Theories of International Trade Lecture no. 5 Prof.

Mazahir Saifee
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Evolution of Trade Theories
‡ Mercantilism ‡ Absolute advantage (Classical) ‡ Comparative advantage

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Mercantilism: mid-16th century
‡ A nation s wealth depends on accumulated treasure ‡ Gold and silver are the currency of trade. ‡ Theory says you should have a trade surplus.
± Maximize exports through ± Minimize imports through tariffs quotas. subsidies. and

‡ Flaw: Zero-sum game .
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Mercantilism: mid-16th century
‡ A nation s wealth depends on accumulated treasure
± Gold and silver are the currency of trade

‡ Theory says you should have a trade surplus.
± Maximize export through subsidies. ± Minimize imports through tariff and quotas

‡ Flaw: restrictions, impaired growth
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Defining mercantilism
` trade theory holding that nations should accumulate financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports
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Assumption of theory
‡ ‡ ‡ ‡

Trade is between two countries. Only two commodities are traded. Free trade exist between the countries. The only element of cost of production is labour.

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Theory of absolute advantage
‡ Adam Smith: Wealth of Nations (1776) argued: ± Capability of one country to produce more of a product with the same amount of input than another country ± A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient ‡ Trade between countries is, therefore, beneficial ‡ Assumes there is an absolute balance among nations
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Theory of absolute advantage
destroys the mercantilist idea since there are gains to be had by both countries party to an exchange ‡ questions the objective of national governments to acquire wealth through restrictive trade policies ‡ measures a nation s wealth by the living standards of its people
‡
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Theory of absolute advantage
PPF ± Production Possibility Frontier

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Criticism
‡ ‡ ‡ ‡ ‡ ‡

No absolute cost advantage Country size Variety of resources Transport cost Scale economies Absolute advantage for many products

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Assumption of the theory
‡ The only element of cost of production is labour. ‡ There are no trade barriers. ‡ Trade is free from cost of production. ‡ Trade takes place only between two countries. ‡ Only two products are traded ‡ There are no cost of transport
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Theory of comparative advantage
‡ David Ricardo: Principles of Political Economy (1817)
± Extends free trade argument ± Efficiency of resource utilization leads to more productivity ± Should import even if country is more efficient in the product s production than country from which it is buying. ± Look to see how much more efficient. If only comparatively efficient, than import.

‡ Makes better use of resources ‡ Trade is a positive-sum game

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Cont
‡ Comparative cost advantage theory states that a country should export those products for which it is relatively more productive than that of other counties and import for which other countries are relatively more productive than it is.

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Theory of comparative advantage

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Comparative advantage and the gains from trade

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Comparative advantage: Bollywood

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Assumptions and limitations
‡ Driven only by maximization of production and consumption ‡ Only 2 countries engaged in production and consumption of just 2 goods? ‡ What about the transportation costs? ‡ Only resource labour (that too, nontransferable) ‡ No consideration for learning theory
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