Download Mercantilism and Early Classical Thought

Chapter 2
Early Trade
Theories:
Mercantilism and the
Transition to the
Classical World of
David Ricardo
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• Describe Mercantilist concepts and
policies.
• Examine Hume’s price-specie flow
mechanism and its challenge to
Mercantilist thought.
• Discuss Smith’s ideas of wealth and
absolute advantage as foundations
of international trade.
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Mercantilism
• A collection of economic thought in
Europe during the period between
1500 and 1750.
• Mercantilism is often called the
political economy of state building.
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The Mercantilist
Economic System
• A country’s wealth is measured by its holdings of
precious metals (specie).
• International trade is a zero sum game. (One
country’s gain is the loss for the trading partner)
• A country should maintain a positive trade
balance (that is, export more than it imports).
• A country with positive trade balance would
increase its wealth through acquisiton of precious
metals.
• The countries had to have a strong military power
and merchant marine to increase their trading.
• According to mercantilists, economic system had
3 components: 1) Manufacturing sector 2) Rural
sector (agriculture) 3) Foreign colonies
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The Mercantilist
Economic System
 Mercantilism employed the labor theory of value.
 Each commodity was valued relatively in terms of
their labor content. For eg: 2 labor hours / bottle
for wine production.
 Mercantilists believed that economy was
operating at less than full employment.
 Thus, a country with positive trade balance would
see an increase in money supply through inflow of
precious metals (gold and silver) which in turn
would stimulate employment and national output
with no impact on inflation.
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The Role of Government
• “Bullionism” (Government controls
the inflow and outlow of precious
metals)
• Similar to currency controls in
Turkey before 1980’s.
• Substantial regulation of the
domestic economy, including
• governmental granting of monopolies ,
and
• controls of labor through craft guilds.
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The Role of Government
• Subsidies on exports and tariffs on
imports
• Policies to ensure low wages,
including
• policies to discourage importation and
encourage exportation, and
• policies to discourage exportation of
specie.
• Use of colonies as cheap labor source.
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The Paradox of
Mercantilism
To be rich, a country needed to have
a lot of poor people!
 Why?
Because by encouraging exports and
controlling imports , the governments also
limited domestic consumption and wealth.
 Besides, individuals would prefer to hold
gold and silver against possible attacks by
other nations.
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The Challenge to
Mercantilism by Early
Classical Writers
 In the early 1700s, questions began to
emerge regarding the logic of
mercantilism.
 Some famous economists including Adam
Smith and David Hume criticized the
Mercantilist system particularly by
emphasizing that international trade
should not be a zero-sum game.
 They advocated that every trading nation
could benefit from the trade.
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Hume’s Challenge: the
Price-Specie Flow
Mechanism
• 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) Contrast to Mercantilist view
• higher prices  lower exports and
higher imports
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Smith’s Challenge:
Absolute Advantage
• Smith believed trade to be a positive-sum game.
• He also believed that a country’s wealth coud be
measured by its porductive capacity not by the
amount of precious metals they possess.
• Countries should export those goods which they
can produce efficiently, and import those which
they cannot.
• If countries trade according to this principle, all
will gain from trade (trade will be mutually
beneficial).
• The concept of “laissez faire” which states that if
individuals pursue their own benefits and wealth,
it will lead to an aggregate social benefit and
wealth.
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Adam Smith’s Invisible Hand
 Government should not interfere with individuals’
free will.
 Government should set the necessary system for
free market.
 If so, even if there are some disturbances to the
system, an “invisible hand” will correct the system
to operate properly .
 A good example would be the price controls by the
government. If government abandons the price
control, market supply and demand will restore the
equlibrium.
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Absolute Advantage: An
Example
Corn
U.S.
Blankets
1 hour/bu 6 hrs/bl
Mexico 3 hrs/bu
5 hrs/bl
Autarky Price
Ratios (APRs)
1B = 6C,
1C = 1/6B
1B = 5/3C,
1C = 3/5B
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Absolute Advantage: An
Example
• Suppose the U.S. and Mexico agree to
trade at a ratio of 1B = 4C (or 1C = ¼
B).
• Suppose further that Mexico will
specialize in blankets and the U.S. in
corn.
• From the U.S.’s perspective:
• Can now buy blankets at a lower price
(1B = 6C in autarky, but 1B = 4C in trade).
• Can sell corn at a higher price (1C = 1/6 B
in autarky, but 1C = ¼ B in trade).
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Absolute Advantage: An
Example
• From Mexico’s perspective:
• Can now sell blankets at a higher price
(1B = 5/3C in autarky, but 1B = 4C in
trade).
• Can buy corn at a lower price (1C = 3/5 B
in autarky, but 1C = ¼ B in trade).
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Absolute Advantage: An
Example
• Bottom line: both countries gain
from trade, even if certain
industries (blanket industry in U.S.,
corn industry in Mexico) stand to
lose.
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Limits to Smith’s Thinking
• If one country has an absolute
advantage in the production of both
(or all) goods, Smith would say that
that country cannot gain from
trade.
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Absolute Advantage: The
Limits to Smith’s Thinking
Corn
U.S.
Blankets
1 hour/bu 5 hrs/bl
Mexico 3 hrs/bu
6 hrs/bl
Autarky Price
Ratios (APRs)
1B = 5C,
1C = 1/5B
1B = 2C,
1C = 1/2B
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Limits to Smith’s Thinking
• If one country has an absolute
advantage in the production of both
(or all) goods, Smith would say that
that country cannot gain from
trade.
• But David Ricardo’s Principle of
Comparative Advantage (1817) took
Smith’s work farther: even in the
above example, trade can be
mutually beneficial!
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