Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

CHAPTER 2 EARL TRADE T!E"R#E$: Mercantilism and the Transition to the Classical World of David Ricardo
Learning Objectives: % % % #( Descri&e the &asic concepts and policies associated 'ith Mercantilism( E)amine !*me+s price-specie-flo' mechanism and the challen,e it posed to Mercantilism( Disc*ss Adam $mith+s concepts of 'ealth and a&sol*te advanta,e as fo*ndations for international trade( Outline #ntrod*ction - The "racle in the 2-st Cent*ry Mercantilism - The Mercantilist Economic $ystem - The Role of .overnment - Mercantilism and Domestic Economic /olicy The Challen,e to Mercantilism &y Early Classical Writers - David !*me 0 The /rice-$pecie-1lo' Mechanism - Adam $mith and the #nvisi&le !and $*mmary ##( Special Chapter Features #n The Real World: Mercantilism is $till Alive Concept 2o) -: Caps*le $*mmary of the /rice-$pecie-1lo' Mechanism Concept 2o) 2: Concept Revie' 0 /rice Elasticity and Total E)pendit*res Titans of #nternational Economics: Adam $mith 3-425--4607 ###( Purpose of Chapter

The p*rpose of this chapter is to trace o*t some of the early ideas re,ardin, the &asis for international trade and the distri&*tion of the &enefits to &e ,ained from trade( The chapter not only provides some historical perspective to trade theory8 &*t it also ma9es clear 'hy certain contemporary protectionist attit*des can &e seen as &ein, &ased in a Mercantilist vie' of the 'orld(

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

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Teaching Tips

A( #t is important to foc*s on the principal tenets of the Mercantilist system and then to e)amine the policy positions that follo' lo,ically( This provides a ,ood &ac9,ro*nd for eval*atin, vario*s trade policy positions later in the &oo9( 2( We feel that this is an e)cellent time to introd*ce the la&or theory of val*e( #t is a ,ood opport*nity to help the st*dent &e,in thin9in, in relative terms( #t is therefore important that the relative nat*re of this concept is clear in the st*dents+ minds( C( "nce the Mercantilist position is laid o*t and the economic policy implications disc*ssed8 one can e)amine ho' !*me+s price-specie-flo' mechanism and $mith+s ideas of the m*t*al ,ains from trade &ased on a&sol*te advanta,e contri&*ted to the decline of the Mercantilist 'ay of thin9in,( D( Disc*ssin, the price-specie-flo' mechanism at this point ,ives the st*dent an early insi,ht into the macro aspect of international trade that often ,ets short shrift 'hen the micro foc*s of Classical comparative advanta,e is introd*ced( :( Answers to End-of-Chapter Questions and Problems

-( Wealth 'as vie'ed as synonymo*s 'ith holdin,s of precio*s metals( ;ation-states 'ished to &ecome 'ealthy and this meant o&tainin, lar,e holdin,s of precio*s metals( #t is also ar,*ed &y some that the shorta,e of coina,e constrained the ,ro'th of these nation-states and that precio*s metals 'ere re<*ired to increase the s*pply of coina,e 3money7 in order for the co*ntries to ,ro'( 2( Critical pillars of Mercantilism: a( the =ero-s*m nat*re of international trade> &( the need for stron,8 po'erf*l ,overnments> c( the la&or theory of val*e> d( the need to re,*late economic activity> and e( the need for a positive trade &alance(

2eca*se 'ealth 'as vie'ed in terms of holdin,s of precio*s metals8 the o&?ective of economic activity and policy 'as to foster increased holdin,s of specie( Mercantilists &elieved that individ*als p*rs*in, their o'n self interest 'o*ld not accomplish this o&?ective and that8 conse<*ently8 economic activity had to &e closely re,*lated and s*pervised(

