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The Classical
Theory of Trade
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The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we
must ever observe this rule; to sell more to strangers yearly than we consume of theirs in value.
Thomas Mun, 1664
The long-term expansion of international trade has
increasingly been interrupted by worldwide financial
and economic crises. Recent events suggest that we have
entered a new critical period in the long history of international trade and exchange. It has never been more important
to understand the underlying basis for trade, the policies
that governments propose to influence it, and how current
ideas have evolved and developed over several centuries.
Because several early views about international trade
form the foundation for present-day analysis and other
less viable views still influence trade policy from time to
time, it is important to trace briefly their origins to evaluate
their appropriateness in today’s world. Part 1 reviews the
early contributions of the Mercantilist and the Classical
schools of thought. Chapter 2, “Early Trade Theories,”
provides a brief overview of Mercantilist views on international trade and the early Classical response of David
Hume and Adam Smith. Chapter 3, “The Classical World
of David Ricardo and Comparative Advantage,” provides
a more extensive discussion of Ricardo’s idea of comparative advantage and is followed by a discussion of several extensions of the basic Ricardian model in Chapter 4,
“Extensions and Tests of the Classical Model of Trade.”
Together these three chapters provide an introduction to
the basics underlying international trade and a foundation
on which to construct contemporary theory.
•
Two men can both make shoes and hats, and one is superior to the other in both employments, but in
making hats he can only exceed his competitor by one-fifth or 20 per cent, and in making shoes he
can excel him by one-third or 33 per cent:—will it not be for the interest of both that the superior man
should employ himself exclusively in making shoes, and the inferior man in making hats?
David Ricardo, 1817
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CHAPTER
EARLY TRADE THEORIES
Mercantilism and the Transition to the Classical
World of David Ricardo
2
LEARNING OBJECTIVES
LO1
Describe the basic concepts and policies associated with Mercantilism.
LO2
Examine Hume’s price-specie-flow mechanism and the challenge it posed
to Mercantilism.
LO3
Discuss Adam Smith’s concepts of wealth and absolute advantage as
foundations for international trade.
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INTRODUCTION
The Oracle in the 21st
Century
When the ancient Greeks faced a dilemma, they consulted the Oracle at Delphi. If we were to
ask the Oracle the secret to wealth, what would she say? Work hard? Get an education? Probably
not. Diligence and intelligence are strategies for improving one’s lot in life, but plenty of smart,
hardworking people remain poor.
No, the Oracle’s advice would consist of just a few words: Do what you do best. Trade for the
rest. In other words, specialize and then trade.1
When did the idea of gains from trade first emerge? How did the views on trade change in
the 18th century? It has long been perceived that nations benefit in some way by trading
with other nations. Although the underlying basis for this belief has changed considerably
over time, it is surprising how often we encounter ideas about the gains from trade and the
role of trade policy that stem from some of the earliest views of the role of international
trade in the pursuit of domestic economic goals. Some of these early ideas are found in the
writings of the Mercantilist school of thought. Later, these ideas were challenged both by
time and by writers who subsequently were identified as early Classical economic thinkers. This challenge to Mercantilism culminated in the work of David Ricardo, which to
this day lies at the heart of international trade theory. To render a sense of the historical
development of international trade theory and to provide a basis for evaluating current
trade policy arguments that are clearly Mercantilist in nature, this chapter briefly examines
several of the more important ideas of these Mercantilist writers, the problems associated
with Mercantilist thinking, and the emergence of a different view of trade offered by Adam
Smith. It is useful to note that Mercantilist notions still exist even though their shortcomings were ascertained long ago.
MERCANTILISM
Mercantilism refers to the collection of economic thought that came into existence in
Europe during the period from 1500 to 1750. It cannot be classified as a formal school of
thought, but rather as a collection of similar attitudes toward domestic economic activity
and the role of international trade that tended to dominate economic thinking and policy
during this period. Many of these ideas not only were spawned by events of the time but
also influenced history through their impact on government policies. Geographical explorations that provided new opportunities for trade and broadened the scope of international
relations, the upsurge in population, the impact of the Renaissance on culture, the rise of
the merchant class, the discovery of precious metals in the New World, changing religious
views on profits and accumulation, and the rise of nation-states contributed to the development of Mercantilist thought. Indeed, Mercantilism is often referred to as the political
economy of state building.
