Title: Why Trade
1Why Trade?
- Short point well made in Motivational section of
chapter - If you want to do well in life
- Do what you do best and trade for the rest.
2 Early Trade Theories
- Mercantilism to the introduction of Classical
Trade Theory - (classical trade theory is the topic of Chapter
3) - Mercantilism
- Adam Smith and the concept of absolute advantage
3Chapter 2
- This chapter discusses the early development of
trade theory as we know it. - It describes a common approach to trade
Mercantilism, and then describes how the trade
theorists of the 18th and 19th centuries
challenged mercantilist thinking - Important point Mercantilist thinking still
pervades our language and still persists.
4Mercantilism
- A collection or pattern of thinking about
economics that became prominent in Europe from
1500 to 1750 - At the time, Europe was emerging from feudalist
society to early industrialism, and trade - Discovery of new lands provided opportunities for
trade exploitation.
5Mercantilism
- Mercantilist thinking served the power holders of
the time. Some of it still shows up today. - Mercantilist thinking included particular
approaches to - The Economic System
- Role of Trade
- The Role of Government
- Domestic Economic Policy
6Mercantilist Economic System
- Three components to Economic system
- Manufacturing (new power rising)
- Rural sector (feudal lords presiding)
- Foreign colonies (newly found sources of wealth)
7Mercantilist Economic System
- One goal for the state
- ACCUMULATE GOLD OR SILVER (specie) IN NATIONAL
TREASURY - Bullionism
- (bullion metal in the mass )
- This was how wars could be paid for and
mercantilists viewed the world as constantly at
war.
8Mercantilist Economic System
- View of the workings of the Economy
- ZERO-SUM GAME
- In a zero-sum game, one side can only win if the
other side loses the same amount. - Example poker I win 100 if someone else, or
some other group of people lose 100. - This is a critically important view that is
challenged.
9Mercantilist Economic System
- View of the workings of the Economy
- Source of value
- Labour theory of value the value of any good
can be traced back to the labour that is used in
its production. - This theory can have several effects on other
parts of thought, depending on the rest of ones
world view.
10Some economic realities of the time
- Countries were emerging from feudalism, the idea
of freedom of choice was not yet strong,
especially for normal people - There was growing overpopulation, and
underemployment. - The start of the industrial revolution meant more
people lived to adulthood, - There were struggles for control of land
resources.
11Mercantilism and Trade
- Trade is a zero-sum game.
- To win at trade, a country should control it
carefully. - A country wants to extract as much resources from
colonies as possible - A country also wants to use trade to promote
exports. This provides jobs for its population.
12Mercantilism and Trade
- Countries want to maintain a positive balance of
trade, or trade balance - A positive trade balance is one where
- Exports Imports
- (This terminology remains today!!!)
13Mercantilism and Trade
- Countries did not want a negative balance of
trade, or trade balance - Imports Exports
- (We still have a problem with this situation.)
14Mercantilism and Trade
- To maintain
- exports imports AND
- extract resources from colonies AND
- acquire gold and silver for national treasuries
- Countries used MONOPOLIES
- East India Company
- Hudson Bay Company
15Mercantilism Role of Government
- Governments role was to control trade and the
economy in order to raise taxes and finance wars
to protect the land from foreign invaders. - Government granted monopoly power to companies
- Controlled inflow and outflow of gold silver
16Mercantilism Role of Government
- Government granted monopoly power to companies
- contribute to positive trade balance
- Controlled shipping
- (only British ships could carry goods between
British ports, including colonies) - today still true, e.g. US, only US ships can
carry goods between US ports.
17Mercantilism Role of Government
- Imposed controls on trade, limiting imports
promoting exports (especially of manufactured
goods) - trying to keep prices low in imported raw
materials which would be worked on at home and
re-exported at a higher price. - Controlled inflow and outflow of gold silver
18Mercantilism Domestic Policies
- Internal restrictions were important too!!!
- Government granted internal monopoly power
through product charters monopolies (tax
exemptions, subsidies, special privileges) - Keep workers poor to keep them productive and to
get more for national treasury. - Labour mobility controlled through craft guilds
- Labour wages set institutionally to keep people
alive, and maintain class system.
19Paradox of Mercantilism
- A rich country by mercantilist standards was
composed of many poor people.
20Concept check
- What part of mercantilist thinking has carried
over to our current trade terminology? - Why would a mercantilist country want to control
shipping?
21Adam Smith
- Adam Smith completely changed the way people
thought about economics - Wealth of a Nation
- NOT gold and silver, but the productive
capacity of citizens - Economic Activity
- NOT a zero sum game, but a way to increase
wealth - Organization of Economy
- SHOULD NOT by government and tradition, but
people should be allowed to seek ways of making
the most money for themselves and the nation
will benefit
22Adam Smith and the concept of Absolute Advantage
- Adam Smith wanted people to understand that if
two countries trade, both CAN benefit. (He didnt
say they will, but they CAN) - He took the idea of specialization and applied it
to individuals, manufacturing and trade.
