CHAPTER 2: Fs CLASSICAL Cc 4 OF INTERNATION: which a durable peace. ‘or the only way in : ee f restoration of economic activity al can be created is by world-wide nd international trade. James Forrestal Classical Mercantilism Country-based Theories of : i Theory of Absolute rieehal chs Advantage ee Theory of Comparative , Advantage” : A Heckscher-Ohlin Theory 5 (H-O Theory) 4 LEARNING OUTCOMES At the end of the chapter, students are expected to: 1. explain the Meanin 19 Of international i i. trade affects nations; trade theories and discuss how differenti ‘i : i liate classical theories from modern theories and have, 4" understanding of the di d ; le different i international business and trade; a eee 52 , Scanned with CamScanner11. 12. 13, 14, discuss the meaning of mercantilism, -explai it 9 » explain. the characteristi mercantilism as Posited by Adam Smith, elucidate on the fen ot production, discuss colonization as a Process to increas, ators ot wealth, and explain the price-specie-flow mechanism advan Hume; © @ nation’s ced by David relate surplus value, capital accumulation, and expanded reproducti ion; elaborate on the tenets of mercantilism as advocated by Phil; " ee , yy Phili i von Hornick, distinguish between protectionism and laissez ris kel differentiate neo-mercantilism from free trade, and. explain a ie physiocrats are; : + n discuss the different proponents of mercantilism and their contributions: discuss the meaning of absolute advantage, elaborate on the theo of absolute advantage as posited by Adam Smith, explain the is of capitalism, and discuss how division of labor leads to specialization efficiency, productivity, and economic development; : explain how the theory of absolute advantage, theory of international trade, and theory of economic development are linked; elucidate on the “vent for surplus” theory; . explain the meaning of comparative advantage, discuss the theory of comparative advantage as posited by David Ricardo, elaborate on the law of diminishing marginal returns, and discuss the theory of monetarism; telate David Ricardo’s theory of comparative advantage to Heckscher- Ohlin’s factor proportions theory, discuss the Heckscher-Ohlin theory, explain the law of supply and demand relative to the factors of production, and elaborate on the effects of the Heckscher-Ohlin theory on international trade; analyze the advantages and constraints of the, classical theories; i ‘ lyze the understand the concepts of the classical theories and analy criticisms of each theory; and appreciate how the classical theories work in th and trade. e real world of business ea Scanned with CamScannerDUCTION : . a ce! INTR ysis of the History of Philippine ied ee a write ‘ An Analy: il Paras, and Vaness@ Soliva, P' Se eae Christian pacsit Nd 7 No.1, tried to analyze how ee policy ie icy Revi . 1, y a oi end the Introduction, the paper has given an evolved. ave a consistent, independent trade policy? ilippines hi es ‘ Does the CE anal “do we have a trade policy, then it would If the question was ‘i e have numerous executive orders lified “yes”: W A ders (eos etal eal tariff and customs codes, international a and obligations, and SO forth, that dictate how imports and exports in the Philippines are to be treated. This isa com ee saad on trade, where we acquire some of our inputs Acari tbat eal earn through exporting our own products to foreign customers. Yet if the question is more precise—a consistent, independent trade policy? —the evidencé does not point in that direction. It is not just that we have numerous policies that apply to Philippine trade, but that in the course of post-independence Philippine economic history, the direction of Philippine trade policy has changed significantly in many occasions. Here we argue, though the analysis of historical data available (from 1949 to present), that we do not have any constant trade policy that is consistent with a given economic or ideological framework. Rather, what we have are trade policies (deliberately in the plural) that are often the result of two competing forces: global economic forces or shocks to which the government must react to or respond to, and the local political economy that has for the most part of this history captured trade policy and enjoyed its benefits—even as the costs of such policies were finally taking its toll on the economy. We argue that two significant global economic events—a 1949 currency crisis and the 1980s’ debt crisis—forced government to take steps needed to stabilize the economy. We further argue that the consequences of these steps, creating two distinct business classes (a traditional industrial’ elite post-1949, and a more globally-oriented entrepreneurial class Post-1980) which have helped shape the political economy out of which further developments in trade Policy came out of. : ae nee Concluded that liberalization—or at least the minimal commitmett ie - argh earoed upon trade barriers and tariff rates—is embedded not onl) Policy framework of Philippine government, but also in international obligations S4 | wrerwaTionat BUSINESS AND TRADE Scanned with CamScannerand law. In addition, they said that the rise of a new business middle class that enjoys penefits from globalization and liberalization of the economy will ensure, that there js at least one political supporter in favor of continued liberalization. It Is this class’ participation in the policy formulation and implementation procedures in Philippine government that can help set the tone for the future of Philippine trade policy. It is understandable that countries will always want to protect its-own people and its own industries and businesses. And as we had discussed in Chapter 1, there will always be pros and cons to international trade and it will be up to the country to adopt a trade policy, which it thinks will benefit the country as a whole. How protective it should be or how liberal it should be will depend on the government of the respective countries. qrave 59 Scanned with CamScannerLESSON 2.1. International Trade Theories: LESSON OBJECT! IVES: end of the lesson, the students should be able to: At the a 4. explain the meaning of international trade theories; 2. discuss how international trade affects nations; and 3.. differentiate classical theories from modern theories. developed theories to explain the mechanisms of international business and trade. International trade theories are simply different theories to explain international trade. Trade is the concept of exchanging goods and services between two people or entities. International trade, therefore, is the concept of this exchange between people or entities in two different countries, People or entities trade, because they believe that they can satisfy their needs and benefit from the exchange. While at the surface this may sound very simple, theré is a great deal of theory, policy, and business strategy that influence international trade. International trade theories are various theories that analyze and explain the patterns and mechanisms of international trade. They deal with how countries exchange goods and services and help countries in deciding what.should be exported and what should be imported, in what quantity, and with whom trade should be done globally. As we had discussed in Chapter 1, these theories were initially company-based and were called classical theories. Classical economists were oriented primarily toward growth economics, and their main concern was to explain how the “wealth of nations” could be increased. The classical theories of each country are just as important as modern theories as they explain how nations expanded around the globe and built their wealth through trade. Overtime, economists have According to Reyes (2012), the main points of the classical theories of international trade are the following: 1. Trade 7 an important stimulator of economic growth. It enlarges @ Country's consumption capacities, increases world output, and provides a to scarce resources and worldwide markets for products, witho ich poor countries would be unable to grow. z ia tends to promote greater international and domestic equality y equalizing factor prices, raising real incomes of trading countries: 56 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannerand making efficient use of each nation's and the world's resource endowments, i.e., raising relative wages in labor-abundant countries and lowering them in labor-scarce countries. Trade helps countries to achieve development by promoting and 3. rewarding those sectors of the economy where individual countries have a comparative advantage, whether in terms of labor efficiency or factor + endowments. 4. In a world of free trade, international prices and costs of ‘productions determine how much a country should trade in order to maximize its national welfare. Countries should follow the dictates of the principle of comparative advantage and not try to interfere with the free workings of the market. 