The Mercantilist
Economic System
Central to Mercantilist thinking was the view that national wealth was reflected in a
country’s holdings of precious metals. In addition, one of the most important pillars of
Mercantilist thought was the static view of world resources. Economic activity in this setting can be viewed as a zero-sum game in which one country’s economic gain was at
the expense of another. (A zero-sum game is a game such as poker where one person’s
1
“The Fruits of Free Trade,” 2002 Annual Report, reprint, Federal Reserve Bank of Dallas, p. 6 (italics in original
article).
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19
winnings are matched by the losses of the other players.) Acquisition of precious metals
thus became the means for increasing wealth and well-being and the focus of the emerging
European nation-states. In a hostile world, the enhancement of state power was critical to
the growth process, and this was another important Mercantilist doctrine. A strong army,
strong navy and merchant marine, and productive economy were critical to maintaining
and increasing the power of a nation-state.
Mercantilists saw the economic system as consisting of three components: a manufacturing sector, a rural sector (domestic hinterland), and the foreign colonies (foreign
hinterland). They viewed the merchant class as the group most critical to the successful
functioning of the economic system, and labor as the most critical among the basic factors of production. The Mercantilists, as did the Classical writers who followed, employed
a labor theory of value; that is, commodities were valued relatively in terms of their
relative labor content. Not surprisingly, most writers and policymakers during this period
subscribed to the doctrine that economic activity should be regulated and not left to individual prerogative. Uncontrolled individual decision making was viewed as inconsistent
with the goals of the nation-state, in particular, the acquisition of precious metals. Finally,
the Mercantilists stressed the need to maintain an excess of exports over imports, that
is, a favorable balance of trade or positive trade balance. This doctrine resulted from
viewing wealth as synonymous with the accumulation of precious metals (specie) and the
need to maintain a sizable war chest to finance the military presence required of a wealthy
country. The inflow of specie came from foreigners who paid for the excess purchases
from the home country with gold and silver. This inflow was an important source of money
to countries constrained by a shortage in coinage. Crucial to this view was the implicit
Mercantilist belief that the economy was operating at less than full employment; therefore,
the increase in the money supply stimulated the economy, resulting in growth of output
and employment and not simply in inflation. Hence, the attainment of a positive trade balance could be economically beneficial to the country. Obviously, an excess of imports over
exports—an unfavorable balance of trade or a negative trade balance—would have the
opposite implications.
The Role of
Government
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The economic policies pursued by the Mercantilists followed from these basic doctrines.
Governments controlled the use and exchange of precious metals, what is often referred
to as bullionism. In particular, countries attempted to prohibit the export of gold, silver,
and other precious metals by individuals, and rulers let specie leave the country only
out of necessity. Individuals caught smuggling specie were subject to swift punishment,
often death. Governments also gave exclusive trading rights for certain routes or areas to
specific companies. Trade monopolies fostered the generation of higher profits through
the exercise of both monopoly and monopsony market power. Profits contributed both
directly and indirectly to a positive trade balance and to the wealth of the rulers who
shared the profits of this activity. The Hudson Bay Company and the Dutch East India
Trading Company are familiar examples of trade monopolies, some of which continued
well into the 19th century.
Governments attempted to control international trade with specific policies to maximize
the likelihood of a positive trade balance and the resulting inflow of specie. Exports were
subsidized and quotas and high tariffs were placed on imports of consumption goods. Tariffs
on imports of raw materials that could be transformed by domestic labor into exportables
were, however, low or nonexistent, because the raw material imports could be “worked up”
domestically and exported as high-value manufactured goods. Trade was fostered with the
colonies, which were seen as low-cost sources of raw materials and agricultural products
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and as potential markets for exports of manufactures from the parent country. Navigation
policies aimed to control international trade and to maximize the inflow (minimize the outflow) of specie for shipping services. The British Navigation Acts, for example, excluded
foreign ships from engaging in coastal trade and from carrying merchandise to Britain or
its colonies. Trade policy was consistently directed toward controlling the flow of commodities between countries and toward maximizing the inflow of specie that resulted from
international trade.
