doc. Ing. Tomáš Dudáš, PhD.

Structure of the presentationWhy are theories of international trade developed?

Mercantilism and its influence on the international trade

Adam Smith and the theory of absolute advantages

David Ricardo and the theory of comparative advantages

Mercantilism – historical background

• Mercantilism was founded in the early 16th century England, from where it spread later to France and other European countries

• Its origin was associated with many geographical and technological breakthroughs of that period

• 1492 – Columbus discovers America

• 1498 – Vasco de Gama opens naval trade route to India

• A new class was born - the merchants and mercantilism was the political economy of state building

PeriodRoughly from the 1600-1800The Term “Mercantilism” was coined by

Maquis de Mirabeau (a physiocrat)It is a system closely associated with the

rise of nations and the concept of Nationalism

It was a system prevalent in:FranceSpainEnglandHolland

Mercantilism – basic ideas• Most widely known mercantilist thinker – Thomas Mun

• The basis of mercantilist thought can be summarized into the following two statements:• The economic health of a nation is measured by the

amount of precious metals (gold and silver) it possesses• The only way for a nation to increase its wealth, is the

import of precious metals from abroad• Direct import from the colonies• International trade

• Mercantilism therefore considered positive trade balance as essential and used any economic policy measures to promote this goal

• Mercantilists regarded international trade as a zero-sum game

Mercantilism – basic types Early mercantilism(bullionism)

• Main goal– accumulation of precious metals• Any export of precious metals was prohibited

Developed mercantilism • Main goal – active trade balance• Support of manufacture production• Preached the necessity of maintaining domestic

consumption to a minimum in favor of exports and the need to maintain wages at the lowest level (labor theory of value)

Mercantilism – economic policies• Strict prohibition of the outflow of precious metals

abroad• Obligation to pay for imports with exports• Restrictions on imports of finished products from

abroad• Support of the establishment of manufactories• Establishment of commercial monopolies• Ban on the export of raw materials and semi-products

and promotion of their imports• Laws of trade and navigation• Regulation of wages• Support for population growth and immigration

Mercantilism - critique• David Hume - accumulation of precious metals

will inevitably lead to an increase in prices and wages - hence increased inflation• The theory of self-regulation of trade balance

• Ultimately, a mercantilist country is losing its competitiveness

• Adam Smith - also a strong critic of mercantilism• The source of wealth is labour• Active balance of trade leads to an impoverished

country• Liberalism is better than protectionism• Trade is a positive sum game

Adam Smith (1723 – 1970)• Scottish moral philosopher and a pioneer of

political economy• The Theory of Moral Sentiments – the term

"invisible hand„ is used for the first time• 1776 – An Inquiry into the Nature and Causes

of the Wealth of Nations• Critique of mercantilism• Proponent of the international division of

labour

• Theory of absolute advantages

Theory of absolute advantages - assumptioms

• 2*2*1 model (2 countries – 2 goods – 1 factor of production)• Homogeneous goods• Labor is homogeneous within a country but heterogeneous

across countries. • Complete mobility of labor in the country and complete

immobility of labor across the country• No transportation costs• Full employment• Production technology differences exist across industries

and across countries and are reflected in labor productivity parameters.

• The labor and goods markets are assumed to be perfectly competitive in both countries.

• Firms are assumed to maximize profit while consumers (workers) are assumed to maximize utility.

Theory of absolute advantages– basic idea

The biggest and the natural advantages of international division of labor occur, when countries specialize in producing those goods that they can produce with the lowest overall costs and import goods that other countries produce at the absolute lowest costs 

Smith demonstrated his idea on the example of wine production in Scotland 

Theory of absolute advantages– example

Slovakia and Hungary produce two goods - sheep cheese (bryndza) and sausage 

Why do absolute advantages exist? Differences in natural and climatic conditions

and technologies

Bryndza Sausage

Slovakia 5 hours/1 ton 10 hours/1 ton

Hungary 10 hours/1 ton 2 hours/1 ton

Theory of absolute advantages– example

• What is the internal exchange rate?