5. ‘In order to promote growth and development, an outward-looking international policy is required. In all cases, self-reliance based on partial or complete isolation is asserted to be economically inferior to participation in a world of free unlimited trade. A number of explicit and implicit assumptions that in many ways are often contrary to the reality of contemporary international economic relations have been instrumental in the development of the traditional international trade theories. These theories, therefore, often lead to conclusions not in accordance with both the historical and the contemporary trade experiences of many developed and developing countries. Be that as it may, there is no denying that international business and trade, more so a world of free trade, is beneficial to everyone involved. In the real world, a variety of national production and international noncompetitive pricing policies are present. It is, therefore, incumbent upon governments and nations to carefully study their own environments and the international environment to determine what policies to institute and what strategies to take to promote their - ‘own economic development and growth. : In the mid-twentieth century, economists shifted from country-based to firm-based or company-based theories, which were called modern theories. The moder theories are useful and can help with international trade by helping a business determine the right country to expand into and how to make goods more efficiently than other firms. These theories incorporate more factors than the Country-based classical theories. The theories covered in this chapter, in the next chapter, and in Chapter 4 are simply that—theories. While these theories have helped economists, countries, governments, and businesses understand international business and trade better and how to promote, regulate, and manage the same, these theories are, at CHAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 57 Scanned with CamScannere real world. Countries do not have absolute advantages in many areas of services or production and, in fact, the factors it ee are not proportionately distributed between countries. Some a oi i“ : disproportionate benefit of some factors, while others have e soe ra nate disadvantage of most factors. There are countries with plenty of arable an , like. the United States and Russia that can be used for a wide range of agricultural products, but are not considered as agricultural countries. They are, on the sontrary, more advanced and more industrialized than other agricultural countries, like the Philippines. This is because they have extensive access to capital. ‘They may not have skilled labor, but their labor force may be among the best educated. Be that as it may, these rich countries still imports a lot of goods and services from other countries to satisfy the needs of its more affluent citizens, whose demands and expectation are far more complicated. The largest and richest economies In the world could be the greatest importers from other countries because they have the means to buy what they want. These ticl h and more industrialized countries are the ones that go to the less fortunate countries to establish factories, affiliates, and . subsidiaries, because the less fortunate c ountries are the ones rich in cheap labor and cheap raw materials. These less fortunate countries are now the’ ones that seek to create their own comparative advantages through. their cheap factors of production. As a result, it is not clear that any y one theory is dominant around the world. In practice, governments and companies use a combination of these theories to both interpret trends and develop strategy. times, contradicted inth Just as these theories have evolved over the past 500 years, they will continue to change and ‘adapt as new factors impact international trade (creativecommons.com 2021). We study the different theories to highlight the basics of international trade theories to enable students to understand the realities that face global businesses. LESSON SUMMARY 1. International trade theories are various theories that analyze and explain the patterns and mechanisms of international trade, how countries exchange sti ae ape and help countries in deciding what should be exported and what should be imported, in what quantity, and wi bs quantity, with whom trade should be 2. Trade is the concept of exchangin or entities. ging goods and services between two people 3. International trade is.the exch: erat ange go i entities in two different countries. aoe an veg Tea 58 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannercalled International trade theories were initially company-baset om ety ones Classical theories, Classical economists were oriented ie wealth of growth €conomics, and their main concern was to explain a nations” could be increased. . the following: 5. The main points of the classical theories of international trade are a. _ Trade is an important stimulator of economic growin. lity ic equality. b. Trade tends to promote greater international and come: ¢. Trade helps countries to achieve development. : ind costs of productions . ii i i a i d. In a world of free trade, international prices rder to maximize its determine how much a country should trade in national welfare. : -reli ed-on e@. In order to promote. growth and development, self et ei to partial or complete isolation is asserted to be economically Participation in a world of free unlimited trade. 6. In the mid-twentieth century, economists shifted’ from country-based.: to firm-based or company-based theories, which were called modern theories. These theories are useful and can help with international trade by helping a business determine the right country to expand into and make goods more efficiently than other firms. KEY TAKEAWAYS 1. International trade theories are various theories that analyze and explain the patterns and mechanisms of international trade. 2. Trade is. the concept of exchanging goods and services between two people or entities. 3. International trade is the exchange goods and services between people or entities in two different countries. 4, International trade theories were initially company-based and were called classical theories. HAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 59 Scanned with CamScannerClassical economists were oriented and their main concern was to explai primarily toward growth economics, in how the ‘wealth of nations” couig be increased. 6. The main points of a. b. Cc. the classical theories of international trade are the following: Trade is an important stimulator of economic growth. Trade tends to promote greater international and domestic equality. Trade helps cotntries to achieve development. In a world of free trade, international prices and costs of productions determine how much a country should trade in order to maximize its national welfare. Participation in a world of free unlimited trade is economically far better than complete isolation to promote economic development. 7. °In the mid-twentieth century, economists shifted from country-based to firm-based or company-based theories, which were called modern theories. DISCUSSION QUESTIONS Instruction: Answer the following questions comprehensively. 1. 2. Explain the méaning of international trade theories. Differentiate classical theories from modern theories. CONNECTIONS AND APPLICATIONS In at least two paragraphs, write your reflections on the following aspects of the lesson discussed earlier‘on a separate sheet of paper. How International Trade Affects Nations Scanned with CamScannerGRADING RUBRICS | Focus and ‘There is one There is one clear, | There is one topic. | The topic and main Details clear, well-focused | well-focused topic. | Main ideas are ideas are not clear. topic. Main ideas | Main ideas are somewhat clear. ‘ are clear and are _| clear, but are not well supported ‘well supported by detailed _| by detailed : and accurate information. 7 “ | information. Organization | The introduction is _| The introduction is | The introduction There is no clear interesting, states | interesting, states | states the main _| introduction, the main topic, the main topic, topic. Aconclusion | structure, or and provides an and provides an in included. conclusion. overview of the ‘overview of the paper. Information | paper. A conclusion is relevant and is included. | presented in a logical order. The conclusion is strong. | Word Choice | Thewriteruses | Thewriteruses The writer “The writer uses vivid words vivid words | uses words to limited vocabulary. and phrases. and phrases. | communicate dargon or clichés The choice and | The choice and’ | clearly, but writing | are present and placement of words | placement of words | lacks variety. detract from the seem accurate, | are inaccurate at | meaning. | natural, and not times. | | | forced. ; | | | Sentence Allsentences are | Most sentences are | Most sentences are | Sentences sound Structure, well constructed | well constructed well constructed, | awkward, are Grammar, andhave varied | andhave varied | buttheyhavea —_| distractingly and Spelling | structure and structure and | similar structure | repetitive, or | length. The writer | length. The writer | and/or length. | are difficult to | makes no errors | makes afewerrors | Thewriter makes | understand. The * | in grammar and/or | in grammar and/or | several errors in | writer makes | spelling. spelling, but they | grammar and/ numerous errors | do not interfere with | or spelling that in grammar and/ | understanding. _ interfere with ‘or spelling that | | understanding. |. | interfere with | I understanding, GHAPTER2 | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 61 Scanned with CamScannerLESSON 2.2. Mercantilism LESSON OBJECTIVES: At the end of the lesson, the students should be able to: discuss the meaning of mercantilism; explain the characteristics of mercantilism as posited by Adam Smith; elucidate on the factors of production; discuss colonization as a process to increase a nation’s wealth; explain the price- specie-flow mechanism of David Hume; relate surplus value, capital accumulation, and expanded reproduction; elaborate on the tenets of mercantilism as advocated by Philipp Wilhelm von Hornick; = : 8. _ distinguish between protectionism and laissez faire policy; OO Os Os 9. differentiate neo-mercantilism from free trade; 10. explain who the physiocrats are; and /41, discuss the different proponents of mercantilism and their contributions. The Commercial Revolution which took place between 1450 and 1750 (300 years) brought a revolutionary change in the economy of Europe. It saw the transition from local economies to national economies, from feudalism to capitalism, from a rudimentary trade to a globally larger international trade. Figure 2.1 depicts what went on during the commercial revolution. 7 he local economics : ~> national economies = he feudalism : > capitalism “y cas : rudimentary trade > globally larger ~y international trade Figure 2.1. Basic Features of the Commercial Revolution 62. | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannerThe commercial revolution gave birth to mercantilism, which played:a vital role for the economic prosperity.of a nation and created a milestone in the field of European’ Economy (historydiscussion.net 2021). Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country's wealth was determined by the amount of its gold and silver holdings. Mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the value of.imports is greater than the value of exports. In relation to this trade surplus objective, Scottish economist David Hume (1711-1776) modelled the price-specie-flow mechanism to illustrate how trade imbalances can self-correct and adjust under the gold standard. According to this flow mechanism, balance of payments was & “real” phenomenon effected by changes in trade balances, and these trade balances were stimulated by changes in prices, which in turn resulted from gold flows between nations. Fluctuations in prices in acountry adjusted completely or partially by an inflow or outflow of gold or specie which adjusts the price levels across borders and equalized them bringing’ balance in international transactions and payments. - Acloser look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. These rulers placed lots of importance on the development of | merchants and naval fleets, which would facilitate exports. By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries. In addition, mercantilism believes that the state should actively intervene in the economy. According to this, the state should intervene in the economy with the policies that will give more international trade; hence, customs tariffs, quotas, and so on were imposed to curtail imports. This strategy is called protectionism, a practice that is still logically present in our current times. It was called protectionism because the country tried to protect the export industries that brings in the gold and silver, not only by imposing import restrictions, but also by such measures as subsidizing select export industries. While export-oriented companies usually support protectionist policies that favor them, other companies and consumers are hurt by protectionism. Taxpayers pay for government subsidies for select exports in the form of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services. Free-trade advocates highlight how free trade benefits all members of the global community, while mercantilism’s protectionist policies only benefit select industries, at the expense of both consumers CHAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 63 Scanned with CamScannere industry (creativecommons.com ithi i th nies, within and outside of rf ; nena aah protectionism protected the industries that produces the exports, it hurts the consumers. Mercantilists view the ‘interests of the country to always take precet erests of its citizens. Soon colonization followed and these nation-states pana oe by using their colonies around the world in an effort to control more aa amass more riches. The British colonial empire was one of the more ines examples; it sought to increase-its wealth by using raw materials from places ranging trom what are now the Americas and India. France, the Netherlands, Portugal, and Spain were also successful in building large colonial empires that generated extensive wealth for their governing nations. s metals, particularly gold and silver, were considered Ith as a country’s wealth was determined by the amount of gold and silver that it holds. According to the mercantilists, it is the goal of the economy politics to ensure that the state is enriched and for this reason, increasing the entry of gold and silver and stocking the country with the same is among the suggestions of this thought stream. The thought was that the national currency will be strong by creating the highest possible export/trade surplus, exports should be more than imports, because exports bring an inflow of gold, whereas imports lead to the outflow of gold. This is the reason mercantilism was also known as “bullionism.” Bullion means large amounts of gold and silver. If a country does not have mineral resources or does not have access to them, precious metals should be obtained by international trade. The aim of mercantilism is to enlarge state treasury as much as possible by engaging in more foreign trade. dence over the int During thosetimes, preciou: indispensable to a nation’s weal Adam Smith described mercantilism as having the following characteristics: 4. Itwas used to enhance the economic power of states through building wealth, an important measure of which was precious\metals, especially silver and gold. 2. It led to massive and rapid unification of control (protectionism) of countries under strict economic and political policies, in sharp contrast with what was observed under feudalism resulting in economic nationalism. 3. The countries aggressively sought to have a favorable balance of trade (trade surplus) by selling more than they imported so as to have asurplus of precious metals and accumulate it over time. Mercantilism was the economic theory and practice dominant in modernized parts of western Europe throughout the late Renaissance and early modern period from the fifteenth to the eighteenth century. Mercantilism is economic nationalis™ 64 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScanneraimed to build a wealthy and powerful state. Adam Smith coined the term “mercantile system” to describe the system of political economy that sought to enrich the country by encouraging exports and restraining imports. t Although mercantilism is one of the oldest trade theories, it remains partof modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even.Germany still favor exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of protectionist policies and restrictions and: domestic-industry subsidies (lardbucket.org 2021). Neo-mercantilism, therefore, combines protectionism through tariffs and import barriers and domestic industry protection through subsidies and tax exemptions. Countries, at one point or another, have implemented some form of protectionist policy to guard key industries. in their economy. Many countries of Europe encouraged the intervention of the state (government) in commercial activities for the increase of national wealth and power. Countries concentrated on producing surplus goods for those they can efficiently produce and export such surplus. Mercantilism aimed to encourage production within’ the national territories through the concession of monopolistic privileges granted the export producing enterprises, government subsidies, and tax exemptions and the importation of advanced technology (mostly to benefit the export industries), acquisition of manufacturing secrets, and encouraging immigration of skilled workers that will bring in remittances to the country. Mercantilism, as a form of economio nationalism, funds corporate, military, and national growth. It advocates trade policies that protect domestic industries. In mercantilism, the government strengthens the private owners of the factors of production, which are: 1.. Labor 2. Natural resources (land) 3. Capital goods (capital) 4, Entrepreneurship Labor is.the most important factor of production because without labor, the other factors of production would be of no use. Labor refers to the work performed by a person for a monetary consideration. It is the monetary consideration that forms part of the cost of production. Natural resources are those found in nature, including land.. Land, trees, and mines are natural resources and’ a major factor of production. Capital goods consist of those goods which are produced by the economic system and are used as inputs in the production of further goods and services. Capital is often the one considered as a factor of production, which refers to the money or funds used to purchase the goods.used in the production process. quarter? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 65 ‘Scanned with CamScanneri ct proportion ang ors in the corre jes the ae considered as one of the factors 7 were the factors of production, In the fourth factor of production, The entrepreneur is the one that ane mobilizes them; that is why the entrep and capit of production. Before, only land, Soe added, 28 i urs ' eee eee light how free trade benefits all members: of the ss hight! protectionist policies only benefit select ies both withi ; 1 nse of both consumers and other one. ben X in and industries ie brasgehees trade is when international trade is a ae artiers, eee auses or other restrictions, and on ee ae roi ‘ ¥ i rnment reg! ! work, it requires less gove! ; 4 : oa oats trade was more beneficial and sustainable in a much broader ‘0 1 sense than mercantilism. : Free trade advocate: mts global community, while mercantilism’s The doctrines of mercantilism were articulated by a eee oe of journalists, government officials, administrators, merchants, : usil a rt and pamphleteers who did not form a group advocating a fixed line of thoug| It and policy. Given that they were addressing their national governments on national issues, mercantilist writings tend to vary by country. And since they have different professions, profession was also a factor. While there are some pan-European features which are common among Mercantilist writers, there was great variety and No two mercantilists really had the same theory. The proponents of the theory were Sir William Petty and Sir. Thomas Mun in England, Jean-Baptiste Colbert, Jean Bodin, Irish-born Richard Cantillon, and Lord Antoine de Montchrétien in France, and-Antonio Serra and Giovanni Botero in Italy, although they never used the term themselves. It was the Scottish economist ‘Adam Smith, in his An Inquiry into the Nature and Causes of the Wealth of Nations (1776), who gave currency to the term. His book is often referred to only as Wealth of Nations, Adam Smith observed that mercantilism was rather @ political movement Mostly motivated by economic gains of states. The real meaning and definition of the term are not clear as they are seen to represent a school of thought, rather thana Political system. Adam Smit dei an ith dedicated many pages of his book, Wealth of Nations, lining and describing the term. Later on, in 1776, Adam Smith