Mercantilism and
Domestic Economic
Policy
The regulation of economic activity also was pursued within the country through the control of industry and labor. Comprehensive systems of regulations were put into effect utilizing exclusive product charters such as those granted to the royal manufacturers in France
and England, tax exemptions, subsidies, and the granting of special privileges. In addition
to the close regulation of production, labor was subject to various controls through craft
guilds. Mercantilists argued that these regulations contributed to the quality of both skilled
labor and the manufactures such labor helped produce—quality that enhanced the ability
to export and increased the wealth of the country.
Finally, the Mercantilists pursued policies that kept wages low. Because labor was the
critical factor of production, low wages meant that production costs would be low and a
country’s products would be more competitive in world markets. It was widely held that
the lower classes must be kept poor in order to be industrious and that increased wages
would lead to reduced productivity. Note that, in this period, wages were not market determined but were set institutionally to provide workers with incomes consistent with their
traditional position in the social order. However, because labor was viewed as vital to the
state, a growing population was crucial to growth in production. Thus, governments stimulated population growth by encouraging large families, giving subsidies for children, and
providing financial incentives for marriage.
Mercantilist economic policies resulted from the view of the world prominent at that
time. The identification of wealth with holdings of precious metals instead of a nation’s
productive capacity and the static view of world resources were crucial to the policies that
were pursued. While these doctrines seem naive today, they undoubtedly seemed logical in
the period from 1500 to 1750. Frequent warfare lent credibility to maintaining a powerful
army and merchant marine. The legitimization of and growing importance of saving by the
merchant class could easily be extended to behavior by the state, making the accumulation
of precious metals seem equally reasonable. However, the pursuit of power by the state at
the expense of other goals and the supreme importance assigned to the accumulation of
precious metals led to an obvious paradox: rich nations in the Mercantilist sense would
comprise large numbers of very poor people. Specie was accumulated at the expense of
current consumption. At the same time, the rich nations found themselves expending large
amounts of their holdings of precious metals to protect themselves against other nations
attempting to acquire wealth by force.
CONCEPT CHECK
1. Why were Mercantilist thinkers concerned
with the acquisition of specie as opposed to
overall productive capacity?
2. Why was regulation of economic activity
critical to this line of thinking?
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3. If one is referred to as a Mercantilist, what
types of trade policy does one favor? Why?
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EARLY TRADE THEORIES
IN THE REAL WORLD:
MERCANTILISM IS STILL ALIVE
On April 30, 1987, the U.S. House of Representatives
passed the Trade and International Economic Policy Reform
Act, which became known as the Omnibus Trade Bill. Prior
to its passing, Rep. Richard A. Gephardt (D–MO) offered an
amendment “to require the U.S. trade representative to enter
into negotiations with countries running excessive unwarranted trade surpluses with the United States and mandate
retaliatory action against such countries if negotiations fail.”
Under the proposed amendment, countries with “excessive” trade surpluses with the United States were to be
placed on a list, and each country’s trading practices would
be scrutinized by the U.S. trade representative, a cabinetlevel member of the executive branch. A six-month negotiation period would begin with those countries. Successful
negotiations would lead to no action by the United States,
but the trading practices of the country in question were
to be reexamined at yearly intervals. In the case of unsuccessful negotiations, the United States was to retaliate on a
dollar-for-dollar basis against the value of the unfair trading practices that the country in question maintained. If the
country failed to eliminate its unfair trading practices and
maintained a huge trade surplus with the United States, it
would be faced with a bilateral surplus reduction requirement of 10 percent for each of four years. The amendment
passed by a vote of 218 to 214. It was later enacted into
law in a slightly relaxed form (as the “Super 301” provision)
in the Omnibus Trade and Competitiveness Act of 1988.
Thankfully (for economists), Super 301 is no longer a part
of U.S. trade policy.
Other comments and examples abound with respect to the
initiation of policy measures to restrict trade so as seemingly
to benefit the trade-restricting nation. For example, Canada
and the United States have “cabotage” laws. The Canadian
law states that ships carrying merchandise between Canadian
ports must be owned and crewed by Canadians; the United
States law adds to the ownership and crew provisions that
the ship must have been built in the United States. Such laws
are “justified” as providing for national defense because
they give rise to a strong merchant marine. Of course, they
also add to export receipts because of this legislated use of
domestic shipping services. One 1995 estimate indicated
that the U.S. law costs U.S. consumers and firms $2.8 billion
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annually ($4.1 billion in 2011 dollars). Also, in the United
States (as well as in Canada), foreign airlines cannot pick
up passengers for transport solely between domestic cities.
