CHAPTER 2 CLASSICAL TRADE THEORY

 The development of Mercantilist thought

 David Hume’s price-specie-flow mechanism

 The theory of absolute advantage

 The theory of comparative advantage

§1 Mercantilism
 The school of economic thought that came into existence in Europe
during the period from 1500 to 1750.
 The political economy of state building. Nation: cultura
l entity.
State: political
1. The development of mercantilist thought entity.

(1) Geographical explorations (in the late 15th century)

 Provided new opportunities for trade.
 Colonial systems of the European nation-states established.
 Wealth was needed to maintain the system.
 Colonialism went hand in hand with the evolving exchange of
goods among the European countries themselves.
(2) The collapse of feudal society and the rise of the merchant class
Feudal society: A state of autarky, a society that did not trade.

Merchants began meeting in the marketplace.

Travelers began exchanging goods

from faraway places at the water's edge.

TRADE WAS ATTRACTIVE!


The following also contributed to the development
of Mercantilist thought:

 Upsurge in population
 Impact of the Renaissance on culture
 Discovery of precious metals in the New World
 Changing religious views on profits and
accumulation
 Rise of nation-states
2. The mercantilist economic system

 (1) National wealth

 (2) Economic activity: zero-sum game.

(One country's economic gain was at the expense of another)

 (3) Accumulation of wealth through trade.

Favorable balance of trade would help to earn gold.

3. Economic policies pursued by the mercantilists

 (1) Controlled the use and exchange of precious metals.

 (2) Prohibited the export of precious metals by individuals,
rulers let specie leave the country only out of necessity.
 (3) Smugglers of specie were subject to swift punishment,
often death.
 (4) Exclusive trading rights for certain routes or areas were
The Dutch East India Trading Company
given to specific companies.
 (5) Subsidize exports, restrict imports of consumption goods.
4. Discussions

 While the mercantilists' doctrines seem naive today, they

undoubtedly seemed logical in the period from 1500 to 1750.

 Frequent warfare lent ( 增添 ) credibility to maintaining a powerful

army and merchant marine .

 The legitimization and growing importance of saving by the

merchant class could easily be extended to the behavior by the
state, making the accumulation of precious metals seem equally
reasonable.
§2 David Hume’s Challenge to Mercantilism

1. Assumptions of price-specie-flow mechanism

 MSV = PY (quantity theory of money)

 Demand for traded goods is price elastic.
 Perfect competition in both product and factor markets.
 A gold standard exists.
(All currencies are pegged to gold and hence to each
other)
2. The price-specie-flow mechanism

A logical argument by David Hume against the mercantilist idea

that a nation should strive for a positive balance of trade, or net
exports.

An automatic trade balance adjustment:

 Exports > Imports (favorable balance of trade).

 Gold flow into the country (Amount = Exports- Imports).

 Money supply would rise.

 Prices of products would rise. Exports decrease, imports increase.

(balance of trade altered till zero)
§3 Adam Smith’s Theory of Absolute Advantage

 Adam Smith published The Wealth of Nations

in 1776 in London.

 Adam’s two main areas of contribution:

absolute advantage and the division of labor.

 Absolute advantage: ability to produce the

same products as others with fewer labor
hours.
1. Assumptions of the theory of absolute advantage

 (1) Only two countries and two products in the world.

 (2) Each country has a fixed endowment of resources.
 (3) Factors of production are completely mobile within a country.
 (4) Factors of production are completely immobile between
countries.
 (5) A labor theory of value is employed.
 (6) The level of technology is fixed for both countries, although
the technology can differ between them.
 (7) Costs of production are constant.
 (8) There is full employment.
 (9) The economy is characterized by perfect competition.
 (10) There is no government imposed obstacles to economic
activity.
 (11) Internal and external transportation costs are zero.
2. Challenge to Mercantilism
 (1) A nation's wealth was reflected in its productive capacity.
(ability to produce final goods and services)

 (2) Specialization would generate productivity gains. Increased

division and specialization of labor would generate productivity gains.
Conclusion: A country should specialize in and export those goods it
produced more efficiently because absolute labor required
per unit was less than that of the prospective trading
partner.

 (3) Free environment. Growth in productive capacity was fostered

best in an environment where people were free to pursue their
own interests. A government policy of laissez faire would best
provide the environment for increasing a nation's wealth.
(laissez faire [lei′sei′feər]: allowing individuals to pursue their own activities
within the bounds of law and order and respect for property rights)
1
3

• 3. Example

Labor requirements and absolute advantage in Britain and Portugal

Cloth Wine Price ratio in autarky
Britain 1 hr./yd. 4 hrs./bbl. 1W : 4C (or 1C : 1/4 W)
Portugal 2 hrs./yd. 3 hrs./bbl. 1W : 2/3 C (or 1C : 2/3 W)

Absolute advantage: Britain in cloth, Portugal in wine.

Exchange ratio: 1W: 3C

Britain: Obtaining wine in Portugal for only 3 yards of cloth per barrel
instead of 4 yards at home.
Portugal: Acquiring cloth for a cost of only 1/3 barrel of wine instead of 2/3
barrel of wine at home.
§4 David Ricardo’s Theory of Comparative Advantage

1. The concept of comparative advantage

 David Ricardo, in his 1819 work entitled On the Principles

of Political Economy and Taxation

 Comparative advantage: The ability of a country

to produce a particular good at a lower relative
cost than another country.