organized all the concepts arid observations about the economic polici mi T resi ‘ ic poli earchers Policies made by other 1 is time period. i is derived from Adam Smith's work, Pe The modern Understanding of the term While Adam Smith was among the fi 4 = rst writers wi . ili e viewed mercantilism as not freely initiate no explored mercanilism, hi ‘d and did not bring benefits to all parties. Scanned with CamScannertrade (free trade) was much better than the mercantile doctrine as it would benefit most parties. Free trade is a system that allowed for liberalization which would pave the way for a freely initiated trade and engage the maximum possible number of people bringing benefits to most parties and lead to further development of all participants in the long run. These proposals made by Adam Smith led to the development of doctrines of laissez-faire that subsequently paved the way for free markets. Laissez-faire economics is a theory that restricts government intervention in the economy. Laissez-faire means “leave them alone” or “let it be.” Smith demonstrated that the free market would translate into an all-encompassing economic development in a significantly wider sense than mercantilism. Smith also emphasized division of labor that will lead to specialization. As we had already studied, division of labor means dividing an activity/ob into tasks with each task to be performed by an employee or a group of employees, such that once the different employees or group of employees performing their respective tasks is done, the entire job/activity is done. He maintained that with division of labor, specialization follows. Each employee or group of employees will be specialists in their own respective tasks. Specialization is a method of production whereby an entity focuses on the production of a limited scope of goods to gain a greater degree of efficiency. With specialization, productivity and efficiency is attained. According to Smith, specialization would lead to the development of economies of scale (mass production of goods), which would create efficiency with the -ultimate * effect of achieving sustainable growth. For him, the collusive relationship between the government and the business class observed in the mercantile system was detrimental to the citizenry, as it denied producers the opportunity to engage intrade in areas other than those supported by the government. The mercantile system itself prevented the population from participating effectively in production. , Figure 2.2 shows what Adam Smith had in mind when he tackled division of labor, specialization, productivity, economies of scale, efficiency, and sustainable economic growth: 2 7 division of labor”, °> specialization” > productivity x ¥v a i it . ft sustainable economic growth << efficiency < *” economies of scale Figure 2.2. Adam Smith’s Division of Labor CHAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 67 Scanned with CamScannertesman who serve Jean-Baptiste Colbert (1619-1683), @ aga vee tetany of tate i as Comptroller General of Finance (1665-1683) ds'consideied ae ; is XIV of France, w a the Navy (1668-1683) under King Louis antilism in France, where it More profound influence on the development of merc Ithough called Colbert was known as “Colbertism.” Jean-Baptiste’s system, althoug : m, leniier i ication to mercantilism described by Adam was very similar in concept and application if bei ; tury after Jean-Baptiste’s death; the only difference being the Smith elmost.&i contr mic reconstruction that helped nomenclature. He carried out the program of economic made France the dominant power in Europe. He was disturbed that cence held a very significant diplomatic position in Europe, but was weak economically. Jean. Baptiste did not use the term “mercantilism,” but he described and supported a similar system that played a crucial role in boosting the economy after the French industry had been ravaged by religious wars. He proposed ways of reviving it and * saving the country's economy from bankruptcy. He proposed programs aimed at reconstructing the economy to compete effectively in the European economy. He molded the Frefich economic policy emphasizing the need for full state control over the economic activities with a view to make France a powerful and self-sufficient nation. He also emphasized the importance of money and asserted that money is the single aim of commerce and the only means of increasing the power to the state (preservearticles.com 2021). He adopted economic Policies that would increase the Country's exports and reduce imports, so that it could accumulate Precious metals to be distributed to all provinces to boost industry and provide more taxes to the government. He directed governmental support for the establishment of glass manufacturing industries to replace glass imported from Venice and export the surplus and he also worked for the manufacture of cloth and tapestry. Moreover, he raised tariffs and encouraged public work Projects to create an enabling environment for French producers. Colbert fostered national mercantilism, in which the state Concentrates on developing its industry and manufacturing to minimize imports and maximize exports to maintain a favorable balance of trade (difference between exports and imports). Colbert did not seem to seek regional dominance and the Collusion between the government and the business class seen in mercantilism was also absent in his view of mercantilism. Merchant fleets pla French government established marine me 68 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScanner: The long-term effects of Colbertism resulted in impoverished trading partners, while France became wealthier. Such policies were also applied to all its colonies so that there Would be an inflow of precious metals from colonies, to France. The country also tried to ensure, as much as possible, that only the minimum imports came in, while increasing the amount and the value of exports. The precious metals obtained by the French government were used to develop and maintain merchants and navy fleets. i Sir William Petty (1623-1687) was an English economist, physician, scientist, and philosopher. He was a supporter of Oliver Cromwell's government of England. After numerically comparing economic data of England, France, andthe Netherlands, Petty concluded that England was three times richer than the Netherlands and two times richer than France. According to Petty, surplus gain or surplus value leads to expanded reproduction and that expanded reproduction is conditional on capital accumulation (productive capital expansion). This means that if a country has accumulated capital, it will have surplus value and, consequently, expanded reproduction. Figuratively, this will mean: surplus value " Py expanded Capital accumulation > P ” (surplus gain) yp reproduction (productive capital expansion) y Figure 2.3. Sir William Petty’s Expanded Reproduction Expanded reproduction is a model in which a. capitalist economy smoothly reproduces itself, a system founded‘on capital accumulation, that is, the expansion of productive capital. The surplus value created by the workers is not merely realized but reinvested. The economy experiences expanded reproduction when it consistently expands each year. While the labor market in England. included an abundance of productive labor, the French absolutist system was supported by masses of men engaged in unproductive labor such as the nobility or the clergy. Therefore, even though both countries held similar productive conditions (e.g., climate, population, technology), England was richer than France due to a more extensive productive labor force * thatcould reproduce economic surplus and not just simply consume it unproductively. This distinction between productive and unproductive labor is later asserted by Adam Smith in The Wealth of Nations; thus, in many ways we could consider Petty a precursof to Smith (bohemianeconomics.wordpress.com 2021). cuarrer2 | CLASSICAL (COUNTRY-BASED THEORIES OF | INTERNATIONAL TRADE 69 Scanned with CamScannerWilhelm von Hornick, in his Austria a nine-point program of what. he the tenets of mercantilism The Austrian lawyer and scholar Pane Over All, If She Only Will of 1684, detaile arta deemed effective national economy, which sul comprehensively (iquisearch.com 2021): 1. That every inch of a country's soil b manufacturing; : ‘ 2. ‘That all raw materials found in a country be used in oe manufacture, : since finished goods have a higher value than raw materials; utilized for agriculture, mining, or 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; 7. That as much as possible, imports be confined to raw materials that can : be finished; 8. That opportunities be constantly sought for selling a country’s surplus manufactures to foreigners, so far as necessary, for gold and silver; and 9. _ That no importation be allowed, if such goods are sufficiently and suitably ‘supplied at home. Sir Thomas Mun (1571-1641), a famous €conomic thinker, was most closely associated with the idea of mercantilism in England, where mercantilism was called commercial system or mercantile system, because it emphasized the importance Of commerce and free trade. This school of thought mainly focused on international trade and the balance of trade through acquisition of silver and gold. Sir Mun.was the director of the East India Company, publishing books and Pamphlets on his theory of mercantilism, molding England's trade Policies to maximize the nation’s wealth, and further setting a precedent for international trade that many countries thereafter followed. When Thomas Mun first introduced his idea of foreign. trade, it was during a time of an economic downfall in England. Many people beli¢ved that the East India-Company was to blame because. they had financed their trade by exporting a large amount of “bullion in order to Purchase spices.” When accusations arose of his company being at fault for the trade imbalance in England, Mun’s ‘defense strategy Scanned with CamScannerinvolved informing the citizens of the country about the benefits of international trade to increase