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

5( The parado) of Mercantilism is that 'ealthy co*ntries 'o*ld contain lar,e n*m&ers of very poor people( A second parado) is that 'ealthy co*ntries had to spend ,reat amo*nts of specie to protect their holdin,s of specie( Wa,es 'ere 9ept lo' 3at instit*tional s*&sistence levels7 to red*ce la&or costs8 and families 'ere enco*ra,ed to have children thro*,h vario*s ta)es and s*&sidies( These actions contri&*ted to a very lar,e poor 'or9in, class( @( Critical ass*mptions of the price-specie-flo' mechanism: a( some lin9 &et'een the money s*pply and the price level8 e(,(8 the <*antity theory of money> &( perfect competition8 'ith fle)i&le 'a,es and prices> c( price-elastic demand for traded ,oods> and d( e)istence of a ,old standard8 'ith no ,overnment interference 'ith the movement of ,old and no actions to sterili=e ,old+s impact on the money s*pply( #f the demand for traded ,oods 'ere price inelastic8 the movement of ,old and prices 'o*ld 'orsen trade &alances8 not correct them( This 'o*ld &e desta&ili=in,8 not sta&ili=in,( A( !*me+s price-specie-flo' mechanism s*,,ested that a co*ntry co*ld not s*stain a positive &alance of trade &eca*se of the effect on money and prices( The e)ternal payments position had reperc*ssions on internal economic varia&les( A contin*al positive trade &alance 'as th*s not a via&le policy tar,et8 and not a contin*o*s so*rce of increased 'ealth( $mith+s concept of a&sol*te advanta,e indicated that &oth co*ntries co*ld ,ain from trade8 in direct contrast to the Mercantilist+s =ero-s*m-,ame vie' of trade( B( The Cnited $tates has an a&sol*te advanta,e in the prod*ction of 'heat 35 hrs(D*nit E @ hrs(D*nit7 and the Cnited Fin,dom has an a&sol*te advanta,e in clothin, 3@ hrs(D*nit E 6 hrs(D*nit7( The Cnited $tates 'o*ld ,ain at the &arter price of -C:2W 3-W:0(AC7 since it only ,ets 0(55C for -W in a*tar9y( $imilarly8 the Cnited Fin,dom 'o*ld &enefit &eca*se it ta9es only 0(AC to o&tain a *nit of 'heat 'ith trade instead of -C in a*tar9y( 4( 3a7 #n a*tar9y the Cnited Fin,dom 'o*ld prod*ce 4A *nits of clothin, 3500 la&or ho*rsD@ hrs(7 and A0 *nits of 'heat 3200 la&or ho*rsD@ hrs(7( 3&7 #f the Cnited Fin,dom allocates all of its la&or to clothin, prod*ction8 it 'ill prod*ce -2A *nits of clothin, 3A00 total la&or ho*rsD@ hrs(7( Cnited Fin,dom cons*mption of clothin, 'ith trade 'ill &e the difference &et'een domestic prod*ction and e)ports8 i(e(8 GA *nits of cloth( Cnited Fin,dom cons*mption of 'heat 'ill &e e<*al to the G0 *nits of 'heat imports it receives for its @0 *nits of clothin, e)ports H3@0 *nits of e)ports7 32WD-C7I( Th*s8 'ith trade8 Cnited Fin,dom cons*mption of clothin, increased from 4A to GA *nits and its cons*mption of 'heat increased from A0 *nits to G0 *nits(

