Siddhartha K.

Rastogi
IIM Indore
 Pre-1500s

 Mercantilism

 Classical Thought

 Factor Endowment Models

 New Trade Theories

 Feudalism: society divided among classes of haves and
have-nots
 Cargo: Unpredictably long, fraught with natural, man-made risks
 No trade theory existed per se

 Production and trade driven by specific regions,

communities, customs, and traditions
 Trade secrets: highly protected as no IPR protection existed

 Trade prevalent and largely open but local taxes varied

 Trade prohibition or protection often demanded
• A collection of economic thought in Europe (primarily Britain
and France) during 1500-1750
• as an intellectual reaction to the problems of the times

• Economic thinking evolved from a simple set of ideas about

individuals, households, and producers
• to a more complicated view of the economy as a system with laws
and interrelationships of its own

• Mercantilist literature of 1650-1750 was of higher quality

• containing nearly all the analytical concepts on which Adam Smith
based his Wealth of Nations (1776)
• Assumption: The total wealth of the world is fixed

• Implication: In trade, the gain of one is necessarily

the loss of another
• International trade is a zero sum game

• Trade as a means of increasing the wealth and power

of a nation
• A country’s wealth is measured by its holdings of precious
metals
• The growth of national wealth can take place only to the
detriment of trading partners
• Advocated increasing the nation’s wealth by simultaneously encouraging
production, maintaining a positive trade balance, and holding down domestic
consumption

• Employed the Labour theory of value

• Promoted low wages to give domestic economy competitive advantages
• Thus, the wealth of the nation rested on the poverty of the many

 Main objective of mercantilist writers was to establish an alliance between

emerging merchant class and dominant aristocracy, to the detriment of
competing nations

 Mercantilist paradigm was quite successful in sustaining the growth of British

economy, and of its manufactures in particular
 However, labour, peasantry, and colonies were exploited for that
• Hume (mid-18th century): maintaining a trade surplus
forever is impossible

• Trade surplus  inflow of specie

• inflow of specie  increased Ms
• increased Ms  higher prices (and wages)
• higher prices  lower exports and higher imports

Across the world, all countries will end up with

balanced trade in long run
 All the economies have full employment of resources
 Quantity Theory of Money ( M.V = P.Y )
 Change in P or Y is critical because…

 Perfect Competition and seamless Adjustments in product

and Factor markets

 Pegged Convertibility through Gold Standard and Perfect

Capital Mobility
• Wealth of nations lies in productive capacity
• Not in the precious metals

• Government intervention hinders invisible hand

• Laissez-faire, markets are efficient

• Trade is a positive-sum game (always?)

• Countries should export those goods which they can produce

efficiently and import those which they cannot
• Dependence on labor theory of value maintained
• If countries trade as per this principle, trade is mutually beneficial
 C o rn B la n k e ts A u ta rk y P ric e
R a tio s (A P R s)
U .S . 1 h o u r /b u 6 h r s /b l 1B = 6C,
1 C = 1 /6 B
M e x ic o 3 h r s /b u 5 h r s /b l 1 B = 5 /3 C ,
1 C = 3 /5 B
• Suppose the U.S. and Mexico agree to trade at a ratio of 1B = 4C (or
1C = ¼ B)

• From the U.S.’s perspective:

 Can now buy blankets at a lower price (1B = 6C in autarky, 1B = 4C in trade)
 Can sell corn at a higher price (1C = 1/6 B in autarky, 1C = ¼ B in trade)

• From Mexico’s perspective:

 Can now sell blankets at a higher price (1B = 5/3C in autarky, 1B = 4C in
trade)
 Can buy corn at a lower price (1C = 3/5 B in autarky, 1C = ¼ B in trade)
•both countries gain from trade; even if certain industries (blanket
industry in U.S., corn industry in Mexico) stand to lose
•Factors shift away within nation but not across nations
•If one country has an absolute advantage in the production of both (or
all) goods, that country cannot gain from trade

Corn Blankets Autarky Price

Ratios (APRs)

U.S. 1 hour/bu 5 hrs/bl 1B = 5C,

1C = 1/5B

Mexico 3 hrs/bu 6 hrs/bl 1B = 2C,

1C = 1/2B
 End goal of economic activity is consumption
 Neither production nor specie collection

 Absolute Advantages not necessary

 Although within national boundaries, AA defines trade patterns
 However, factors are immobile internationally; hence, returns won’t equalize

 Comparative Advantage always exists, whatever be the composition

 Formed the basis of all models to come till date

 Principle – Opportunity cost of resources matters the most
 Just that definition of resources and matrices of items kept on expanding
 Two Country – Two Commodity world
 Constant Returns with fixed technology
 Total resource stock is fixed and fully employed by the two sectors
 And perfectly mobile between the two sectors
 But no mobility across the two countries

 Homogeneity of labour
 All labour within country knows all works equally well
 And labour is the only resource that matters (labour theory of value)
 Across countries, labour may differ (due to technology and natural endowment)