England's wealth. Sir Mun wrote a pamphlet, A Discourse of Trade, to explain why his company had chosen to be a participant of trade. Mun explained that if the company had chosen to deter from the trading of bullion for spices, England would have actually been at more of a disadvantage economically (bartleby.com 2021). Sir Thomas Mun declared that “foreign trade ought to be encouraged, for upon it hinges the great revenue of the King, the honor of the kingdom, the noble . profession of the merchant, the supply of our poor, the improvement of our lands ° and means of our treasure,” (economicsdiscussion:net 2021). Antoine de Montchrétien published a book titled A Tract on Political Economy in which he laid great emphasis on development of agriculture and described it as the basis of all wealth. He stood for the principle of self-sufficiency and asserted that it is not the abundance of gold and silver, the quantities of pearls and diamonds, which make a state rich and opulent, but the convenience of the things necessary to life (preservearticles.com 2021). Richard Cantillon, another French scholar, is considered by many to be the first economic theorist. His,contributions span such diverse topics as methodology, value and price theory, population, money, international trade, business cycles, and the circular flow model of the economy. He emphasized the need of importing raw materials and exporting finished products to maintain a favorable balance of trade. Inhis Of the Balance of Trade, he wrote to counter the mercantilist idea that a nation. should strive for a positive balance of trade. Cantillon’s only known book, Essai sur la Nature du Commerce en General (the Essai), may represent one of the single largest steps forward in the social sciences. Many attempts have been made to classify Richard Cantillon into a well-defined school of thought and he has been claimed as a forerunner by many schools of economic thought, but for purposes of categorization, he is most often placed with the mercantilists. He laid emphasis on the import of precious metals to make the country prosperous. Cantillon lived and wrote before the physiocrats. Physiocrats is an eighteenth-century group of French economists who believed that agriculture was the source of all wealth and that agricultural products should be highly priced. Advocating adherence to a supposed natural order of social institutions, they also stressed the necessity offree ~~ trade. He was involved in John Law’s Mississippi Bubble, one of the grandest attempts to actualize the mercantilist dream of increasing the supply of money, and he was involved in the merchant trade and merchant banking business, So it would be natural to.consider him a mercantilist writer [Thornton, Mark (11. June 2009) cambridge.org]. . amentwrms @ACER-THECUIES OFINTERNATIONAL TRADE 71 ‘Scanned with CamScanner: i directly touc! Giovanni Botero and Antonio Serra of Italy ere aa _ mercantilism, but developed theories using a seal Oitieiaed in to be the result of human In : oe. an describes why the few islands of pabcncnele seats ~ time were found in cities with their large division of labor, pesihia on - au high value added given to imported raw materials that were use tt mo . rs ot io Serra adds the argument Te Of the goods for exports. In 1613, Antonio ’ virtuous circle of growth is found in increasing returns to scale. Ar a“ and Serra were emphasizing was that a nation can be fich throug! in us rialization that will bring results of cumulative causations originating in increasing retums (elgaronline.com 2021). LESSON SUMMARY 1. The “Commercial Revolution” brought a revolutionary change in the economy of Europe: the transition from local economies to national economies, from feudalism to capitalism, and from a rudimentary trade to a globally larger international trade. i ' 2. This commercial revolution gave birth to mercantilism. According to the mercantilists, it is the goal of the economy politics to ensure that the state is enriched by increasing the entry of gold and silver and stocking the country with the same through creating the highest possible export/trade surplus because exports bring an inflow of gold, whereas imports lead to the outflow of gold. This is the reason mercantilism was also known as “bullionism.” 3. Mercantilism believes that the state should actively intervene in the economy. Countries employed a policy of, protectionism —protecting the export industries that bring in the gold and silver through customs tariffs, quotas, and the like to curtail imports. 4. The period also marked the rise of new nation: able to amass more gold and wealth for their countries by increasing exports and trade. These nation-states expanded their wealth by using their colonies around the world in an effort to control more trade and amass more riches. 5. Mercantilism aimed to encourage production within the national territories ene anthe concession ofmonopolstcprivileges grantedto the export producing enterprises, granting government subsidies, and giving tax exemptions. The importation of advanced technology (mostly to benefit the export industries) acquisition of Manufacturing secrets, and encouraging immigration of skilled “States, whose rulers were Scanned with CamScannerworkel ill bring ii i nea oad io bring in remittances to the country were done. Nation-states fi : lots of importance on the development of merchants and naval . leets, which would facilitate exports. In mercantilism, the government strengthens the private owners of the factors of production, which are the following: a. Labor — refers to the work performed by a person for a monetary consideration. It is the monetary consideration that forms part of the cost of production. b. Natural resources — are those found in nature, including land, trees, and mines. c. Capital goods (capital) — consist of those goods which are produced by the economic system and are used as inputs in the production of further goods and services. Capital refers to the money or funds used to purchase the goods used in the production process. d. Entrepreneurship — the entrepreneur is the one that combines the factors in the correct proportion and mobilizes them. + Although mercantilism is one of the oldest trade theories, it remains part of our modern life. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form of neo- mercantilism, protectionism through tariffs and import barriers and, domestic industry protection through subsidies and tax exemptions. hlight how free trade benefits all members of the ercantilism’s protectionist policies only benefit select f both consumers and other companies both within hen international trade is free from and can flourish on its Free trade advocates hig! global community, while mi industries at the expense of and outside the industry. Free trade is wi barriers, such as tariffs, quotas, or other restrictions, natural growth. It requires less government regulatory power. ry were Sir William Petty and Sir Thomas Mun The proponents of the theo! din, Irish-born Richard Cantillon, in England, Jean-Baptiste Colbert, Jean Bo and Lord Antoine de Montchrétien in France, and Antonio Serra and Giovanni Botero in Italy, although they never used the term themselves. It was the Scottish, economist Adam Smith, in his Wealth of Nations (1776), who gave currency to the term. antilism, as not freely initiated and did not bring futed the general notion that the wealth of a nation ry. Through his book, Adam Smith |. Adam Smith viewed. merc benefits to all parties. He ret should be measured by the country’s treasu! cuarTeR2 | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE = 73 Scanned with CamScanneras much better than illustrated that a freely conducted trade (free trade) w' he it i fit most parties. i trine as it would bene’ mercantile doctri “allowed for liberalization which would pave the d engage the maximum possible number of ties and lead to further development of ay 11. Free trade is a system that allo way for a freely initiated trade ant people bringing benefits to most pal participants in the long run. 12. Laissez-faire economics is a theo the economy. Smith demonstrated that all-encompassing economic developm mercantilism. 13., Smith also developed the concept of specialization leading tothe development of economies of scale, creating efficiency with the ultimate effect of achieving sustainable growth. For him, the collusive relationship between the govern iment and the business class observed in the mercantile system was detrimental to the citizenry. 14. Adam Smith described mercantilism as having the following characteristics: ry that restricts government intervention in the free market would translate into an ent in a significantly wider sense than a. It was used to enhance the economic power of states through building wealth, an important measure of which was precious metals, especially silver and gold. b. It led to massive and rapid unification of control of countries under strict economic and political policies, in sharp contrast with what was observed under feudalism resulting in economic nationalism. ¢. The countries aggressively sought to have a favorable balance of trade by selling more than they imported so as to have a-surplus of precious metals and accumulate it over time. 15. Jean-Baptiste Colbert was Considered as a more profound influence on the development of mercantilism in France, where it was known as “Colbertism.” Jean-Baptiste’s system was very similar in concept and application to . Mercantilism described by Adam Smith. He Carried out the program of economic reconstruction that helped make France the dominant Power in Europe. . Sir William Petty posits that Surplus gain or surplus value leads to expanded feproduction and that expanded reproduction is conditional on capital pital expansion), Expanded réproduction is 4 conomy Smoothly reproduces itself. The surplus is not merely realized but reinvested. value created by the workers 74 | INTERNATIONAL BUSINESS AND TRADE Seanned with CamScanner17. 18. 19. 20. 21: 22. 