However, an exception in the United States has been made
for Canadian National Hockey League teams flying on chartered flights between consecutive U.S. venues. (A similar
provision is made for U.S. teams flying on chartered flights
in Canada.) Further, a dispute arose in 2009 when the U.S.
Department of Transportation gave approval for Air Canada
to fly U.S. teams between U.S. cities.
In addition, the Mercantilist balance-of-trade doctrine
was verbalized beautifully by the head of a local chapter of
presidential candidate Ross Perot’s United We Stand organization in 1993. In reference to the U.S. trade deficit of the
time, he said, “If we just stopped trading with the rest of the
world, we’d be $100 billion ahead.”
Finally, considerable debate occurred over “Buy
American” provisions with respect to iron and steel that
were contained in the 2009 stimulus package passed early
in the Obama administration (although President Obama
himself was not in favor of those provisions). Overall, The
Economist summarized the attitudes of many people when
it stated, in 2004, that “Mercantilism has been defunct as
an economic theory for at least 200 years, but many practical men in authority remain slaves to the notion that exports
must be promoted and imports deterred.”
Sources: Congressional Digest, June–July 1987, pp. 169, 184, 186,
192; Bob Davis, “In Debate over Nafta, Many See Global Trade
as Symbol of Hardship,” The Wall Street Journal, October 20,
1993, p. A9; “Jones Act,” obtained from www.mctf.com/jones_act
.shtml; “The Jones Act,” obtained from www.geocities.com/The
Tropics/1965/jones.htm; “Liberating Trade,” The Economist, May
13, 2004, obtained from www.Economist.com; United States Trade
Representative, 1999 Trade Policy Agenda and 1998 Annual Report of
the President of the United States on the Trade Agreements Program,
p. 254, obtained from www.ustr.gov/reports/tpa/1999/viii.pdf; Anthony
Faiola,“‘Buy American’ Rider Sparks Trade Debate,” The Washington
Post, January 29, 2009, p. A01, obtained from www.washingtonpost
.com; Sallie James, “A Service to the Economy: Removing Barriers to
‘Invisible Trade,’” Center for Trade Policy, Cato Institute, February 4,
2009, p. 13; Neil King, Jr., and John W. Miller, “Obama Risks Flap on
‘Buy American,’” The Wall Street Journal, February 4, 2009, p. A4;
and Susan Carey, “NHL Teams in Air Brawl,” The Wall Street Journal,
September 15, 2009, p. A3.
•
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THE CHALLENGE TO MERCANTILISM BY EARLY CLASSICAL WRITERS
In the early 18th century, ideas regarding the nature of economic activity began to change.
Bullionism and bullionists began to be thought of as naive. National political units had
already emerged under the pressure of peasant wars and kingly conquest, and feudalism
began to give way to centralized monarchies. Technological developments coupled with
the strengthening of the profit motive supported the development of market systems, and
state monopolies began to disappear. New ideas and new philosophies (particularly the
skeptical inquiry of the humanist viewpoint), fostered in part by the Italian Renaissance,
contributed to the continuing spirit of change. By the late 18th century, ideas concerning
international trade began to change when early Classical writers such as David Hume and
Adam Smith challenged the basic tenets of Mercantilism.
David Hume—The
Price-Specie-Flow
Mechanism
One of the first attacks on Mercantilist thought was raised by David Hume (in his Political
Discourses, 1752) with his development of the price-specie-flow mechanism. Hume challenged the Mercantilist view that a nation could continue to accumulate specie without any
repercussions to its international competitive position. He argued that the accumulation of
gold by means of a trade surplus would lead to an increase in the money supply and therefore to an increase in prices and wages. The increases would reduce the competitiveness of
the country with a surplus. Note that Hume is assuming that changes in the money supply
would have an impact on prices rather than on output and employment. At the same time,
the loss of gold in the deficit country would reduce its money supply, prices, and wages,
and increase its competitiveness (see Concept Box 1). Thus, it is not possible for a nation
to continue to maintain a positive balance of trade indefinitely. A trade surplus (or deficit)
automatically produces internal repercussions that work to remove that surplus (or deficit).
The movement of specie between countries serves as an automatic adjustment mechanism
that always seeks to equalize the value of exports and imports (i.e., to produce a zero trade
balance).