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

G( 3a7 #n a*tar9y Cnited $tates 'heat prod*ction 'ill &e --0 *nits 3550 la&or hrs(D5 hrs(78 and cloth prod*ction 'ill &e 50 *nits 3240 la&or ho*rsD6 hrs(7( 3&7 With trade8 the Cnited $tates 'ill cons*me -20 *nits of 'heat 3200 *nits of prod*ction less the G0 *nits of e)ports7 and @0 *nits of cloth imports( Conse<*ently8 'ith trade8 C($( cons*mption of 'heat has risen from --0 to -20 *nits and its cons*mption of cloth has risen from 50 to @0 *nits( #n this case trade is a positive-s*m ,ame since &oth parties are a&le to cons*me more of &oth ,oods 'ith trade compared to a*tar9y8 i(e(8 &oth co*ntries *nam&i,*o*sly ,ain from trade( 6( A Mercantilist 'o*ld vie' the contin*in, trade s*rpl*s as a very desira&le o*tcome8 since it prod*ces a net increase in Chinese holdin,s of forei,n e)chan,e 3claims on forei,n co*ntry assets7 'hich is similar to increased holdin,s of specie in Mercantilist times( To the Mercantilist8 the s*rpl*s represents s*ccessf*l Chinese policy8 not a pro&lem( !*me 'o*ld ar,*e that the sit*ation 'o*ld &e self-correctin, if a fi)ed e)chan,e rate system is in place as lon, as prices and 'a,es are fle)i&le and China does nothin, to interfere 'ith the flo' of payment and its impact on the money s*pply( The increase in the money s*pply accompanyin, the trade s*rpl*s 'o*ld lead to a relative increase in the prices of Chinese ,oods8 th*s red*cin, the trade s*rpl*s( #n China+s tradin, partners8 the money s*pply 'o*ld decrease and prices 'o*ld decrease8 th*s decreasin, their deficits( Movement to a =ero trade &alance 'o*ld also occ*r *nder a fle)i&le-rate system &eca*se the trade s*rpl*s 'o*ld lead to an increase in the val*e of the Chinese c*rrency and therefore to a relative increase in the prices of Chinese ,oods and services( -0( With a price elasticity of demand of 3-7 2(08 a -0 percent increase in price 'ill ca*se the <*antity demanded in $pain to fall &y 20 percent H3-2(07 30(-07I( 2eca*se $'it=erland 'as initially e)portin, A8000 *nits8 the ne' level of e)ports 'ill &e @8000 H3A80007 3- - 0(207I( The ne' val*e of $'iss e)ports 'ill &e @@08000 francs H3@80007 3--07I8 'hich is e)actly e<*al to its ne' level of imports( The increase in $'iss prices has th*s 'or9ed to remove its trade s*rpl*s 'ith $pain( #n the alternative case8 'ith a price elasticity of demand for $'iss e)ports of 3-7 0(28 the -0 percent rise in the price of $'iss ,oods 'ill ca*se the <*antity demanded in $pain to fall &y only 2 percent H3-0(2730(-07I( The initial e)port of A8000 *nits decreases &y 2 percent of A8000 or &y -00 *nits8 to a <*antity of @8600 *nits( The ne' val*e of $'iss e)ports to $pain 'ill th*s &e A568000 francs H3@860073--07I( The $'iss trade s*rpl*s 'ith $pain 'ill hence &e A568000 francs 0 @@08000 francs J 668000 francs8 'hich is lar,er than the ori,inal s*rpl*s of 608000 francs( The inelastic demand sit*ation has res*lted in the price-specie-flo' mechanism ,eneratin, an increase in $'it=erland+s s*rpl*s8 not a decrease(

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

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Sample Exam Questions Essay K*estions

-( E)plain ho' the price-specie-flo' mechanism operates to maintain &alanced trade &et'een co*ntries( What are the ass*mptions that are critical to the mechanism+s s*ccessf*l operationL 2( Why 'as a positive trade &alance so important to MercantilistsL #n Mercantilist thin9in,8 'hy did a positive trade &alance not res*lt in domestic inflation and a loss of international competitivenessL 5( What 'ere the critical fo*ndations of Mercantilist tho*,htL What trade policies res*lted from this 'ay of thin9in,L @( E)plain 'hat is meant &y a =ero-s*m ,ame8 and 'hy it 'as central to Mercantilist thin9in,( Then8 e)plain ho' $mith+s idea of a&sol*te advanta,e altered the nat*re of the M,ame(N A( 3a7 Why did the Mercantilists thin9 that a sit*ation 'here a co*ntry+s e)ports e)ceed its imports is a Mfavora&leN sit*ation for the co*ntryL 2riefly8 'hat policies 'o*ld a Mercantilist recommend in order to ,enerate s*ch a Mfavora&leN sit*ationL 3&7 What 'as the Mprice-specie-flo' doctrineN and ho' did it *ndermine Mercantilist thin9in,L Why 'o*ld a sit*ation 'here the demands for traded ,oods are MinelasticN 'ith respect to price chan,es pose a pro&lem for the Mprice-specie-flo' doctrineN in its attac9 on Mercantilist thin9in,L 2( B( M*ltiple-Choice K*estions #n the price-specie-flo' doctrine8 a deficit co*ntry 'ill OOOOOOOOOO ,old8 and this ,old flo' 'ill *ltimately lead to OOOOOOOOOO in the deficit co*ntry+s e)ports( a( P &( c( d( 4( lose> lose> ,ain> ,ain> a decrease an increase a decrease an increase

