1. Theory of Mercantilism
Mercantilism is a trade theory holing that a country’s wealth is measured by its holdings of “treasure” which usually means its gold. The mercantilists proposed theory of mercantilism. They were a group of economists who preceded Adam Smith. The foundations of economic thought between 1500 and 1800 were based on mercantilism. Mercantilists believed that the world had a finite store of wealth; therefore, when one country got more, other countries had less. Mercantilists restricted imports and encouraged or subsidized exports as a conscious policy to make their citizens better off. Mercantilists judged the success of trade by the size of the trade balance.
Mercantilism was a sixteenth-century economic philosophy that maintained that a country’s wealth was measured by its holdings of gold and silver. This required that the countries to maximize exports and minimize imports. The logic was transparent to sixteenth-century policy makers that if foreigners bought more goods from us than we bought from them, then the foreigners had to pay us the difference in gold and silver, enabling us to amass more treasure. With that treasure we could expand the nation’s global influence.
Mercantilists pressed for favorable balance of trade (BOT) or balance of payments (BOP) as against the unfavorable one. In a way it is good because your currency appreciates with mounting surplus on the Fore front, and the country can attract more foreign capital infusion further strengthening the country’s economy, infrastructure, etc. Now China and Japan with enormous favorable BOT and BOP get all the benefits envisaged by mercantilists.
According To Adam Smith-
-Mercantilism is an economic theory popular in the 1500s and was the biggest reason for Europe’s desire to colonize new lands – the theory states that there is a certain amount of wealth in the world and it is in a nations best interest to accumulate it – through wealth, a nation can achieve power
– a country achieves wealth through producing and exporting more good then they import – this theory was invented to serve the interest of the empire, not the colony
Evaluation of Mercantilism Theory:
Mercantilist writers have been lauded and criticized in the literature on foreign trade at least since Hume’s Political Discourses in 1752. Mercantilists have been criticized for everything from their views regarding the gains from trade to their self-promotion of the merchant’s role in society as being important. Mercantilist writers assumed that the economy will generally operate at a pace that leaves resources –land and labor – idle, but in reality the economy naturally tends to full employment. This is a “flaw” in the logical foundation of mercantilist thought. The regime of WTO has moved the world away from mercantilism by pressing for free trade with reduced protectionism.
Theory of Neo-Mercantilism:
Mercantilism is still in vogue. Mercantilist policies are politically attractive to some firms and their workers, as mercantilism benefits certain members of society. Modern supporters of these policies are known as neo-mercantilists, or protectionists. The neo-mercantilists want higher production through full employment and that every industry produces an exportable surplus leading to favorable BOT. Consciously or otherwise, every country is concerned about increasing export earnings. The merits of surging Fore surplus built through exports speaks well of a country’s capability to cater to world’s needs qualitatively, quantitatively and in varied product/service ranges. Every country does what is possible to meet this end. But the modern trade emphasis is ‘Export more and Import more’.
The main economic system used during the sixteenth to eighteenth centuries. The main goal was to increase a nation’s wealth by imposing government regulation concerning all of the nation’s commercial interests. It was believed that national strength could be maximized by limiting imports via tariffs and maximizing exports. This approach assumes the wealth of a nation depends primarily on the possession of precious metals such as gold and silver. This type of system cannot be maintained forever, because the global economy would become stagnant if every country wanted to export and no one wanted to import. After a period of time, many people began to revolt against the idea of mercantilism and stressed the need for free trade.
Mercantilism is a theory developed by the merchants; hence the name. It rests on the role of a strong state in supporting (state-granted) monopolies and protecting shipping and trading lanes. Mercantilism encourages exports and discourages imports. Gold and silver are used to keep score of the game played between nation-states, and represent the wealth of the nation.
2. Absolute Advantage theory
Adam Smith, in The Wealth of Nations, postulated that under free trade, each nation should specialize in producing those goods that it could produce most efficiently. Some of these would be exported to pay for the imports of goods that could be produced more efficiently elsewhere.
Smith ridiculed the fear of trade comparing nations to households. Since every household finds it worthwhile to produce only some of its needs and to buy others with products it can seal, the same should apply to nations:
It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The Taylor does not attempt to make his own shoes, but buys them from shoemaker… What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with some part of the product of our own industry, employed in a way in which we have some advantage.
The theory of absolute advantage is based on the assumption that the nation is absolutely better (i.e., more efficient) at production of certain goods than are its trading partners. Smith showed by his example of absolute advantage that both nations would gain from trade.