Today the Classical price-specie-flow mechanism is seen as resting on several assumptions.
CONCEPT BOX 1
CAPSULE SUMMARY OF THE PRICESPECIEFLOW MECHANISM
Given sufficient time, an automatic trade balance adjustment would take place between a trade surplus country and a trade
deficit country by means of the following steps:
Italy (Trade Surplus) vis-à-vis Spain (Trade Deficit)
Step 1
Step 2
Step 3
Step 4
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Exports , Imports
Net outflow of specie
Decrease in the money supply
Decrease in prices and wages
Decrease in imports and increase in exports
UNTIL
Exports . Imports
Net inflow of specie
Increase in the money supply
Increase in prices and wages
Increase in imports and decrease in exports
UNTIL
Exports 5 Imports
Exports 5 Imports
•
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EARLY TRADE THEORIES
CONCEPT BOX 2
CONCEPT REVIEWPRICE ELASTICITY AND TOTAL EXPENDITURES
You learned in previous economics courses that price elasticity of demand refers to the ratio between the percentage change in quantity demanded of a given product and
the percentage change in its price, that is, h 5 (ΔQ/Q)/
(Δ P/P). (Because quantity demanded varies inversely with
price, price elasticity of demand will have a negative sign.
Economic convention often ignores the negative sign, but
it is understood that h’s value will be less than 0, that is,
negative.) When this ratio (ignoring the negative sign) is
greater than 1.0, indicating that the percentage change in
quantity demanded for a given price change is greater than
the percentage change in price, demand is said to be elastic. When the ratio has a value of 1.0, demand is said to be
unit-elastic, and when the ratio is less than 1.0, demand is
said to be inelastic. Because the relative change in quantity
is greater than the relative change in price when demand is
elastic, total expenditures on the product will increase when
the price falls (quantity demanded increases) and fall when
the price increases (quantity demanded falls). When demand
is inelastic, the exact opposite happens: Total expenditures
rise with a price increase and decline with a price decrease.
In the case of unit elasticity, total expenditures are invariant
with changes in price. Thus, for trade balances to change in
the appropriate manner in the price-specie-flow mechanism,
it is sufficient to assume that demand for traded goods is
price elastic.
•
1. There must be some formal link between money and prices, such as that provided in
the quantity theory of money when full employment is assumed:
MsV 5 PY
where: MS 5 the supply of money
V 5 the velocity of money, or the rate at which money changes hands
P 5 the price level
Y 5 the level of real output
If one assumes that the velocity of money is fixed by tradition and institutional arrangements and that Y is fixed at the level of full employment, then any change in the supply of
money is accompanied by a proportional change in the level of prices.
2. Demand for traded goods is price elastic (see Concept Box 2). This is necessary to
ensure that an increase in price will lead to a decrease in total expenditures for the traded
goods in question and that a price decrease will have the opposite effect. If demand is price
inelastic, the price-specie-flow mechanism will tend to worsen the disequilibrium in the
trade balance. However, demand elasticities tend to be greater in the long run than in the
short run as consumers gradually adjust their behavior in response to price changes. Hence,
even though the price-specie-flow mechanism may be “perverse” in the short run, Hume’s
result is likely to occur as time passes.
3. Perfect competition in both product and factor markets is assumed in order to establish the necessary link between price behavior and wage behavior, as well as to guarantee
that prices and wages are flexible in both an upward and a downward direction.
4. Finally, it is assumed that a gold standard exists. Under such a system, all currencies are pegged to gold and hence to each other, all currencies are freely convertible into
gold, gold can be bought and sold at will, and governments do not offset the impact of the
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gold flows by other activities to influence the money supply. This is sufficient to establish
the link between movements of specie and changes in a nation’s money supply.
If all of these assumptions are satisfied, the automatic adjustment mechanism will, allowing time for responses to occur, restore balanced trade anytime it is disrupted. Balance-ofpayments adjustment mechanisms and the gold standard are still prominent in discussions
of international monetary economics.
