Trade Theories

Trade Theories:
#1 - Mercantilism
Defining mercantilism …
Mercantilism
• According to this theory, a country

should accumulate financial wealth by
building up as many inflows of
“currency” as possible.
Mercantilism: 16th – late 18th century
• A nation’s wealth depends on accumulated

treasure:
• Gold and silver are the currency of trade
• Two means of increasing a country’s wealth

are: colonialism and international trade.
Mercantilism
• Another example of imperialism is called the
Triangle Trade
• After the vast majority of their workforce in
the New World was killed off by smallpox, the
Europeans turned to Africa for a new labor
force
Triangle Trade
The 'Triangular Trade' was so-called because it
was three-sided, involving voyages from:
•England to Africa
•Africa to the Americas
•The Americas back to England
Triangle Trade
The Triangular Trade is a term used to describe
the trade occurring between England, Africa,
and the Americas. The trade fell into the three
categories:
•The raw materials and natural resources such
as sugar, tobacco, rice and cotton that were
found in the 13 colonies - also refer to
Colonialism
Triangle Trade
• Manufactured products from England and
Europe such as guns, cloth, beads
• Slaves from West Africa, many of whom toiled
in the Slave Plantations
Triangle Trade
Mercantilism
• Slaves were bought in Africa using gold and sugar
from America
• Those slaves were used to produce raw materials
and cash crops (sugar, cotton, tobacco) to be shipped
back to Europe.
• The factories produced manufactured goods
(textiles, rum, etc.) to be sold to Africa and America
Mercantilism
• Mercantilism is an economic theory and
practice where the government seeks to
regulate the economy and trade in order to
promote domestic industry – often at the
expense of other countries
• Mercantilism is associated with policies which
restrict imports, increase stocks of gold and
protects domestic industries
Mercantilism
• A system of government institutions and

policies designed to restrict international
trade:
– Maximize exports through subsidies
– Minimize imports through tariffs and quotas
• The theory therefore says that a country should

always have a trade surplus
Mercantilism: Policies
• Forbidding colonies to trade with other nations
• Monopolizing markets with staple ports;
• Forbidding trade to be carried in foreign ships;
• Maximizing the use of domestic resources;
• Also restricting domestic consumption with non-tariff

barriers to trade.
Mercantilism – 9-point plan
• That every inch of a country's soil be utilized for

agriculture, mining or manufacturing.
• That all raw materials found in a country be used in
domestic manufacture, since finished goods have a
higher value than raw materials.
• 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.
• That as much as possible, imports be confined to

raw materials that can be finished [in the home
country].
• That opportunities be constantly sought for selling a
country's surplus manufactures to foreigners, so far
as necessary, for gold and silver.
• That no importation be allowed if such goods are
sufficiently and suitably supplied at home.
Mercantilism: Flaws
• Impaired economic growth
• Ignores living standards
• Ignores human development

Trade Theories:
#2 - Absolute Advantage
Adam Smith and the
Attack on Mercantilism and Economic
Nationalism
• In 1776, Adam Smith published the first modern statement of

economic theory, An Inquiry into the Nature and Causes of the
Wealth of Nations
– The Wealth of Nations attacked mercantilism—the system
of which dominated economic thought in the 1700s
– Smith proved wrong the belief that trade was a zero sum
game—that the gain of one nation from trade was the loss
of another
– On the other hand… Voluntary exchange (trade) is a
positive sum game —both nations can gain
Theory of absolute advantage
• Adam Smith ideas based on…

– The capability of one country to produce more
of a product with the same amount of input
than another country
– (same thing) The ability of a country to produce

a good using fewer resources than another
country (lower opportunity cost)
• Adam Smith argued:

– 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

• … 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.
• … also measures a nation’s wealth by the
living standards of its people.
TRADE BASED ON
ABSOLUTE ADVANTAGE
• Consider this “simple” example involving the EU and
India
• Only two products are produced, machines and
cloth
• Labor is fixed, homogeneous within a country, the
only factor of production, and is fully utilized
• Technology and production costs are constant
• Transportation costs are zero and the countries
barter (trade) for goods
TRADE BASED ON
ABSOLUTE ADVANTAGE
One Person Per Day of Labor

Produces
Country Machines Cloth
10 yards of
EU 5 machines
cloth
15 yards of
India 2 machines
cloth
THE PRODUCTION POSSIBILITIES FRONTIER
AND CONSTANT COSTS
• The Production Possibilities Frontier (PPF) is a curve

showing the various combinations of two goods that
a country can produce when all of a country’s
resources are fully employed and used in their most
efficient manner.
One Person Per Day of Labor Produces
EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth

Production Possibilities Curves for the United States and India
Machines
Cloth
10 15
EU
India
Cloth Mach
Cloth Mach
10 0
15 0
8 1
7.5 1
6 2
0 2
4 3
2 4
0 5
“Opportunity Cost” also known as “Relative Price”
India - Opportunity Costs EU - Opportunity Costs
Machine = 7.5 cloth Machine = 2 cloth

Cloth = 0.133 machine Cloth = 0.5 machine
Same graph, drawn more to scale!
What Determines the Slope of the PPC?

Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
This slope is also known as the … Marginal Rate of Transformation
Machines
EU: Slope = Opportunity Cost = -0.5
India: Slope = Opportunity Cost = -0.133

5
2
Cloth
10 15
Absolute Advantage: Production conditions when
each country is more efficient in the
production of one commodity.
• EU workers are more productive in producing

machines
• The EU has an absolute advantage in machine
production
• Indian workers are more productive in producing

cloth
• India has an absolute advantage in cloth
production
TRADE BASED ON
ABSOLUTE ADVANTAGE:
trade is mutually beneficial……………….

What does this mean?

What ???
• Adam Smith: Wealth of Nations (again)

argued:
– A country should produce only goods where

it is most efficient, and trade for those
goods where it is less efficient
Assume TWO Persons per day, so that each product can be fully produced
Two Persons Per Day of Labor Produces

EU 5 machines (and) 10 yards of cloth
India 2 machines (and) 15 yards of cloth
World Output 7 machines (and) 25 yards of cloth
This is a condition under Autarky: (The

complete absence of trade)
•Under Autarky all nations can only

consume the goods they produce at
home
Assume TWO Persons per day, so that each product can be fully produced

However, if each country produces to their absolute advantage …below…

India 0 machines 30 yards of cloth .

.
TRADE BASED ON
ABSOLUTE ADVANTAGE
So there has obviously been an increase in World Output!!
Change in the Production of
EU +5 machines –10 yards of cloth
India –2 machines +15 yards of cloth
Change in World Output +3 machines +5 yards of cloth
.
TRADE BASED ON
ABSOLUTE ADVANTAGE
• Both countries can benefit if trade

occurs
– EU produces machines and exports them

to India
– India produces cloth and exports it to the
EU


.
Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?
.
India - Opportunity Costs EU - Opportunity Costs
Machine = 7.5 cloth Machine = 2 cloth

Cloth = 0.133 machine Cloth = 0.5 machine
World Price
Back to our opportunity costs (above) Trade will
occur at a trading price … World Price …which
will occur between these respective “Relative
Prices”… Also called the “Terms of Trade”
m m m
P IND (7.5)  P  P (2)
W EU
c c c
P (0.5)  P  P
EU W IND (0.133) Look…
Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
This slope is also known as the … Marginal Rate of Transformation
c c c
P (0.5)  P  P
EU W IND (0.133)
Machines
EU: Slope = Opportunity Cost = -0.5
India: Slope = Opportunity Cost = -0.133

5
Pw
2
Cloth
10 15
Introduction: The Gains from Trade
• The improvement in national welfare (for

both countries) is known as the gains
from trade
Implications of Adam Smith’s Theory
• Access to foreign markets helps create wealth

– If no nation imports, every company will be limited by
the size of its home country market
– Imports enable a country to obtain goods that it cannot

make itself or can make only at very high costs
– Trade barriers decrease the size of the potential

market, hampering the prospects of specialization,
technological progress, mutually beneficial exchange,
and, ultimately, wealth creation
Adam Smith and Trade Barriers
• Smith was highly critical of trade barriers (Tariffs,

Quotas, Subsidies…)
• Trade barriers decrease

- Specialization
- Technological progress
- Wealth creation
• The modern view of trade shares Smith’s dislike for

trade barriers
2-Country Scenario

Produces
U.S. 5 machines 15 yards of cloth
India 1 machine 5 yards of cloth
U.S. has an Absolute Advantage in both goods.