ADAM SMITH’S TRADE THEORY OF ABSOLUTE ADVANTAGE:
The first classical theory of international trade was propounded by Adam Smith, the founder of classical economics. His theory is known as the Theory of Absolute Advantage.
It may be possible for all the countries to produce all the commodities they need, in spite of resource constraint. But, the cost of production of goods for which a country is deficient in its resources would be exorbitantly high. It is better to import such goods rather than produce them. Most Countries therefore tend to specialize in producing commodities in which they have absolute advantage in cost of production. Therefore, most countries export goods which they can produce at a lower cost and import what they can produce’ at a higher cost. This common sense logic of international division of labor suggested by Adam Smith marks the beginning of modern theories of foreign trade.
The theory of absolute advantage states that the basis of trade between the nations is the absolute advantage a country has in producing a commodity over the other countries. In simple words, two countries are able to trade between them because each one of them is able to produce at least one commodity at a comparatively lower cost.
The theory of absolute advantage was advanced to buttress Smith’s argument that if there was no government involvement in trade, and if each individual was left to do what in his or her own best interest, then there would be more goods and services available, prices would be reduced, and the wealth of each nation, measured as the welfare of the citizens, would increase. Smith’s theory was offered to replace mercantilism. The Theory of Absolute Advantage and the Theory of Comparative Advantage rest on very strong assumptions, as follows:
Two countries, two commodities – assumed in both theories. The theories are obvious for this case. The three-by-three case (and those beyond) cannot be established analytically, and it is not even clear how the principle should be formalized. (See p. 3 of Ronald Jones, “The Positive Theory of International Trade,” Handbook of International Economics, R. Jones and P. Kenen (eds.), 1984.)
Efficiency objective – The Absolute and Comparative Advantage theories assume that total world production, and therefore efficiency, is the objective. Efficiency is not always a country goal.
Zero Transportation Costs – both theories presume that transportation costs between and within countries are zero.
Factor Mobility/Immobility – both theories presume that resources are absolutely mobile within a country and absolutely immobile between countries.
Full employment – Both theories assume full employment in each country.
Comparative Advantage versus Absolute Advantage:
As we can see from the example above, a country can have a comparative advantage in producing a good even if it is absolutely less efficient at producing that good. To understand this more clearly, think of an example of a doctor in private practice:
A young doctor opens her own practice, working by herself, and within a few months has developed a substantial clientele. At first, she was performing all her clerical work—filing, typing and answering the phone—by herself. With an ever-busier schedule, however, she realizes that she could spend more time seeing patients, and thus see a greater number of patients, if she hired an assistant.
As it turns out, the young professional is not only a brilliant doctor, but is also lightning-fast at typing and filing. She is, in fact, better at doing both jobs than the clerical assistant she hires. In other words, she has an absolute advantage at both tasks: medical diagnosis and clerical work.
Does it make sense then for the doctor and her assistant to share both tasks, each spending part of the day diagnosing patients and doing clerical work? The answer is no. By having the assistant perform all the clerical work, the doctor is able to maximize her specialization and see more patients. The patients are undoubtedly better off too.
In other words, even though the assistant is worse at performing both tasks, an economist would say that he nonetheless has a comparative advantage at clerical work. As you can see, by working together – trading their services – the doctor and the assistant are able to maximize their skills, making both better off.
As these examples show, trade allows countries to specialize in the production of what they do best and make the most efficient use of their resources, thereby decreasing the price of both goods. No matter how inefficiently a country produces every kind of good, it can always be said to have a comparative advantage in at least one of those goods.
That is the theory of comparative and absolute advantage. It helps explain what happens in the real world of international trade, and it offers broad guidance to countries as they decide which goods and services to produce and subsequently export, and which, in turn, to import.
Trade in Theory and Practice:
In reality, of course, trade specialization does not work precisely the way the theory of comparative advantage might suggest, for a number of reasons:
No country specializes exclusively in the production and export of a single product or service.
All countries produce at least some goods and services that other countries can produce more efficiently.
A lower income country might, in theory, be able to produce a particular product more efficiently than the United States can but still not be able to identify American buyers or transport the item cheaply to the United States. As a result, U.S. firms continue to manufacture the product.
The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776. A country that has an absolute advantage produces greater output of a good or service than other countries using the same amount of resources. Smith stated that tariffs and quotas should not restrict international trade; it should be allowed to flow according to market forces. Contrary to mercantilism Smith argued that a country should concentrate on production of goods in which it holds an absolute advantage. No country would then need to produce all the goods it consumed. The theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game.