Adam Smith and the
Invisible Hand
A second assault on Mercantilist ideas came in the writing of Adam Smith. Smith perceived that a nation’s wealth was reflected in its productive capacity (i.e., its ability to produce final goods and services), not in its holdings of precious metals. Attention thus turned
from acquiring specie to enlarging the production of goods and services. Smith believed
that growth in productive capacity was fostered best in an environment where people were
free to pursue their own interests. Self-interest would lead individuals to specialize in and
exchange goods and services based on their own special abilities. The natural tendency “to
truck, barter, and exchange” goods and services would generate productivity gains through
the increased division and specialization of labor. Self-interest was the catalyst and competition was the automatic regulation mechanism. Smith saw little need for government
control of the economy. He stressed that a government policy of laissez-faire (allowing
individuals to pursue their own activities within the bounds of law and order and respect
for property rights) would best provide the environment for increasing a nation’s wealth.
The proper role of government was to see that the market was free to function in an unconstrained manner by removing the barriers to effective operation of the “invisible hand” of
the market. In The Wealth of Nations, Smith explained not only the critical role the market
played in the accumulation of a nation’s wealth but also the nature of the social order that
it achieved and helped to maintain.
Smith applied his ideas about economic activity within a country to specialization and
exchange between countries. He concluded that countries should specialize in and export
those commodities in which they had an absolute advantage and should import those
commodities in which the trading partner had an absolute advantage. Each country should
export those commodities it produced more efficiently because the absolute labor required
per unit was less than that of the prospective trading partner.
Consider the two-country, two-commodity framework shown in Table 1. Assume that
a labor theory of value is employed (meaning that goods exchange for each other at home
in proportion to the relative labor time embodied in them). In this situation, with a labor
theory of value, 1 barrel of wine will exchange for 4 yards of cloth in England (or 1C for
1
/4 W); on the other hand, 1 barrel of wine will exchange for 1 1/2 yards of cloth in Portugal
(or 1C for 2/3 W). These exchange ratios reflect the relative quantities of labor required to
produce the goods in the countries and can be viewed as opportunity costs. These opportunity costs are commonly referred to as the price ratios in autarky. England has an absolute
advantage in the production of cloth and Portugal has an absolute advantage in the production of wine because less labor time is required to produce cloth in England and wine in
TABLE 1
England
Portugal
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Labor Requirements and Absolute Advantage
Cloth
Wine
Price Ratios in Autarky
1 hr/yd
2 hr/yd
4 hr/bbl
3 hr/bbl
1W:4C
1W:1.5C
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EARLY TRADE THEORIES
TITANS OF INTERNATIONAL ECONOMICS:
ADAM SMITH 17231790
It is more than 200 years since the death of this Scottish
social philosopher, yet his ideas on economic organization and economic systems continue to be fashionable
worldwide, especially with the recent spread of the market
system in Central and Eastern Europe, the former Soviet
Union, and several Asian economies. Smith was born in
1723 in Kirkcaldy, County Fife, Scotland, a town of 1,500,
where nails were still used for money by some residents.
Smith demonstrated intellectual ability early in life, and he
received a sound Scottish education. At 17 he went to Oxford
University where he studied for six years. He returned to
Edinburgh and gave lectures on political economy that
contained many of the principles he later developed in The
Wealth of Nations. (The actual full title is An Inquiry into
the Nature and Causes of the Wealth of Nations, which is
commonly shortened to The Wealth of Nations.) In 1751 he
accepted the Chair of Logic at the University of Glasgow,
and two years later, the Chair of Moral Philosophy, which he
held until 1764. During those years he wrote his first book,
The Theory of Moral Sentiments (1759), an inquiry into the
origin of moral approbation and disapproval, which attracted
immediate attention in England and on the Continent.
Work on The Wealth of Nations began in the late 1760s in
France, where he was serving as a tutor to the young duke of
Buccleuch. Although an initial draft of the masterpiece was
apparently completed by 1770, he continued to work on it
for six more years, finally publishing it in 1776. Little did he
know the impact that his work, often referred to as the most
influential book on economics ever written, would have for
years to come.
