INTRODUCTION

The idea of gains from trade has a long history that began when people started exchanging goods
and services. The Mercantilist school of thought dominated economic thinking in Europe in the 16th
century, advocating for a favourable balance of trade to accumulate gold and silver, which was
challenged in the 18th century by Classical economic thinkers who argued that a nation's
productivity was the key to wealth. They introduced the theory of comparative advantage, which
suggests that nations should specialize in producing goods and services they can produce efficiently
and then trade for goods and services they cannot produce. Today, the benefits of trade are widely
recognized, but debates about trade policies continue.

MERCANTILISM
• Mercantilism was an economic system practiced in Europe between 1500-
1700 that emphasized a positive balance of trade (exports greater than
imports) to accumulate gold and silver reserves and promote domestic
industry.
• The Zero-Sum Game is the belief that international trade is a win-lose game,
where one country's gain is another country's loss.
• The Labour Theory of Value states that the value of a good is determined by
the amount of labour required to produce it.
• Mercantilists believed in maintaining a favourable balance of trade, achieved
by exporting more than importing. This would result in an inflow of gold and
silver, which was seen as a measure of a country's wealth.
• The role of government in Mercantilism was to promote exports and
discourage imports through various policies and regulations.
• Bullionism was the policy of controlling precious metals to ensure a positive
balance of trade. The government would often prohibit the export of precious
metals and impose tariffs on imported goods to promote domestic industry.
• The objective of Mercantilist policy was trade maximization, where the country
would export as much as possible and import as little as possible.
• Mercantilist policy involved the regulation of economic activity, especially
manufacturing, to ensure that the country produced everything it needed and
did not have to rely on imports.
• Mercantilists believed in a low wages policy to keep production costs low,
which would allow the country to produce goods more cheaply and compete
more effectively in international markets.
• Mercantilists believed in the importance of saving to finance wars and other
government activities. The government would often encourage saving and
discourage consumption to maintain a surplus.

CHALLENGE TO MERCANTILISM
 • Mercantilism emphasized the importance of a favourable balance of trade,
where a country exports more than it imports, to accumulate gold and silver
reserves.
• David Hume proposed the Price-Specie-Flow Mechanism to explain how trade
imbalances can correct themselves: ΔMS = ΔX - ΔM where ΔMS is the change
in the money supply, ΔX is the change in exports, and ΔM is the change in
imports.
• Adam Smith argued that a country's wealth was not determined by the
amount of gold and silver it possessed but by the productivity of its economy.
• Smith proposed the Invisible Hand Principle, which suggests that individuals
pursuing their own self-interest can promote the general welfare of society.
The principle applies to international trade, where free trade allows individuals
to pursue their comparative advantages, leading to increased specialization
and efficiency.
• Smith also proposed the Quantity Theory of Money: MV = PY where M is the
money supply, V is the velocity of money, P is the price level, and Y is real
output.
• Smith's theory of Absolute Advantage suggests that a country should
specialize in producing goods that it can produce more efficiently than other
countries and trade those goods for goods it cannot produce efficiently. The
formula for absolute advantage is: A_XY < 1, where A_XY is the unit labor
requirement of country X relative to country Y in producing good Y.
• David Ricardo developed the theory of Comparative Advantage: A_XY < A_YX
<br>where A_XY is the opportunity cost of producing good X in country Y
and A_YX is the opportunity cost of producing good Y in country X.
• The theory of Comparative Advantage suggests that trade can benefit all
countries involved, even if one country is more efficient than the others in
producing all goods.
• The theory of Comparative Advantage implies that trade can increase the total
output of goods in the world and improve the welfare of all countries
involved.
• Laissez-Faire is the doctrine that the government should not intervene in
economic affairs, including international trade.
Summary
• Chapter 2 discusses two important economic systems in history: Mercantilism
and the Challenge to Mercantilism.
• Mercantilism was an economic system practiced in Europe between 1500-
1700 that emphasized a positive balance of trade, the accumulation of gold
and silver reserves, and the promotion of domestic industry.
• Mercantilist governments employed various policies and regulations, including
Bullionism and the regulation of economic activity, to achieve their objectives.
• The Challenge to Mercantilism emerged in the 18th century with the work of
economists like David Hume and Adam Smith.
• The Price-Specie-Flow Mechanism, the Quantity Theory of Money, and the
concept of Comparative Advantage were key ideas that challenged the
principles of Mercantilism.
• The Challenge to Mercantilism paved the way for the development of free
trade and globalization in the 19th and 20th centuries.