 No Transaction costs
 Nil transportation cost, time, bureaucratic and accounting costs
 Shifting of resources across sectors is also costless

 Perfect markets, No government interference

 Labour Hours Wine Cloth Price Ratio in Autarky
Taken
Portugal 8 9 1W = 8 / 9 C 1 C = 9 / 8W
England 12 10 1W = 6 / 5 C 1 C = 5 / 6W

 Portugal has absolute advantage in both the goods

 But Portugal is more efficient in wine production
 Autarky price ratio of 8/9 < 6/5 (or 9/8 > 5/6)
 i.e. 1 wine costs 8/9 in Portugal but 6/5 in England (and so on)
• England is better off as long as it gets 1 wine for less than 6/5 cloth
• Portugal is better off as long as it gets 1 cloth for less than 9/8 wine
• Ratio in which commodities are exchanged  Terms of Trade

• If ToT is 1 : 1, both benefit

• If ToT is 1w : 1.2c, England is indifferent
• If ToT is 1w : 0.89c, Portugal is indifferent
• ToT must be between these two
 CA isn’t always the basis of trade

 Trade is also driven by

 Relative Factor Abundance (MCx / MCy)
 Relative Prices of Goods (Px / Py)
 Relative Demand Differences (MUx / MUy)
 Relative Technology of Production
 A set of four theorems
 Heckscher – Ohlin Theorem
 Factor Price Equalization Theorem
 Stolper-Samuelson Theorem
 Rybczynski Theorem

 Deals with relative abundance of factors

 How abundance determines relative prices
 How relative prices define trade patterns
 How trade patterns alter relative factor prices
 Countries will export products that use their relatively
abundant factors of production and import products that
use their relatively scarce factor
In equilibrium, With both countries facing the same relative (and absolute) product
prices,

With both having the same technology and constant returns to scale

Relative (and absolute) costs will be equalized,

Effectively meaning factor prices will be equalized across

countries
With full employment (both before and after trade opening)
Increase in the price of the relatively abundant factor
And
Fall in the price of the relatively scarce factor
Implies that
The owners of abundant factor will gain in real income terms
Whereas
The owners of scarce factor will face a fall in real income level.
 As a result of trade, the factor in which the country has abundance
(therefore, a comparative advantage) grows in productivity and in
resource allocation more than the other factor.

 Growth in this factor of production leads to an expansion in the output of

the product that uses that factor intensively

 And an absolute contraction in the output of the product that uses the
other factor intensively.

 It holds true if the growth of this country does not alter the international
price ratio (i.e. true for small country cases)
 Leontief tested the H-O theorem twice
 In 1953, with 1947 data
 In 1956, with 1951 data

 and propounded
 Leontief Paradox
 Leontief Statistic

 Many other similar tests followed. For example:

 Bharawaj (1962) studied India's trade pattern.
 Consistent with HO theory, India's exports were labour-intensive.
 However, Indian exports to the US were capital-intensive, violating H-O.
 Used the 1947 input-output table for the US economy
 Aggregated industries into 50 sectors - 38 traded, 12 non-traded
 Aggregated factors into labour and capital
 Estimated the capital and labour requirements to produce the Ex-Im basket

Capital
Labour Requirement Capital / Labour Ratio
Requirement ($
(man-years) (K/L)
Mn)
Exports aKx = 2.550780 aLx = 182.313 $13,991
Imports aKm = 3.091339 aLm = 170.114 $18,172

 This gave a Leontief Statistic [(K/L)imp]/[(K/L)exp] of (18172/13991)

= 1.2988
 Implying, comparatively, imports are capital-intensive and exports are labour intensive
 Leontief’s choice of 1947 was wrong - post-war economic disorganization
 Leontief repeated the same experiment with 1951 data; found LS of 1.06

 Leontief used the data from US produced versions of the imported goods
 As reliable data from exporting countries was not available
 But this implies, he considered US prices of labour (high) and capital (low)

 Leontief suggested an explanation for this paradox: “US workers may be more
and up to three times as effective than foreign workers”.
 A better K/L ratio in US
 Superior economic organization and economic incentives in the US
 A realistic difference in effectiveness between the representative workers in the US and
those in the foreign countries was found to be about 20-25%
 In recent years, studies using appropriate methods have shown:
 Allowing for demand reversals, FIRs, the tariff structure, and natural
resources as a factor of production may lessen the extent of or eliminate
the paradox
 Allowing for different levels of skill in the labor force does seem to
eliminate the paradox.
 if technological differences and home bias are included in the model
 if the assumption of an integrated world is relaxed
 A substantial effect of relative factor abundance on the commodity
composition of trade is established

 Recent work highlights that there are multiple factors affecting trade
 This leads to new trade theories
 Explain the basis and pattern of trade beyond H-O
 Discuss the role of
 economies of scale

 product differentiation

 technology dissemination

 demand patterns

 time lags

 Demonstrate how the presence of imperfect competition can affect trade

 Describe the phenomenon known as intra-industry trade
 Explore the new economic phenomena of outsourcing, multi-national
companies, and virtual trade