It is remarkable that this writer of moral philosophy was
able to envision some sort of order and purpose in the world
of contrasts with which he was confronted daily. There
hardly seemed a moral purpose to the contrast between the
opulence of the leisured classes and the poverty, cruelty,
and danger that existed among the masses and which Smith
deplored. Production occurred in diverse situations such as
the Lombe textile factory (consisting of 26,586 water-driven
wheels and 97,746 movements working 221,178 yards of
silk thread each minute—and staffed by children working
12- to 14-hour days), mines with degrading human conditions, simple cottage industries, and bands of roaming agricultural laborers from the Welsh highlands. The brilliant
man who saw some central purpose to this hostile world was
the epitome of the “ivory tower” professor. He not only was
notoriously absentminded but also suffered from a nervous
disorder throughout his life, which often caused his head
to shake and contributed to his odd manner of speech and
walking gait. A true intellectual, his life was his writing and
discourse with students and thinkers such as David Hume,
Benjamin Franklin, François Quesnay, and Dr. Samuel
Johnson. A confirmed bachelor, Smith lived out the rest of
his life in Edinburgh, where he served as commissioner of
customs and took care of his mother. Smith died at the age
of 67 on July 17, 1790.
Sources: Robert L. Heilbroner, The Worldly Philosophers: The
Lives, Times, and Ideas of the Great Economic Thinkers, rev. ed.
(New York: Simon and Schuster, 1961), chap. 3; “The Modern
Adam Smith,” The Economist, July 14, 1990, pp. 11–12.
•
Portugal. According to Smith, there is a basis for trade because both nations are clearly
better off specializing in their low-cost commodity and importing the commodity that can
be produced more cheaply abroad.
For purposes of illustrating the gains from trade, assume that the two countries, rather
than producing each good for themselves, exchange goods at a rate of 1 barrel of wine for 3
yards of cloth. For England this means obtaining wine in Portugal for only 3 yards of cloth
per barrel instead of 4 yards at home. Similarly, Portugal benefits from acquiring cloth for
a cost of only 1/3 barrel of wine instead of 2/3 barrel of wine at home. It is important to note
(as will be discussed in Chapter 3) that gains from trade can occur over a wide range of
barter prices. Smith’s argument was especially significant at the time because it indicated
that both countries could benefit from trade and that trade was not a zero-sum game as
the Mercantilists had believed. The fact that trade was mutually beneficial and was
a positive-sum game (i.e., all players can receive a positive payoff in the game) was a
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PART 1
THE CLASSICAL THEORY OF TRADE
powerful argument for expanding trade and reducing the many trade controls that characterized the Mercantilist period. Smith saw the source of these absolute advantages as
the unique set of natural resources (including climate) and abilities that characterized a
particular nation. He also recognized that certain advantages could be acquired through the
accumulation, transfer, and adaptation of skills and technology.
Smith’s ideas were crucial for the early development of Classical thought and for altering the view of the potential gains from international trade. David Ricardo expanded upon
Smith’s concepts and demonstrated that the potential gains from trade were far greater than
Adam Smith had envisioned in his concept of absolute advantage.
CONCEPT CHECK
1. Is there a basis for trade in the following case,
according to Smith’s view? Why or why not?
If there is, which commodity should each
country export?
Germany
Sweden
Cutlery
Wheat
50 hr/unit
40 hr/unit
30 hr/bu
35 hr/bu
2. Suppose that Germany has a trade surplus
with Sweden. Explain how the price-specieflow mechanism would work to bring about
balanced trade between the two countries,
given sufficient adjustment time.
SUMMARY
Immediately prior to Adam Smith, the Mercantilists’ views on
the role and importance of international trade were dominant.
They emphasized the desirability of an export surplus in international trade as a means of acquiring specie to add to the wealth
of a country. Over time, this concept of wealth, the role of trade,
and the whole Mercantilist system of economic thought were
challenged by writers such as David Hume and Adam Smith.
Smith’s concept of absolute advantage was instrumental in
altering views on the nature of and potential gains from trade.
The realization that all countries could benefit simultaneously
from trade had great influence on later Classical thought and
trade policy.
KEY TERMS
absolute advantage
bullionism
favorable balance of trade (or positive trade balance)
gold standard
labor theory of value
laissez-faire
Mercantilism
positive-sum game
price-specie-flow mechanism
quantity theory of money
unfavorable balance of trade
(or negative trade balance)
zero-sum game
QUESTIONS AND PROBLEMS
1. Why did the Mercantilists consider holdings of precious
metals so important to nation-state building?
2. What were the pillars of Mercantilist thought? Why was
regulation of the economy so important?
3. What is meant by the “paradox of Mercantilism”? How was
this reflected in Mercantilist wage and population policies?