#n the Mercantilist vie' of international trade 3in a t'o-co*ntry 'orld78

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

a( &oth co*ntries co*ld ,ain from trade at the same time8 &*t the distri&*tion of the ,ains depended *pon the terms of trade( &( &oth co*ntries co*ld ,ain from trade at the same time8 and the terms of trade 'ere of no conse<*ence for the distri&*tion of the ,ains( c( neither co*ntry co*ld ever ,ain from trade( P d( one co*ntry+s ,ain from trade 'as associated 'ith a loss for the other co*ntry( G( Accordin, to the la&or theory of val*e8 a( the val*e of la&or is determined &y its val*e in prod*ction( &( the val*e of a ,ood is determined &y the amo*nt of la&or 'ith 'hich each *nit of capital in an ind*stry 'or9s( P c( the price of a ,ood A compared to the price of ,ood 2 &ears the same relationship as the relative amo*nts of la&or *sed in prod*cin, each ,ood( d( the val*es of t'o minerals s*ch as coal and ,old 'ith similar prod*ction costs may &e very different( #f the demand for traded ,oods is price-inelastic8 the price-specie-flo' mechanism 'ill res*lt in a( ,old movements &et'een co*ntries that remove trade deficits and s*rpl*ses( P &( ,old movements &et'een co*ntries that 'orsen trade deficits and s*rpl*ses( c( ne,li,i&le movements of ,old &et'een co*ntries and hence little or no ad?*stment of trade deficits and s*rpl*ses( d( a removal of the &asis for trade &et'een co*ntries( -0( #n Adam $mith+s vie'8 international trade a( &( c( P d( --( &enefited &oth tradin, co*ntries( 'as &ased on a&sol*te cost differences( reflected the reso*rce &ase of the co*ntries in <*estion( all of the a&ove(

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Which of the follo'in, policies 'o*ld OT &e consistent 'ith the Mercantilist &alanceof-trade doctrineL P a( &( c( d( payment of hi,h 'a,es to la&or import d*ties on final prod*cts e)port s*&sidies prohi&ition of imports of man*fact*red ,oods

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

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D*rin, the price-specie-flo' ad?*stment process to a trade im&alance8 if demands for ,oods are inelastic8 then8 'hen the price level OOOOOOOOOO in the co*ntry 'ith the trade deficit8 the val*e of that co*ntry+s e)ports 'ill OOOOOOOOOO as the price-specie-flo' process ta9es place( a( P &( c( d( falls> increase falls> decrease rises> increase rises> decrease

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David !*me+s price-specie-flo' mechanism a( reinforced the Mercantilist notion that a co*ntry co*ld maintain a permanent Mfavora&leN &alance of trade 'here e)ports e)ceeded imports( P &( 'or9s more effectively if demands for traded ,oods are Mprice-elasticN rather than Mprice-inelastic(N c( ass*med that the co*ntries involved have s*&stantial *nemployment( d( 'or9s e<*ally effectively 'hether demands for traded ,oods are Mprice-elasticN or Mprice-inelastic(N

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The price-specie-flo' mechanism s*,,ested that a( a co*ntry co*ld easily maintain a &alance-of-payments s*rpl*s for a lon, period of time( &( a deficit co*ntry 'o*ld e)perience an increase in its money s*pply and its price level( P c( a s*rpl*s co*ntry 'o*ld e)perience an increase in its money s*pply and its price level( d( a co*ntry+s internal price level has no relation to the co*ntry+s forei,n trade activities(

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The policy of minim*m ,overnment interference in or re,*lation of economic activity8 advocated &y Adam $mith and the Classical economists8 'as 9no'n as a( P &( c( d( the la' of comparative advanta,e( laisse=-faire( the la&or theory of val*e( Mercantilism(

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A Mercantilist policyma9er 'o*ld &e in favor of 'hich of the follo'in, policies or events pertainin, to hisDher co*ntryL

