, and of routine administration.
Thus, the blessedness of free trade and of government inactivity
was knocking at the door.


iii. The search for the natural order led physiocrats to the adoration of
agriculture.
For the physiocrats, agriculture alone produced the wealth of a
nation.
For them, agriculture is a productive activity, but all other
occupations although necessary are ‘unproductive’ and ‘sterile’.
‘Agriculture, says Quesnay, ‘is the source of all the wealth of the
state and of the wealth of all the citizens’.
Every thing that is disadvantageous to agriculture is prejudicial to
the state and the nation, and every thing that favors agriculture is
profitable to the state and the nation’.
The physiocratic accentuation of the importance of agriculture was
a reflection of the needs of France at the time, and a reaction
against that phase of mercantilism, which stressed the importance
of commerce and manufacturing.
The exaltation of agriculture over other economic activities rests on
a subordination of these which is theoretically demonstrable.

In Quesnay’s earliest articles on Ferms and Grains, this position is emphatically

stated:
“Agriculture and commerce are constantly regarded as the two sources of
our wealth.
Commerce, like industry, is merely a branch of agriculture. It is agriculture
which furnishes the material of industry and commerce and which pays
both; but these two branches give back their gain to agriculture, which
renews the wealth which is spent and consumed each year”. (Grains, P.
216).
Indeed, Quesnay at times speaks as if the commercial classes were
scarcely a part of the nation at all.
A mixed agricultural and commercial kingdom, he says, unites two nations
which are distinct are from the other.
The agricultural is the constitutive part of the society. ‘The other is an
extrinsic addition which forms a part of the general republic of external
commerce.


iv. Quesnay has developed his famous ‘Tableau Economique’, where he showed
the circular flow of goods in an economy.
The ‘Tableau Economique’ represents the first systematic analysis of the
flow of wealth on what later came to be called a macroeconomic basis.
Economists such as Smith, Marx, and Keynese, who favoured the description of
economic activities in terms of large aggregates, paid tribute to Quesnay for
originating this approach.
Neoclassical economists, on the other hand, who prefer the microeconomic
approach of describing activities in terms of individuals, have tended to belittle
him.

The Net Product

In the physiocratic system, agriculture has been given a dominant place
because of its strategic role in the economic development of the country.
Agriculture, for the physiocrats, is the only sector which yields net
product or surplus produce. In other words, it is only in agriculture that
the wealth produced is greater than the wealth consumed.
Net product is defined as the excess of wealth produced over and above
what is required to produce it. According to the Physiocrats, no other
sector except agriculture is capable of yielding net product.
In commerce, we produce nothing but only transfer the already produced
commodities form one hand to the other.
In industry, too, the artisans simply combine or modify the raw material
and produce no surplus-wealth.
In industry and in commerce, wealth produced exactly equals wealth
consumed Price of the manufactured goods just equals the cost of
production.

‘A weaver buys food and clothing, giving 150 francs for them, together with a
quantity of flux, for which he gives 50 francs. The cloth will be sold for 200
francs, a sum that will cover all expenditure.
Thus, industry and commerce are regards as sterile or unproductive, because no
surplus wealth is produced in these sectors. But sterile does not mean ‘useless’.
The necessity of these sectors was clearly emphasized by the physiocrats.
It is nature that produces the surplus, Quesnay says, and not the worker.
So the productive class uses 2000 million worth of agricultural products and
1000 million worth of manufactured products to produce 5000 worth of gross
output of which 2000 million worth is the NET PRODUCT, which is claimed by
the landlords.
Quesnay emphasized that since the landlords claim the net product they must
bear the whole burden of taxation.

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