 Comparative advantage can be determined by

relative labor productivity, relative cost or
opportunity cost.
(1) Determined by relative labor productivity

Rrelative labor productivity of Product A (to Product B)

Labor productivity of Product A (Q A /L)

Labor productivity of Product B (Q B /L)

If (QA/L)/(QB/L) in Country I is HIGHER than in Country II,

then Country I has a comparative advantage in Product

A.
(2) Determined by relative cost

Relative cost of Product A (to Product B)

Amount of input for prducing one unit of Product A (aLA )
=
Amount of input for producing one unit of Product B (aLB )

If aLA/aLB in Country I is LOWER than in Country II,

then Country I has a comparative advantage in Product A.

(3) Determined by opportunity cost

Decreased quantity of Product B ( ΔQB )

Opportunity cost of Product A =
Increased quantity of Product A ( ΔQ A )

If △QB/△QA in in Country I is LOWER than in Country II,

then Country I has a comparative advantage in Product A.

2. Example
Table 2-3 Labor requirements and absolute advantage in Britain and
Portugal prior to division of labor
Wine Cloth Price ratio in autarky
Portugal 80 hrs./bbl. 90 hrs./yd. 1W : 8/9C (IC : 9/8W)
Britain 120 hrs./bbl. 100 hrs./yd. 1W : 6/5C (1C : 5/6W)

Table 2-4 Comparative advantage determined by relative labor productivity,

relative cost and opportunity cost
Wine (to cloth) Wine Cloth (to wine) Cloth
Relative Relative Opportunity Relative Relative Opportunity
labor cost cost labor cost cost
productivity productivity

Portugal 9/8 8/9 8/9 8/9 9/8 9/8

Britain 5/6 6/5 6/5 6/5 5/6 5/6
Portugal: a comparative advantage in wine;
Britain: a comparative advantage in cloth.
Ricardo’s theory of comparative advantage holds:

 The relative cost differences arising from technology differences

give rise to trade.
 A country can benefit from export if only it has a comparative
advantage in the production of the exporting product.
 A country may have no absolute advantage in all products.
However, it surely has a comparative advantage in a particular
product.
 Therefore, any country will have a product to export and gain from
international trade.
Two ways to illustrate the gains from trade:

• In terms of labor time saved (at 1W:1C)

Britain: 100 hours to produce 1C, exchange for 1W

which requires 120 hours to produce at home,
thus saves 20 hours.

Portugal: 80 hours to produce 1W, exchange 1C which

requires 90 hours to produce at home, thus saves
10 hours.

1W: 1.1C ?
(2) In terms of more goods obtained

Table 2-5 Wine and cloth obtained by Portugal and Britain after division of labor
Wine Cloth
Portugal (80 hrs+90 hrs.) / 80 = 2.125 bbl.
Britain (100 hrs + 120 hrs.) / 100 = 2.2
yds.

Table 2-6 More wine and cloth obtained by Portugal and Britain after trading at
1W:1C
Wine Cloth
Portugal 1.125 bbl. 1 yd.
Britain 1 bbl. 1. 2 yds.

Portugal would gain 0.125 barrel more of wine;

Britain would gain 0.2 yard more of cloth.
3. Analysis of the theory of comparative advantage by using
modern tools
(1) Tools to be used

① Production possibility curve (frontier) PPF

Y A graph that reflects all the
combinations of products
that a country can produce
A
given its resources are fully
utilized.
Y1 ·D A straight line of slope
· E represents the opportunity
C· costs of production are the
same at the various levels
Y2
· F of production.

0 X1 X2 B X
Production possibility curve
Y Y

PPF of Country II
A PPF of Country I

0 B X 0 B X

The slope of line AB in the left figure is smaller than the slope of line AB in
the right figure, indicating that the opportunity costs of good X in
Country I are smaller than in Country II and Country I has a comparative
advantage in good X while County II has a comparative advantage in
good Y.
② Community indifference curves
An illustration of various
combinations of two
Y commodities that yield the
same level of well-being
for the community (or
country) as a whole.
CIC3
A The (negative of the) slope
Y1 · B
CIC2
at any point on an
Y2 · CIC1 indifference curve is called
the marginal rate of
0 X1 X2 X substitution.
Community indifference curves (MRS=MUX/MUY)

The indifference curve is

down-sloping and convex
to the origin, meaning a
diminishing MRS..
(2) Equilibrium analysis
① General equilibrium in autarky

 The equality of supply and demand in all markets of an

economy simultaneously.
 In autarky, a country achieves general equilibrium at the
point where its CIC is tangent to the slope of its PPF (MRT).
 MRT (Transformation): The rate at which a producer is able to
substitute a small amount of one input-variable for a small amount
of another.

 MRT = (MCX/MCY) = (PX/PY) = (MUX/MUY) = MRS

② Introduction of trade

Y Y

CIC2 B′ CIC’1 CIC’2

CIC1

Country I Country II

Y2
• E Y'2 • E’
A Y'1 •· A’
Y1 •
Pw
P’ X/Y Pw
PX/Y
0 X1 X2 X 0′ X'2 X
X'1
Equilibrium points and gains in autarky Equilibrium points and gains in
and with trade for Country I when autarky and with trade for
opportunity costs of production are the Country II when opportunity costs
same. of production are the same.