4. What are the critical assumptions of the price-specie-flow
mechanism? What happens to the trade balance in a surplus country if the demand for traded goods is price inelastic? Why?
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5. Briefly explain why the ideas of Smith and Hume were so
devastating to Mercantilist thinking and policy.
6. The following table shows the hours of labor required to produce 1 unit of each commodity in each country:
United States
United Kingdom
Wheat
Clothing
3 hr
4 hr
9 hr
4 hr
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CHAPTER 2
EARLY TRADE THEORIES
Which country has an absolute advantage in wheat? In clothing? Why? If trade takes place between the United States
and the United Kingdom at a barter price of 1 clothing for 2
wheat (or 1 wheat for 1/2 clothing), why does each country
gain from trade? Explain.
7. (a) Suppose that, in the situation in Question 6, the United
Kingdom has 500 hours of labor available to it. Prior to
trade, the country is using 300 of those labor hours
to produce clothing and the remaining 200 labor hours to
produce wheat. How much wheat and how much clothing will the United Kingdom be producing in this pretrade situation? (Because there is no trade, your answers
will also indicate the amounts of wheat and clothing
consumed in the United Kingdom prior to trade.)
(b) Now suppose that the United Kingdom enters into trade
with the United States at the previously indicated barter price of 1 clothing for 2 wheat (or 1 wheat for 1/2
clothing). The United Kingdom now devotes all of its
labor hours to clothing production and hence produces
125 units of clothing and 0 units of wheat. Why is this
so? Suppose that the country exports 40C (and therefore receives 80W in exchange) and keeps the remaining 85C for its own consumption. What will be the
United Kingdom consumption of wheat and clothing
in the trading situation? By how much has the United
Kingdom, because of trade, been able to increase its
consumption of wheat and its consumption of clothing?
8. (a) Continuing with the numerical example in Question 6,
now assume that the United States has 600 hours of labor
available to it and that, prior to trade, it is using 330 of
those hours for producing wheat and the remaining 270
hours for producing clothing. How much wheat and how
much clothing will the United States be producing (and
therefore consuming) in this pretrade situation?
(b) Assume that trade between the United Kingdom and the
United States takes place as in Question 7(b). With trade
the United States devotes all of its labor hours to wheat
production and obtains 200 units of wheat. Consistent
with the United Kingdom’s trade in Question 7(b), the
United States then exports 80W and imports 40C. What
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27
will be the United States consumption of wheat and
clothing in the trading situation? By how much has the
United States, because of trade, been able to increase its
consumption of wheat and its consumption of clothing?
Looking at your answers to this question and to Question
7(b), can you conclude that trade is indeed a positivesum game? Why or why not?
9. China has had an overall trade surplus in recent years.
Economists suggest that this continuing phenomenon is
due to several things, including an inappropriate exchange
rate. How would a Mercantilist view this surplus? Why
might David Hume argue that the surplus will disappear on
its own?
10. Suppose that, in the context of the price-specie-flow mechanism, Switzerland currently exports 5,000 units of goods
to Spain, with each export unit having a price of 100 Swiss
francs. Hence, Switzerland’s total value of exports to Spain
is 500,000 Swiss francs. At the same time, Switzerland
imports 410,000 francs’ worth of goods from Spain, and
thus has a trade surplus with Spain of 90,000 Swiss francs
(5500,000 francs 2 410,000 francs). Because of this trade
surplus, suppose that all prices in Switzerland now rise uniformly by 10 percent, and assume that this rise in price of
Swiss goods causes its imports from Spain to rise from
their initial level of 410,000 francs to a level of 440,000
francs. (For purposes of simplicity, assume that the price
level in Spain does not change.)
Suppose now that the elasticity of demand of Spanish
consumers for Swiss exports is (ignoring the negative sign)
equal to 2.0. With the 10 percent rise in the price level in
Switzerland, the Swiss export price for each unit of its
exports thus rises to 110 francs. With this information, calculate the resulting change in quantity and the new total
value of Swiss exports. Has the price rise in Switzerland
been sufficient to eliminate its trade surplus with Spain?
Why or why not? Alternatively, suppose that the elasticity of demand of Spanish consumers for Swiss exports
(again ignoring the negative sign) is equal to 0.2. With the
10 percent rise in Swiss export prices, what happens to
Switzerland’s trade surplus with Spain in this case?
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