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

a( &( c( P d( -4(

a decrease in the si=e of the pop*lation a minim*m 'a,e &ill to protect the standard of livin, of 'or9ers a prohi&ition on the e)port of man*fact*red ,oods an increase in the percenta,e of factors of prod*ction devoted to addin, val*e to imported ra' materials in order to later e)port the res*ltin, man*fact*red ,oods(

#n the conte)t of David !*me+s price-specie-flo' mechanism that challen,ed the feasi&ility of the Mercantilist ideas re,ardin, a trade s*rpl*s8 'hich one of the follo'in, statements is NOT correctL a( &( P c( d( There is a decrease in the money s*pply in the deficit co*ntry( There is an increase in the price level in the s*rpl*s co*ntry( There is an increase in real income in the s*rpl*s co*ntry( /rice chan,es in the s*rpl*s co*ntry ca*se that co*ntry+s e)ports to decrease(

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#n David !*me+s price-specie-flo' doctrine or ad?*stment mechanism8 the ass*mption is made that chan,es in the money s*pply have an impact on OOOOOOOOOO( 1*rther8 the demand for traded ,oods is ass*med to &e OOOOOOOOOO 'ith respect to price( P a( &( c( d( prices rather than on o*tp*t> prices rather than on o*tp*t> o*tp*t rather than on prices> o*tp*t rather than on prices> elastic inelastic elastic inelastic

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The Mparado) of MercantilismN reflected that fact that a( P &( c( d( trade s*rpl*ses 'ere fostered &y protective tariffs( rich co*ntries 'ere comprised of lar,e n*m&ers of poor people( ,old inflo's led to hi,her prices and red*ced e)ports( ,old co*ld not &e hoarded and provide money for the economy at the same time(

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.iven the follo'in, Classical-type ta&le sho'in, the n*m&er of days of la&or inp*t re<*ired to o&tain one *nit of o*tp*t of each of the t'o commodities in each of the t'o co*ntries: &icycles Cnited $tates Cnited Fin,dom @ days A days comp*ters 5 days B days

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

The Cnited $tates has an a&sol*te advanta,e in the prod*ction of OOOOOOOOOO( a( &( P c( d( &icycles 3only7 comp*ters 3only7 &oth &icycles and comp*ters neither &icycles nor comp*ters J real

2-( With M$ J s*pply of money8 : J velocity of money8 / J price level8 and o*tp*t8 'hich one of the follo'in, indicates the <*antity theory of money e)pressionL a( &( c( P d( 22( M$ J /: M$/ J : M$ J / - : M $: J /

#n the price-specie-flo' mechanism8 there is a ,old OOOOOOOOOO a co*ntry 'ith a &alanceof-trade s*rpl*s8 and this ,old flo' *ltimately leads to OOOOOOOOOO in the s*rpl*s co*ntry+s e)ports( a( P &( c( d( inflo' into> an increase inflo' into> a decrease o*tflo' from> an increase o*tflo' from> a decrease

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#n the price-specie-flo' ad?*stment mechanism8 a co*ntry 'ith a &alance-of-trade s*rpl*s e)periences a( &( P c( d( a ,old inflo' and a decrease in the price level( a ,old o*tflo' and an increase in the money s*pply( an increase in the money s*pply and a decrease in e)ports( a decrease in the money s*pply and a decrease in imports(

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

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$*ppose that co*ntry A+s total e)ports are -08000 *nits of ,ood Q at a price of R20 per *nit8 meanin, that co*ntry A+s e)port earnin,s or receipts are R2008000( $*ppose also that the forei,n price elasticity of demand for co*ntry A+s e)ports of ,ood Q is 3-7 0(B( #f co*ntry A+s prices for all ,oods8 incl*din, its e)ports8 no' rise &y -0S &eca*se of a ,old inflo' s*ch as in the Mercantilist model8 then8 other thin,s e<*al8 co*ntry A+s e)ports of ,ood Q 'ill fall &y OOOOOOOOOO and co*ntry A+s e)port earnin,s or receipts 'ill &ecome OOOOOOOOOO( a( P &( c( d( B00 *nits> less than R2008000 B00 *nits> ,reater than R2008000 -8000 *nits> less than R2008000 -8000 *nits> ,reater than R2008000

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