• England uses 300 hours (200 wheat – 100 milk)• Germany uses 600 hours (300 wheat – 300 milk)

• What is the production before trade?

• What are the gains from trade if the international price is 1 ton of milk for 3 tons of wheat and England demand 60 milk?

Wheat Milk

England 1 hours/1 ton 5 hours/1 ton

Germany 2 hours/1 ton 4 hours/1 ton

Question

If there is one country that does not have an absolute advantage in the production of any product, will there still be benefit to trade, and will trade even occur?

David Ricardo (1772-1823)• Was a British political economist• He was also a member of Parliament, businessman,

financier and speculator, who amassed a considerable personal fortune

• Ricardo became interested in economics after reading Adam Smith's The Wealth of Nations in 1799 on a vacation

• 1817 – Principles of Political Economy and Taxation

• Theory of comparative advantage (albeit the same principle was described two years earlier by Robert Torrens)

Theory of comparative advantages - assumptioms

• 2*2*1 model (2 countries – 2 goods – 1 factor of production)• Homogeneous goods• Labor is homogeneous within a country but heterogeneous

across countries. • Complete mobility of labor in the country and complete

immobility of labor across the country• No transportation costs• Full employment• Production technology differences exist across industries

and across countries and are reflected in labor productivity parameters.

• The labor and goods markets are assumed to be perfectly competitive in both countries.

• Firms are assumed to maximize profit while consumers (workers) are assumed to maximize utility.

Theory of comparative advantages – basic ideas

• If country A is more productive than country B in every productive activity, would both countries benefit from trade?

• Ricardo's law of comparative advantage showed that the answer is yes.

• The theory of comparative costs argues that, put simply, it is better for a country that is inefficient at producing a good or service to specialise in the production of that good it is least inefficient at, compared with producing other goods.

Theory of comparative advantages - example

England and Portugal produce two goods – cloth and wine

Production costs using labor as the sole input in production

Internal trading rations (without foreign trade) England 100/120 (1:1,2) Portugal 90/80 (1:0,89)

Cloth Wine

England 100 manhours 120 manhours

Portugalsko 90 manhours 80 manhours

Theory of comparative advantages - example

• To find out the comparative advantages, we must compare the autarky (internal) exchange ratios in England and Portugal

• Relative price of cloth• England – 0,83 wine• Portugal – 1,13 wine

• Relative price of wine• England – 1,2 cloth• Portugal – 0,89 wine

Theory of comparative advantages – example 2

• Will there be trade according absolute advantages?

• Will there be trade according comparative advantages? If yes, how?

Corn Cloth

Canada 6 hours 10 hours

USA 3 hours 2 hours

Theory of comparative advantages – further questions

• Where will the international price lie?• Logical answer – in our example somewhere

between 1/0,89 and 1/1,2

• More accurate theory of international pricing was attempted by John Stuart Mill in 1849

• Theory of reciprocal demand• It is reciprocal demand that determines the terms of

trade which in turn determine the relative share of each country.

• If one of the countries in the model is small, it will have greater profits from foreign trade (The Importance of Being Unimportant)

The Importance of Being Unimportant - example

Slovakia and the USA produce cars and milk

The US demand for milk is 5 mld. litersMaximum production capacity of Slovakia is

500 millions of liters

Cars Milk

Slovakia 1000 3

USA 500 2

Theory of comparative advantages – further questions

What happens if the internal exchange ratios are the same?

No international trade off course

Can the model be expanded on more countries and goods?

Yes – up to n*n, but the math is getting more complex and complex

Comparative advantages and economic reality

Transport costs

Trade tariffsProhibitive and fiscal tariffs

In reality, labour is not the only factor of production

Scientific and technical progress Produces dynamic comparative advantages