Production Possibilities Curves for the United States and India
Machines
Graphically obvious …
U.S. has an Absolute Advantage in both goods.
1
Cloth
5 15
One country has Absolute Advantage
in BOTH goods
• In this scenario, there is obviously no

opportunity to trade… especially not for U.S.
Trade Theories:
#3 - Comparative Advantage
Theory of Comparative Advantage
• David Ricardo: Principles of Political Economy (1817)
– Extended free trade argument
– Should import even if the 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, then import.
TRADE BASED ON
COMPARATIVE ADVANTAGE
• Why would trade occur if one country had an

absolute advantage in both goods?
• Comparative Advantage is the ability of a country to

produce a good at a lower opportunity cost than
another country
• We compare the degree of absolute advantage or

disadvantage in the production of goods
Comparative Advantage: U.S. More Efficient
in the Production of Both Commodities

Produces
U.S. has bigger Absolute Advantage in production of Machines
US - Opportunity Costs India - Opportunity Costs
1 Machine = 3 cloth 1 Machine = 5 cloth

1 Cloth = 0.33 machine 1 Cloth = 0.2 machine
TRADE BASED ON
• The U.S. has a greater absolute advantage in
producing machines than it does in producing
cloth (5x more efficient in machines … only 3x
more efficient in cloth).
• India’s absolute disadvantage is smaller in

producing cloth than in producing machines.
• Thus the U.S. has a comparative advantage in

machines and India has a comparative advantage
in cloth.
TRADE BASED ON
OPPORTUNITY COSTS
• Even though U.S. has an absolute advantage
in both goods, India has a comparative
advantage in cloth production;
• Even if U.S. has an absolute advantage in both
goods, beneficial trade is possible;
• If both countries specialize according to their
comparative advantage, they both can gain
from this specialization and trade.
Since we are dealing with Opp. Costs, we
will compare across 15 yards of cloth
One person Per Day of Labor Produces
Let us allow India to produce cloth up to the level that the U.S. can…

U.S. 5 machines -15 yards of cloth
India (3 days) -3 machines (per) 15 yards of cloth
World Output +2 machines 0 cloth
.
TRADE BASED ON
Change in World Output Resulting from Specialization

According to Comparative Advantage
Change in the Production of
U.S. +5 machines –15 yards of cloth
India –3 machines +15 yards of cloth
Change in World Output +2 machines 0 yards of cloth

Trade in the Ricardian Model
(cont.)
• A country can be more efficient in producing
both goods, but it will have a comparative
advantage in only one good.
• Even if a country is the most (or least) efficient

producer of all goods, it still can benefit from
trade.
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for
Selected Sectors, 2000 (Ratios relative to the U.S.)
Food Electrical Transport
Country Products Textiles Clothing Machinery Equipment
Argentina 1.95 1.28 0.64 2.11 1.78
Bolivia 0.61 0.76 0.65 1.00 1.34
Brazil 0.74 0.65 0.47 0.81 0.53
Chile 0.80 0.89 0.51 0.90 0.74
Columbia 0.62 0.66 0.47 1.01 0.97
Cote d’Ivoire 1.50 1.06 1.02 1.34 1.69
Ecuador 0.88 0.30 0.34 1.20 0.55
Egypt 1.45 1.21 0.38 1.10 0.71
Ghana 0.82 0.96 0.60 0.39 1.63
India 1.29 1.57 0.47 0.98 1.43
Indonesia 1.71 0.42 0.45 0.62 0.26
Kenya 1.31 2.20 0.96 0.74 3.34
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for
Selected Sectors, 2000 (Ratios relative to the U.S.)
Food Electrical Transport
Country Products Textiles Clothing Machinery Equipment
Malaysia 1.08 0.59 0.84 1.01 0.69
Mexico 0.90 0.88 0.64 1.06 0.43
Morocco 1.61 1.38 1.05 1.49 0.92
Nigeria 0.29 0.80 0.11 0.56 0.04
Peru 1.02 0.62 0.46 0.95 0.50
Philippines 0.65 0.67 0.59 0.80 0..40
Korea 0.73 0.63 0.62 0.56 0.71
Taiwan 1.93 1.45 0.80 1.81 1.17
Thailand 0.92 0.87 1.07 0.65 0.41
Turkey 1.09 0.96 0.43 0.97 0.65
Uruguay 1.64 0.74 0.69 1.52 1.22
Venezuela 0.93 0.72 0.49 0.68 0.17
DYNAMIC GAINS FROM TRADE
• Static gains from trade are gains in world

output that result from specialization and
trade.
• Dynamic gains from trade are gains from

trade over time that occur because trade
induces greater efficiency in the use of
existing resources.
Assumptions and limitations
• Driven only by maximization of production
and consumption;
• Only 2 countries engaged in production and
consumption of just 2 goods;
• No transportation cost is considered;
• Only resource–labor (that too, non-
transferable); and
• No consideration for ‘learning theory’.
One more time for practice…
Output per hour of “team”