23. ae Wilhelm von Hornick, in his Austria Over All, If She Only Will of 1684, let tailed @ nine-point program of what he deemed effective national economy, which sums up the tenets of mercantilism comprehensively. Sir Thomas Mun was most closely associated with the idea of mercantilism in England, where Mercantilism was called commercial system or mercantile system, because it emphasized the importance of commerce and free trade. This school of thought mainly focused on international trade and the balance of trade through acquisition of silver and gold. Antoine de Montchrétien published a book titled A Tract on Political Economy in which he laid great emphasis on development of agriculture and described it as the basis of all wealth. He stood for the principle of self-sufficiency and asserted that it is not the abundance of gold and silver, the quantities of pearls and diamonds, which make a state rich and opulent, but the convenience of the things necessary to life. Richard Cantillon is considered by many to be the first economic theorist. His only known book, Essai sur /a Nature du Commerce en General (the Essai), may represent one of the single largest steps forward in the social sciences. He emphasized the need of importing raw materials and exporting finished products to maintain a favorable balance of trade. Physiocrats is an eighteenth-century group of French economists who believed: that agriculture was the source of all wealth and that agricultural products should be highly priced. Advocating adherence to a supposed natural order of social institutions, they also stressed the necessity of free trade. The price-specie-flow mechanism was originally attributed to Scottish economist David Hume to illustrate how trade imbalances can self-correct and adjust under the gold standard. Fluctuations in prices in a country adjusted completely or partially by an inflow or outflow of gold or specie which adjusts the price levels across borders and equalized them bringing balance in international transactions and payments. Giovanni Botero and Antonio Serra of Italy did not directly ‘touch on mercantilism, but developed theories using the city as a unit of analysis and finding development to be the result of industrialization. curren? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 75 Scanned with CamScannerKEY TAKEAWAYS re ‘om local economies ty ‘al Revolution’ saw the transition fr d from a rudiment, 1. The cane re from feudalism to capitalism, an ry national economies, rational trade. trade oa Gobel larger in 5 “bullionism,” it is the goal of the enriched by increasing the entry Id, whereas imports lead to the i a 2. According to mercantilism, also known jomy politics to ensure Y at the stale inflow of gol of gold and silver. Exports bring an outflow of gold. 3. Countries employed a policy of pt export industries that brings in the rotectionism; the country tried to protect the gold and silver. ion where one country takes control of states expanded their wealth by using rt to control more trade and amass 4. New nation-states practiced colonizati another country or region. These nation~ their colonies around the world in an effor more wealth. 5. _ Entrepreneurship — The entrepreneur is the one that combines the factors in the correct proportion and mobilizes them. ‘ 6. Capital goods — These consist of those goods which are produced by the economic system and are used as inputs in the production of further goods and services. 7. Capital - This refers to the money or funds used to purchase the goods used in the production process. 8. Natural resources ~ These are found in nature, including land, trees, and “. mines. : Labor - This refers to the work performed. by ‘a person for a monetary Consideration. It is the monetary consideration that forms part of the cost of Production. ‘ . 10... In our modern times, the four factors of Production ar ital, and entrepreneurship. e land, labor, capital, a! 11. Neo-mercantilism, therefor I ‘, combines protectionism throu h tariffs and import barriers and ic it i r 2 iia domestic industry protection through subsidies and 12. 76 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScanner13. 15. 16. 18. 19. 21. 23. 24. 14. Free trade is a system that allowed for liberalization which would pave the way for a freely initiated trade and engage the maximum possible number of people bringing benefits to most parties and lead to further development of all participants in the long run. Laissez-faire economics is a theory that the economy. : ‘ Specialization.is a method of production whereby an entity focuses on the production of a limited number of goods to gain a greater degree of efficiency that would lead to the development of economies of scale. output leads to lower se in size, they become restricts government intervention in Economies of scale occur when increasing | long-run average costs. It means that as firms increa: more efficient. Jean-Baptiste Colbert was considered as a more pr development of mercantilism in France, where it was known as Sir William Petty posited that surplus gain.is the fundamental originator of expanded reproduction, which is conditional on capital accumulation. his Austria Over All, If She Only Will of 1684, hat he deemed effective national economy, comprehensively. ‘ofound influence on the “Colbertism.” Philipp Wilhelm von Hornick, in detailed a nine-point program of w! which sums up the tenets of mercantilism A Discourse of Trade in England, where Sir Thomas Mun wrote a pamphlet, | system or mercantile system. mercantilism was called commercial lontchrétien published a book titled A Tract on Political Economy Antoine de M elopment of agriculture and described in which he laid great emphasis on dev it as the basis of all wealth. Richard Cantillon is considered by many to be the first economic theorist. He emphasized the need of importing raw materials and exporting finished products to maintain a favorable balance of trade. Physiocrats is an eighteenth-century group of French economists who believed that agriculture was the source of all wealth and that agricultural products should be highly priced. Giovanni Botero and Antonio Serra of Italy did not directly touch on but developed theories using the city as a unit of analysis and mercantilism, he result of industrialization. finding development to bet cuarTer2 | CLASSICAL COUNTRY-BASED -THEORIES OF INTERNATIONAL TRADE 77 Scanned with CamScannerDISCUSSION QUESTIONS Instruction: Answer the following ao Pens Nn questions comprehensively. rcantilism. Discuss the meaning of me! - f mercantilism as posite by Adam Smith. Explain the characteristics of Elucidate on the factors of production. 0 i ion’s wealth. Discuss colonization as a process to increase a nation’s we echanism of David Hume. Explain the price-specie-flow m Elaborate on the tenets of mercantilism as advocated by Philipp Wilhelm von Hornick. Distinguish between protectionism and laissez-faire policy. ; Differentiate neo-mercantilism from free trade. Explain who the physiocrats are. CONNECTIONS AND APPLICATIONS In at least two paragraphs, write your reflections on the following aspects of the lesson discussed earlier on a separate sheet of paper. Use the grading rubrics in Lesson 2.1. The Different Proponents of Mercantilism and Their Contributions 7 8 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannerLESSON 2.3. Theory of Absolute Advantage LESSON OBJECTIVES: At the end of the lesson, the students should be able to: 1. discuss the meaning of absolute advantage; 2. elaborate on the theory of absolute advantage as ‘Posited by Adam Smith; 3. explain the meaning of capitalism; 4, discuss how division of labor leads to specialization, efficiency, productivity, and economic development; 5. — explain how the theory of absolute advantage, theory of, international trade, and theory of economic development are linked; and 6. elucidate on the vent for surplus theory. Absolute advantage means a producer, which could be a person, a group, a~ company, or a country, can produce a good or service better, faster, more efficiently, at a greater volume, and with fewer resources than others. It means that a producer can produce a good or service in greater quantity for the same cost or the same quantity at a lower cost or the producer can produce the same quantity of product/service for a lesser quantity of inputs, and, therefore, lower marginal cost than other producers without compromising the quality. Marginal cost is the cost incurred in producing an additional unit of a product. If a country has more resources needed to ‘produce a good or service, it has absolute advantage over a country who does not have those resources because the country which has the duce the good or service faster, more efficiently, and at a greater volume than other countries lacking in such resources. Absolute advantage is a comparative term used in economics when comparing the output capacity: of a country, business, or individual in relation to another similar entity. The entity that produces more with Jess inputs has the absolute advantage. Someone who is the best at doing something is said to have an absolute advantage (econlib. org 2021). Absolute advantage is more about a county having better, faster, more efficient, and greater volume production at lesser workforce, lesser time and at lower marginal cost than other countries, without compromising the quality. needed resources can prot Adam Smith is recognized as the founder of modern economics; hence, e father of economics. He ‘is credited with using the word k, The Wealth of Nations, marked the birth of also called free market economy or free considered as th , mercantilism first and that his boo modern capitalism. Capitalism, CHAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 79 Scanned with CamScannerf production ; i ere most means O' ate , is an economic system, WN istributed largely throys the operation of markets, which determine prices, pl a ot capitalism a8 @ Syston the government. Although the continuous Se eT caphalst institutions existeg sol dates only from the sixteenth century, precursors tin Euro : the ecient world and flourishing pockets of capitalism were presen PE dting the later Middle