3. Comparative Advantage theory
David Ricardo, in 1817, enunciated his refinement of Smith’s concept by postulating the principle of comparative advantage (as opposed to Smith’s concept of absolute advantage). The theory of comparative advantage states that even if a country is able to produce all its good at lower costs than another country can, trade still benefits both countries, based on comparative costs. His writings demonstrated what has become known as:
“… the principle of comparative advantage: a nation, like a person, gains from the trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage.”
The key word is comparative, meaning relative and not necessarily absolute. There are gains from trade whenever the relative price ratios of two goods differ under international exchange for what would be under conditions of no trade. In addition, the theory of comparative advantage demonstrates that countries jointly benefit from trade (under the assumption of both goods).
With the theory of absolute advantage, Ricardo’s theory of comparative advantage does not answer why production cost differ within each country and also no consideration is given to the possibility of producing the same goods with different combinations of factors.
A situation in which a country, individual, company or region can produce a good at a lower opportunity cost than a competitor. This theory that global efficiency gains may still result from trade if a country specializes in those products it can produce more efficiently than other products-regardless of whether other countries can produce those same products even more efficiently. It denotes gains from trade will occur even in a country that has absolute advantage in all products because the country must give up less efficient output to produce more efficient output.
Assumptions underlying the concept of comparative advantage – Perfect occupational mobility of factors of production – resources used in one industry can be switched into another without any loss of efficiency – Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output) – No externalities arising from production and/or consumption – Transportation costs are ignored comparative advantage and international trade:
Comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower. The basic theory of comparative advantage was developed by David Ricardo Ricardo’s theory of comparative advantage was further developed by Heckscher, Ohlin and Samuelson who argued that countries have different factor endowments of labor, land and capital inputs. Countries will specialize in and export those products which use intensively the factors of production which they are most endowed.
If each country specializes in those goods and services where they have an advantage, then total output and economic welfare can be increased (under certain assumptions). This is true even if one nation has an absolute advantage over another country. Worked example of comparative advantage consider the data in the following table: | Pre-Specialization | CD Players | Personal Computers | | UK | 2,000 | 500 | | Japan | 4,000 | 2,000 | | Total Output | 6,000 | 2,500 |
After trade has taken place, total output of goods available to consumers in both countries has grown. UK’s consumption of CD players has increased by 200 and they have an extra 100 PCs. For Japan, they have an extra 200 CD players and 200 PCs. If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialize, the potential gains from trade are much greater. The idea that specialization should lead to increasing returns is associated with economists such as Paul Romer and Paul Ormerod Determinants regarding comparative advantage:
Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets. For a country, the following factors are important in determining the relative costs of production: – The quantity and quality of factors of production available (e.g. the size and efficiency of the available labor force and the productivity of the existing stock of capital inputs). If an economy can improve the quality of its labor force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage.
– Investment in research & development (important in industries where patents give some firms significant market advantage) – for more information on this have a look at this page – Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets. – Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage. – Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country’s domestic producers- although most countries agree to abide by international trade agreements.
– Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)
However, the principle of comparative advantage can be criticized in a several ways:
• It may overstate the benefits of specialization by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.
• The theory also assumes perfect mobility of factors without any diminishing returns. The reality may be very different. Output from factor inputs is likely to be subject to diminishing returns. This will make the PPF for each country non-linear and bowed outwards.
• Complete specialization might create structural unemployment as some workers cannot transfer from one sector to another.
• Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.
• Comparative advantage is not a static concept – it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade.
• Many countries strive for food security, meaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.
• Finally, the principle of comparative advantage is derived from a simple two good/two country model. The real world is far more complex, with countries exporting and importing many different goods and services.
It seems obvious that if one country is better at producing one good and another country is better at producing a different good (assuming both countries demand both goods) that they should trade. What happens if one country is better at producing both goods? Should the two countries still trade? This question brings into play the theory of comparative advantage and opportunity costs. The everyday choices that we make are, without exception, made at the expense of pursuing one or several other choices. When you decide what to wear, what to eat for dinner, or what to do on Saturday night, you are making a choice that denies you the opportunity to explore other options.
4. Heckscher-Ohlin theory
the Heckscher–Ohlin theorem is one of the four critical theorems of the Heckscher–Ohlin model. It states that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In the two-factor case, it states: “A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good.”
This theory said that differences in countries’ endowment of labor compared to their endowment of land or capital explain differences in the cost of production factors.
The critical assumption of the Heckscher–Ohlin model is that the two countries are identical, except for the difference in resource endowments. This also implies that the aggregate preferences are the same. The relative abundance in capital will cause the capital-abundant country to produce the capital-intensive good cheaper than the labor-abundant country and vice versa.