Country Cars Steel (tons)
Japan 2 2
Malaysia 0.5 1
Do you see any Absolute Advantages?
Do you see any Comparative Advantages?
Japan - Opportunity Costs Malaysia - Opportunity Costs
1 car = 1 steel 1 car = 2 steel

1steel = 1 car 1steel = 0.5 car
Output per Hour Worked

Produces
Japan 2 2
Malaysia 0.5 1
Let us allow Malaysia to produce steel up to the level that Japan can…

Produces
Japan 2 2
Malaysia 1 2
World Output +1 0
Gains from Trade with
Summation …
• Japan has an absolute advantage in both cars (2>0.5)

and steel (2>1), yet it can still gain from trade, as can
Malaysia
• Once trade opens, the world price of cars will be
between one and two tons of steel per car
Japan’s Price… … Malaysia’s Price

Terms of Trade and Gains from Trade
• The closer the terms of trade are to one
country’s pre-trade price ratio, the greater the
gain for the other country.
• Importance of being unimportant—when
small countries trade with big countries, the
small countries are likely to enjoy most of the
mutual gains from trade.
Evaluation of the Classical Model
• The model does not explain why differences in productivity

levels between countries exist.
• It makes extreme and unrealistic predictions such as countries
will completely specialize in the production of exportable only.
• It maintains that the gains from trade are greater between
countries of dissimilar production technologies (despite the
fact that most trade occurs between DCs with similar
technology and income levels).
Evaluation (cont.)
• The classical model is a useful tool because:

– It provides a motive for trade between developed
and developing countries
– It explains why high-wage countries may still
benefit from trade even when faced with low-
wage competing countries
Summary of the Comparative Advantage
Model
• It is not necessary for a country to possess absolute
advantage in order to participate in trade. What is
required is comparative advantage in production.
• A country will specialize in and export that good in which

its has comparative advantage, i.e., has a lower pre-
trade relative price than in the other country.
• The terms of trade or world price will settle between the

autarky prices of the two countries and is determined by
reciprocal demand.

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Trade Theories:

• According to this theory, a country

• A nation’s wealth depends on accumulated

• Two means of increasing a country’s wealth

• A system of government institutions and

• The theory therefore says that a country should

• Forbidding colonies to trade with other nations

• Monopolizing markets with staple ports;

• Forbidding trade to be carried in foreign ships;

• Maximizing the use of domestic resources;

• Also restricting domestic consumption with non-tariff

• That every inch of a country's soil be utilized for

• That all export of gold and silver be prohibited and

• That as much as possible, imports be confined to

• Impaired economic growth

• Ignores living standards

• Ignores human development

• In 1776, Adam Smith published the first modern statement of

• Adam Smith ideas based on…

– (same thing) The ability of a country to produce

• Adam Smith argued:

• Trade between countries is, therefore, beneficial

One Person Per Day of Labor

Country Machines Cloth

• The Production Possibilities Frontier (PPF) is a curve

One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines 10 yards of cloth

India 2 machines 15 yards of cloth

Country Machines Cloth

EU 5 machines 10 yards of cloth

India 2 machines 15 yards of cloth

Production Possibilities Curves for the United States and India

Machine = 7.5 cloth Machine = 2 cloth

What Determines the Slope of the PPC?

This slope is also known as the … Marginal Rate of Transformation

EU: Slope = Opportunity Cost = -0.5

India: Slope = Opportunity Cost = -0.133

• EU workers are more productive in producing

• Indian workers are more productive in producing

One Person Per Day of Labor Produces

What does this mean?

• Adam Smith: Wealth of Nations (again)

– A country should produce only goods where

Two Persons Per Day of Labor Produces

This is a condition under Autarky: (The

•Under Autarky all nations can only

Two Persons Per Day of Labor Produces

However, if each country produces to their absolute advantage …below…

Two Persons Per Day of Labor Produces

India 0 machines 30 yards of cloth .

So there has obviously been an increase in World Output!!

Change in the Production of

Country Machines Cloth

EU +5 machines –10 yards of cloth

India –2 machines +15 yards of cloth

Change in World Output +3 machines +5 yards of cloth

• Both countries can benefit if trade