Ages. Modern capitalism emerged as a result of the in France after 1750 and the devastating impac' i inci ice of mercantilist relative to the principles and practice o i . group of economists who believed that the wealth. of nations was derived Solely from agriculture. The term “physiooracy” itself, introduced by pean ce Heme (1767) literally translates to “the rule of nature.” Physiocracy is pel a the first well-developed theory of economics. It immediately preceded the first modem school, classical economics, which began with the publication of Adam Smith's The Wealth of Nations in 1776. The most significant contribution of the physiocrats was their emphasis on productive work as the source of national wealth. The “cornerstone of the physiocratic doctrine was Frangois Quesnay’s (1759-1766) axiom that only agriculture yielded a surplus. Manufacturing, the’ physiocrats argued, took up as much value as inputs into production as it created in output, and consequently created no net product. Contrary to the mercantilists, the physiocrats believed that the wealth of a nation lies not in its stocks of gold and silver, but rather in the size of its net product (newworldencyclopedia.org 2021). The value of outputs minus the value of inputs (net product) is a measure of the income generated ina production process. e appearance of the Physiocrats t that the ideas of Adam Smith m. The physiocrats were a The ideas of Adam Smith represented more than just the first systematic treatise on econbmics as they were a frontal attack on mercantilism. Like the physiocrats, Smith recommended leaving economic decisions to the free play of self- regulating market forces, a natural economic order that functions most efficiently, if the state played a highly limitéd role. Unlike the Physiocrats, however, Smith did Not believe that industry was unproductive and that only the agricultural sector was capable of producing a surplus above the subsistence level, Smith saw that division of labor and extension of markets created almost limitless possibilities for society to expand its wealth through production and trade. In 1776, Adam Smith Recent versions have beer 80 | nvTeRNATIONAL BUSINESS AND TRADE Scanned with CamScanneree He stated that trade should flow naturally according to market en lieved that if a certain country could produce a product cheaper or more efficiently than another country, the former should specialize in producing that product. This means that each country will produce thé product it is.able to produce cheaper and more efficiently, thereby giving specialization to each country. In this case, therefore, these countries can export those products where it is more efficient. Their labor force would become more skilled by doing the same tasks and production would, also, become more efficient. Smith's theory reasoned that with increased efficiencies, countries would benefit and trade would be encouraged. His theory stated that a nation’s wealth should not be judged by how much gold and silver ithas, but rather by the living standards of its people (creativecommons.com 2021). The theory of absolute advantage in international trade evolved as a strong list views:on international trade. reaction to the restrictive and protectionist mercantil This theory was put forward by Adam Smith to explain the reasons for foreign trade. It becomes Smith's work to make foreign economics a science. The theory of absolute advantage and the free trade and international division of labor that it supports shows that both countries will benefit from international trade and that the world resources will be used in the most optimal way. According to the theory, countries should manufacture products that they can produce efficiently at a lower cost as compared to other countries, products the countries have specialization on. Countries should produce and export such products which they can produce efficiently and import those goods that they produce relatively less efficiently and at a higher cost. This kind of trade will be beneficial for both countries. This means that each country should produce goods that they have absolute advantage on, * specialize in the production of such goods, and export them to those countries who do not have absolute advantage in the production of such goods. For example, if Country A can produce cars at a lower cost than others and Country B can produce trucks at a lower cost than others, then Country B should import cars from Country A and Country A can import trucks from Country B. It is in the interest of all the ‘participating countries to go to such an international division of labor based on the d by each country cheaply. Smith also ad specialization of goods produce ivocated that a country’s future income | accumulation. The countries depends upon capital that prosper are those that grow it well, and protect it. This is the their capital, manage i same idea that Sir William Petty had when Petty said that expanded reproduction is conditional on capital accu mulation (see page 69). cuarrer? | exassiCat COUNTRY: BASED THEORIES OF INTERNATIONAL TRADE 81 Scanned with CamScannerin gains from freg e to explain g oa att gout absolute advantagy ultaneously through exports J international trade even more important in te institute.com 2021). He upheld in ic framework (corporatefinanceinstitt aarnhade ft Drodteeah, oo apt of free trade as the only sot s. According.to Smith, free aiwecn mn ee keane prosperity Stroud specialization in the expansion of trad aoa division of lal ; 4 cc rae promotes See such commodities, in case of which they mand production and exchal me absolute advantage. cues bs h tried to show that not only single merchants,. but the society whole, Smith trie i titative ang i tional trade exploits the quan ; sphomaneodeeontin oa tania of labor. Smith connects internationa itati fits of an exten , ee a otc veee of the division of labor. If trade with another nation stern sitelaol of the division of labor will be possible because the internat Sr market is bigger than the domestic market alone. International trade is, thus, a van lageous b a hat because the enhanced division of labor leads to specialization and to an inctease of the exchangeable value of the annual Produce of the land and labor of the country. This means that the real wealth of the nation and its Population increases. of abso! . . He theorized that i elp them gain Ss! Smith used the ieaechs trade in the international ma" d'b in different commodities WOU ‘a and imports, making the unres' Adam Smith emphasized that specialization on the basis of absolute cost advantage would lead to maximization of world Production. An interesting aspect + of Smith’s analysis of trade has been his vent for surplus doctrine. According to him, a nation can exchange its overproduction for other goods which are in demand in other countries. In addition, this doctrine ‘implies that the foreign trade results in the fullest utilization of the idle productive Capacity that is likely to exist in the absence of trade, In this way, more of its population's wants and needs can be satisfied. As a result of Specialization, each nation Produces surplus goods that cannot be absorbed domestically; hence, must be exported. The vent for surplus gain is complementary to Smith's international trade theory, ~ As Smith has ©xpounded, Specialization, which increases Pp innovations. The basic tenet of Produced overall with the same at international trade leads to an increase. in roductivity through technical and organizational absolute advantage is that More goods can be ° mount of labor. Economic development is attained bla resources are activated and industry boosted, Smith's theo of absolute advantage and theory of international trade es theory of economic development, are closely interwoven with his 82 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannerAbsolute advantage, linked through division of labor and specialization, is necessary in international trade that leads to economic development. By division of labor, employees become skilled and specialized in their respective tasks and by specialization, Productivity is enhanced thereby attaining efficiency. As production becomes more efficient, there would be an incentive to create faster and better production methods to increase the specialization. Smith’s theory reasoned that with increased efficiencies, countries in the exporting industry and countries in the importing industry would both be benefited; hence, trade should be encouraged. His theory stated that a nation’s wealth should not be judged by how much gold and silver it had, but rather by the living standards of its people. According to Smith, the countries are measured by goods and services that can provide real wealth, not to the nation, but to.its citizens. The gains from international trade are reinforced by the increased competition that domestic producers are confronted with. Increased competition drives companies to perform and produce. better, to have absolute advantage. Smith also mentioned an additional beneficial aspect of international trade—it transfers knowledge and technology between different nations. The adoption and use of new production techniques lead to productivity growth and thus, to an increase in wealth and economic development. Figure 2.4 is a configuration of the essence of Smith's theory of absolute advantage, theory of international trade, and theory of economic development. We can see that it is very similar to our Figure 2.2,Adam Smith's division of labor as they are both from Adam Smith. > productivity division of labor specialization v increase in nation’s wealth economic development SE Figure 2.4. Configuration of the Essence of Adam Smith's Theory of Absolute Advantage, ‘Theory of International Trade, and Theory of Economic Development evceens 1 OP AGCIAT COUNTRY-RASFD THEORIES OF INTERNATIONAL TRADE 83 Scanned with CamScannerLESSON SUMMARY cer 4. Absolute advantage means a produ faster, more efficiently, at agi reatel volut : Se ee aie a ‘od po Hs produce a good or service at lesse, ; it rr others. It means that pi marginal cost than o' Sr acountry has more resources needeg Pp f ry rg) ther producers. I to va 500d or service, it has absolute advantage over a country to produce a g ‘ wh does not have those resources. roduce a good or service bette, oan. Pad with fewer resources than me, d in producing an additional unit of a product, economics; he 3. Adam Smith is recognized as the sane aes sin tga a idered as the father of economics. ‘ adh aarcerisih first and that his book The Wealth of Nations.marke birth of modern capitalism. Ic 4. Capitalism, also called free market economy or free ee oe is an economic system, where most means of production are privately wnied and production is guided and income distributed largely through the operation of markets, which determine prices, products, and services rather than the government. 