Initially, when the countries are not trading:
– the price of capital-intensive good in capital-abundant country will be bid down relative to the price of the good in the other country,
– the price of labor-intensive good in labor-abundant country will be bid down relative to the price of the good in the other country.Once trade is allowed, profit-seeking firms will move their products to the markets that have (temporary) higher price.
As a result:
– the capital-abundant country will export the capital-intensive good,
– the labor-abundant country will export the labor-intensive good.
Features of the model:
• Relative endowments of the factors of production (land, labor, and capital) determine a country’s comparative advantage. Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability of goods is determined by input costs. Goods that require inputs that are locally abundant will be cheaper to produce than those goods that require inputs that are locally scarce.
• For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor — grains. If capital and land are abundant, their prices will be low. As they are the main factors used in the production of grain, the price of grain will also be low—and thus attractive for both local consumption and export. Labor intensive goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.
Factor Proportions Theory:
Trade theory, like all of economic theory, changed drastically in the first half of the twentieth century. The factor proportions theory developed by the Swedish economist Eli Heckscher and later expanded by his former graduate student Bertil Ohlin formed the major theory of international trade that is widely is still widely accepted today. Whereas Smith and Ricardo emphasized a labor theory of value the factor proportions theory was based on a more modern concept of production that raised capital to the same level of importance as labor.
Factor Intensity in Production:
The factor intensity in production theory considered two factor of production, labor and capital. Technology determines the way they combine to form a product. Different products required different proportions of the two factors of production.
It is easy to see how the factor proportions of how a product is produced differs substantially among groups of products. For the manufacturing of leather footwear is still a relatively labor intensive process even with the most sophisticated leather treatment and patterning machinery. Other products such as computer memory chips, however although requiring some highly skilled labor require massive quantities of capital for production and development and the manufacturing facilities needed for clean production to ensure the extremely high quality demanded in the industry. The concept of factor proportions is very useful in the comparison of the production processes of goods.
According to factor proportions theory, factor intensities depend on the state of technology and the current method of manufacturing a product. The theory assumed that the same technology of production would be used for the same goods in all countries. It is not therefore differences in the efficiency of production that will determine trade between countries at it did in classical theory. Classical theory implicitly assumed that technology or the productivity of labor is different across countries. Otherwise there would be no logical explanation as to why one country requires more units of labor to produce a unit of output than another country. Factor proportions theory assumed no such productivity differences.
Factor Endowments, Factor Prices, And Comparative Advantage:
If there is no difference in technology or productivity of factors across countries, what then determines comparative advantage in production and export? The answer is that factor prices determine cost differences. And these prices are determined by the endowments of labor and capital the country possesses. The theory assumes that labor and capital are immobile, meaning they cannot move across country borders. Therefore the country’s endowment determines the relative costs of labor and capital as compared to other countries.
Each country is defined or measured by the amount of labor and capital that it possesses. If a country has when compared with other countries more labor and less capital it would be characterized as relatively labor abundant. That which is more plentiful is cheaper; so a labor abundant country would therefore have relatively cheap labor.
For a country such as China possesses a relatively large endowment of labor and a relatively smaller endowment of capital. At the same time Japan is a relatively capital abundant country with a relatively smaller endowment of labor. China possesses relatively cheaper labor and should therefore specialize in the production and export of labor intensive products. Japan possesses relatively cheap capital and should specialize in the production and export of capital intensive products. Comparative advantage is derived not from the productivity of a country, but from the relative abundance of its factors of production.
Using these assumptions, factor proportions theory stated that a country should specialize in the production and export of those product that use intensively its relatively abundant factor.
(i) A country that is relatively labor abundant should specialize in the production of relatively labor intensive goods. It should then export these labor intensive goods in exchange for capital intensive goods.
(ii) A country that is relatively capital abundant should specialized in the production of relatively capital intensive goods. It should then export these capital intensive goods in exchange for labor intensive goods.
The Heckscher-Ohlin theory states that international and interregional differences in production costs occur because of differences in the supply of production factors:
Commodities requiring for their production much of [abundant factors of production] and little of [scarce factors] are exported in exchange for goods that call for factors in the opposite proportions. Thus indirectly, factors in abundant supply are exported and factors in scanty supply are imported (Ohlin, 1933).These simple statements lead to an important conclusion: under free trade, countries export the products that use their scarce factors intensively and imports the products using their scarce factors intensively.
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Topic: International Trade Theories
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