23Absolute Advantage example
- Lets take 2 countries
- Canada China
- Each has 250 hours to allocate to different
activities - Soybean Toys
- (measured in crates) (measured in boxes)
24Absolute Advantage example
- Soybean Toys
- Canada requires 5 hours to produce one crate of
soybeans, and 20 hours to produce one box of
toys. - China requires 15 hours to produce one crate of
soybeans and 10 hours to produce one box of toys. - These requirements determine prices inside each
of the two countries. -
25Absolute Advantage example
- Canada requires 5 hours to produce one crate of
soybeans, and 20 hours to produce one box of
toys. - China requires 15 hours to produce one crate of
soybeans and 10 hours to produce one box of toys. - Therefore, without trade,
- In Canada, four crates of soybeans can be
exchanged for one box of toys. Ps/Pt 1/4 - In China, two crates of soybeans can be exchanged
for three boxes of toys. Ps/Pt 3/2 -
26Labour Requirement Table
- Assume each country chooses to allocate workers
so that an equal amount of each good can be
produced. remember each has 250 hours.
27Labour Allocation Table
- Output Canada 10 of each good,
- China 10 of each good
- Total output 20 soybean crates, 20 toy boxes
28Next, we let the two countries specialize and
trade
- Adam Smith assumed complete specialization
- Canada produces only soybeans
- China produces only toys
29Labour Allocation Table with Specialization
- Output Canada 50 soybeans, China 25 toys
- Gain from specialization to world
- 50 20 30 soybeans
- 25 20 5
- Note range for price ratio Why do you think this
is so?
30Output and trade
- Assume price ratio is 11 ,
- Note with trade the price ratio between the two
goods is equalized across countries. - price ratio in Canada is 11
- price ratio in China is 11
- We call this world price ratio
31Output and trade
- Assume price ratio is 11 ,
- then Canada can sell 15 soybeans for 15 toys.
Canada then has 35 soybeans, 15 toys. - Gain from trade for Canada is 25 soybeans, 5 toys.
32Output and trade
- Assume price ratio is 11 ,
- let Canada sell enough soybeans that it has at
least as many, or more than it did without trade
- for this example, Canada sells 15 soybeans
- (I picked this number, it is not found in
table)
33Output and trade
- If price ratio is 11 ,
- China sells 15 toys for 15 soybeans
- China then has 15 soybeans, 10 toys.
- Gain from trade to China is 5 soybeans.
34Distribution of Gains from trade and price ratio
- Now, assume the price ratio is 23 , (2 toys
trade for 3 soybeans) then - Canada can sell 15 soybeans for 10 toys.
- Canada then has 35 soybeans, 10 toys.
- Gain from specialization trade to Canada is 15
soybeans.
35Distribution of Gains from trade and price ratio
- If price ratio is 23 ,
- China sells 10 toys for 15 soybeans
- China then has 15 soybeans, 15 toys.
- Gain from trade to China is 5 soybeans, 5 toys.
36Note on price ratio
- When the price ratio is Ps/Pt 2/3, China gains
more than when the price ratio is Ps/Pt 1/1 - The closer the price ratio is to Ps/Pt ¼, the
more China gains relative to Canada. - The closer the price ratio is to 3/2, the more
Canada gains relative to China. - Think about this!
37YOU DO
- Imagine 2 countries, France and China
- Each country makes wine and cloth
- The labour requirement table is shown on the next
page. - Assume France has 120 people, China has 180
people.
38Labour Requirement Table
- What is the price ratio Pw/Pc in each country
without trade?
39Labour Allocation Table
- Assume in each country goods are produced so that
an equal amount of each good is consumed within
the country. - How much labour is allocated to each good in each
country? - How much of each good is produced in each country
without trade?
40Labour Allocation Table
41You Do
- Assume complete specialization in each country.
- How much labour is allocated to each good in each
country? - Produce a labour allocation table with trade.
- How much of each good is produced in the world in
total? - Produce a product table with trade.
- What is the world gain from trade?
- Assume that, with trade, France wants to consume
the same amount of wine as it did without trade,
and export the rest for cloth. - What are the gains from trade for France and
China?
42Absolute advantage and Classical theory
- The notion that both countries can gain from
trade is the foundation for classical and
neoclassical theory. - Notice in the examples given above, it was not
the fact that one country was better at each good
that drove the result that both countries could
gain from trade.
43Absolute advantage and Classical theory
- The result depends on the different relative
prices in equilibrium - Recall the closer the trade price is to one
countrys price without trade, the less that
country gains from trade.
44Absolute advantage and Classical theory
- Therefore, the gain from trade comes from the
changing prices in the country - with trade, exported good increases in price
(relative to imported good), which increases
income in country - with trade, imported good decreases in price
(relative to exported goo), which allows country
to buy more of the good than it could without
trade.
45Absolute advantage and Classical theory
- The fact that trade depends on different relative
prices of goods in each country is the basis of
classical theory, and the basis of comparative
advantage.