Mercantilists and the Classical theorists Study Unit 2 Mercantilists and the Classical theorists

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Follow us in your textbook… 11th ed. page 29- 48 10th ed. page 31 -53

2.1 Introduction The section on trade theory looks at the early and classical trade theories. Trade theories try to explain why and how countries trade. In order words, the patterns and gains from trade. We focus first on the mercantilists and the classical theorists (Adam Smith and David Ricardo).

2.1 Continue Why do countries trade? To benefit from specialisation Since 1 country cannot produce all goods efficiently, it is better off producing that which it can produce efficiently and importing that which it cannot. Countries therefore trade to increase their consumption.

2.2. Mercantilists’ views on trade Mercantilists were a group of writers in Europe between 1500-1800’s. Believed that for a nation to be rich and powerful it should export more than it imported. Having a trade surplus in the form of bullion ensured riches and power. Advocated for protectionism by government in the form of tariff and other trade barriers.

2.2 Continue Trade was seen to be a zero sum game since for a nation to gain, another has to lose. Believed trade was driven by self interest. They failed to consider the impact having a surplus will have on an economy. Theory also fails to explain welfare effects of trade policy.

Watch the following video about mercantilism (Internet connection required) Click here

Do the following true or false questions: For the mercantilists, international trade was a zero sum game. Hume, Smith and Ricardo were followers of the mercantilist doctrine. According to the mercantilists, national economic welfare can only be increased if the government encourages exports and imports.

Practice Essay question. Mercantilists believed that two nations can gain from trade by trading according to each of their absolute advantages. Is this a valid statement? Explain. [15 marks]

Case study 2-2: Mercantilism is alive and well in the 21st century Most countries support free trade. However, there are always countries debating free trade: The USA and European Union have been disputing the trade of beef raised with hormones. The EU on the other hand prefers bananas from Africa above Central American plantations. Trade restriction are implemented to protect local jobs.

2.3. Classical Theorists 2.3.1. True based on absolute advantage (Adam Smith) According to Adam Smith, a nation has absolute advantage in the production of a commodity if it can produce a commodity more efficiently (less inputs) than the other nation. Having absolute advantage in the production of 1 commodity is a prerequisite for trade to occur. Countries gain from trade by specializing in producing the product of their absolute advantage.

Continue Specialization (division of labour) leads to increased output of both commodities. The gains from specialization is the increased output. If one nation had absolute advantage in producing both goods, then trade will not occur. Because each country produces and exports its commodity of absolute advantage, the theory suggests that there is complete specialization.

Assumptions of the theory of absolute and comparative advantage Producers and consumers are rational. There are 2 countries and 2 commodities. Labour is the only factor of production. Each nation has a fixed endowment of resources Perfect competition exists. Free mobility of labour between the 2 goods in each country but not between nations. No barriers to trade. Constant returns to scale in production. No transport costs Technology level is fixed in both countries, though it may differ between the countries.

Climbing trees for coconuts Absolute Advantage If they do not trade & each spend 30min on catching fish and 30min on coconuts. Then they will have the following Catching fish Climbing trees for coconuts Man Woman A man and a woman are stranded on a island. They need fish and coconuts to survive. The man is a better swimmer and catches 20 fish in an hour. The woman only catches 8.He has an absolute advantage in catching fish The woman is better in climbing trees. In one hour she gets 10 coconuts. The man only gets 6. She has an absolute advantage in getting coconuts 20 10 3 6 8 10 4 5

Climbing trees for coconuts Absolute Advantage Catching fish Climbing trees for coconuts Man Woman If they each specialise and trade the rest, then they will have more coconuts and more fish! Let’s write in the corner how much they will have if they do not trade (just to remember). Compare how much they have if they trade to the values in the corners! (Not trade=10) (Not trade=3) 10 3 20 10 10 (Not trade=4) (Not trade=5) 4 10 5 5 5

Do the following questions Output per labour day South Africa Lesotho Wheat 20 bushels 50 bushels Gold 80 tonnes 20 tonnes In which commodity does Lesotho's absolute advantage lie? In which commodity does South Africa's absolute advantage lie? According to Smith, who should specialise in producing wheat? According to Smith , who should specialise in producing gold?

2.3. Classical Theorists 2.3.3. Ricardian theory of comparative advantage (David Ricardo) According to Ricardo, mutually beneficial trade is possible even if one nation has absolute advantage in the production of both goods. Mutually beneficial trade will only be possible if each nation has comparative advantage in the production of one of the goods. What is important is the degree of the advantage.

Continue A nation will export the commodity for which the opportunity cost is lowest and import that for which the opportunity cost is higher. If the opportunity costs of producing the 2 goods is the same in both nations, then trade will not be possible. This implies that neither of the two nations have comparative advantage in the production of any of the commodities. This thus means that for trade to occur, the opportunity cost must be different in both nations.

Comparative Advantage Catching fish Climbing trees for coconuts Man Woman Now, the woman had a absolute advantage in both fishing and coconuts. Do you think they should still trade? A year later the man became ill and was not able swim any more. Now he could only catch 2 fish in a hour. Yes! Let’s look at the opportunity cost. In the time it takes the woman to catch one fish, she could have gotten 1.25 coconuts. The man has a higher (opportunity) cost in getting fish. It will be better for the man to get the coconuts and for the woman to fish. Now the man has a COMPARATIVE advantage in getting coconuts. In the time it takes the man to catch one fish, he could have gotten 3 coconuts 2 1 20 20 6 6 2 = 3 6 8 8 10 10 10 8 = 1.25 1

For more on absolute advantage study table 2.1 in your textbook More examples For more on absolute advantage study table 2.1 in your textbook For more on comparative advantages study table 2.2 in your textbook

Still want to know more? Watch the following video about absolute and comparative advantage (Internet connection required) Click here

Do the following questions: South Africa Ghana Gold 60 tonnes 20 tonnes Uranium 10 tonnes Domestic ToT 3G:1U 2G:1U South Africa has comparative advantage in the production of gold, while Ghana has comparative advantage in the production of Uranium. How? do the calculations of opportunity costs. International specialisation must be based on Comparative and not absolute advantage. The international terms of trade must fall between the Domestic terms of trade, that is 2G<1U<3G.

Do the following true or false questions: If a nation can produce four more units of X by producing one less unit of Y, then the opportunity cost of producing X is ¼ units of Y. If a nation can produce one more unit of X by producing four less units of Y, then the opportunity cost of producing Y is four units of X. If two nations have the same opportunity costs for two goods, then both countries have a comparative advantage in the production of both goods.

Essay questions on absolute and comparative advantage Given your knowledge of the classical theories, evaluate the following statement: “According to Adam Smith, mutually beneficial trade is only possible if one nation has a comparative advantage in the production of at least one of the commodities. Note: all assumptions and criticisms must be stated. [25 marks]

End of study unit 2