2. Marginal cost is the cost incurre 5. Modern capitalism emerged as a result of the appearance of the physiocrats in France. The physiocrats were a group of economists who believed that the wealth of nations was derived solely from agriculture; that only agriculture ” yielded a surplus. 6. Physiocracy is perhaps the first well-developed theory of economics. It immediately preceded the first modern school, classical economics. The physiocrats believed that the wealth of a nation lies not in its ‘stocks of gold and silver, but rather in the size of its net Product. 7. Net product, a measure of the income generated in the value of Outputs minus the value of inputs. 8. Like the Physiocrats, the free play of self. limited role, @ production process, is » Smith recommended leavi : Ng economic decisions to Tegulating market forces, wit h the state playing a highly ension of markets created almost its Wealth through - production 84 | intern, |ATIONAL, SINES: us SAND TRane ‘Scanned with CamScannerThe theory of ; a _ and ae hilsinanied advantage believes that countries should produce import those cools tan which they have an absolute advantage on and IS that the: :, a, higher cost. : y produce relatively less efficiently and at a Ue ae as the concept of absolute advantage to explain gains from free trade in is ares market. He upheld in this theory the necessity of free trade asthe ms ly Sound guarantee for progressive expansion of trade and increased prosperity of nations. , 12, According to Smith, free trade promotes international division of labor through specialization in the production and exchange of such commodities, in case of which they command some absolute advantage. Specialization increases productivity through technical and organizational innovations. plus 13. Aninteresting aspect of Smith’s analysis of trade has been his vent for sur ther doctrine, which advocates nations exchanging their overproduction for of goods which are in demand in other countries. In addition, this doctrine implies that the foreign trade results in the fullest utilization of the idle productive capacity that is likely to exist in the absence of trade. Smith also mentioned an additional beneficial aspect of international trade— it transfers knowledge and technology between different nations. The adoption and use of new production techniques lead to productivity growth and, thus, to an increase in wealth and economic development. KEY TAKEAWAYS 1. Absolute advantage means that a pro’ in greater quantity for the same cos! marginal cost. ducer can produce a good or service t or the same quantity at a lower 2. Marginal cost is the cost incurred in producing an additional unit of product. 3. Adam Smith is recognized as the father of economics. 4. Capitalism, also called free market economy or free enterprise economy is an economic system, ‘where-most means of production are privately owned and production is distributed through the operation of markets, which determine prices, products, and services. 5. The physiocrats were a group of econ nations was derived solely from agriculture; a surplus. omists who believed that the wealth of that only agriculture yielded cuarren2 | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 85 Scanned with CamScannertries should produgg believes that count pesigratt have an-absolute advantage on ang ot have absolute advantage. I trade, theory of international , and 7 oven and interlinked, 6. . The theory of absolute ad and export such products w! import those goods where they do n ntage, : t are closely interw it i ision of labor through specialization . trade promotes international divisi . ‘ ato ° me alt countries absolute advantage paving the way for internationay trade that wil bring about economic development. 9. Vent for surplus doctrine states that a nation can exchange its overproduction for other goods which are in demand in other countries, which will result in the fullest utilization of the idle productive capacity. 10. An additional beneficial aspect of international trade is it transfers knowledge and technology between different nations. 7. The theory of absolute adval theory of economic development DISCUSSION QUESTIONS _ Instruction: Answer the following questions comprehensively. 1. Discuss the meaning of absolute advantage. Explain the meaning of capitalism. . Discuss how division of labor leads to specialization, efficiency, - and productivity. 4. Explain the theory of absolute advantage as posited by Adam Smith. 5. Elucidate on the vent for surplus theory. CONNECTIONS AND APPLICATIONS In at least two paragraphs; write your reflections on the following aspects of the lesson discussed earli Witeseon 33 earlier on a separate sheet of Paper. Use the grading rubrics Relate Theory of Absolute Advantage, Theory of International Trade. and Theory of Economic Development 86 | INTERNATIONAL BUSINESS AND TRADE Scanned with CamScannerLESSON 2.4. Theory of Comparative Advantage LESSON OBJECTIVES: At the end of the lesson, the students should be able to: 1. explain thé meaning of comparative advantage; 2. discuss the theory of comparative advantage as posited by David Ric 3. © elaborate on the law of diminishing marginal returns; and 4, discuss the theory of monetarism. ardo; Comparative advantage refers to the country’s capability to produce specific goods or manufacture multiple types of goods with limited resources at lower marginal cost and opportunity cost compared to other countries. Absolute advantage talks only about marginal cost; comparative advantage talks about marginal cost and opportunity cost. Therefore, in comparative advantage, we are looking at total cost. Marginal cost is the cost incurred in producing an additional unit of a product, while opportunity cost is described as the sacrifice of the highest value of a good that one has to forego to obtain another. Opportunity cost is what is lost or missed out on when choosing one possibility over another. Assume a company can put their money in the bank and earn a 10% interest. For the same amount of money, the company can buy anew equipment it can use for production. If the company buys the equipment, the opportunity cost is the 10% it will earn if it puts the money in the bank. If a country can produce goods or services at a lower (total) cost than other countries, it has comparative advantage. The trick to understanding comparative advantage is in the phrase “lower cost.” Oil-producing nations have a comparative advantage in chemicals. Their locally produced oil provides a cheap source of material for the chemicals when compared to‘countries without it. A lot of the raw ingredients are produced in the oil distillery process. As Mexico are competitive with the US chemical ~ aresult, Saudi Arabia, Kuwait, and production firms. Their chemicals are inexpensive, making their opportunity cost low (academia.edu 2021). “The challenge to the absolute advantage theory was that some countries may be better at producing several products and, therefore, have an advantage in many areas, while there are countries which do not have any absolute advantage _ on anything. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if a country had the absolute advantage in the production of several products, specialization and n still happen between two countries. Comparative trade cal advantage occurs when a country can produce a product better and more efficiently CHAPTER? | CLASSICAL COUNTRY-BASED THEORIES OF INTERNATIONAL TRADE 87 Scanned with CamScanner: ith’s theory of absolutg i between Smith’s than i ds. The difference is subtle. Comparatiy, wiatae Canney theory of comparative advantage © © whereas absolute advantage focuses on the relative productivity differ g five commons.com 2024 pevantage looks, at the, abeoiue? i eed production. It can te Productivity is an average measure of ee roduction process, ie, output expressed as the ratio of output to inputs used in ‘ ds Se eaiciviy of different entiteg, Per unit of input. Relative productivity compares vonity‘s/country’s Productivity Countries, while absolute productivity looks at an ctor is better at doing hig without regard to other Set De ight faa his job as a deat jo r even if he can also cook. sah tee Lk aa he ce es to do the cooking. Their overall productivity is dedi asa team. That is comparative advantage. We are looking at the doctor and the cook Comparatively/relatively. Barriers to trade may exist, and goods must be transported, Stored, and distributed. However, this simplistic example demonstrates the basis of the comparative advantage theory. A person or a country will specialize in doing what they do relatively better. In reality, the world economy is more complex and consists of more than two countries ‘and products. While the theory of comparative advantage is attributed to Ricardo, Adam Smith was among the first to put in writing the theory of comparative advantage ‘when he wrote (economicsdiscussion.net 2021): 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 Produce of our own industry, employed in a way in which we have some advantage. ° 3 Smith meant that it would be better to import something that is cheaper than Producing it at a higher cost and offset such importation with exporting what can be Produced cheaper. Each Country should export a good for which ithas a comparative Scanned with CamScanner