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Early Trade Theories:

Mercantilism and the Transition to the Classical World of

David Ricardo

Chapter 2Chapter 2

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Course Learning Outcomes(1) To have a sound knowledge of the quantitative

and qualitative methods that will help to examine the premises of different theories for an applied subject so that a contribution to solving current economic problems can be made.

(7) To have sufficient practical and theoretical knowledge base in order to define the economic agents and their interaction both in the national and global level

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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.• A country should maintain a positive trade

balance (that is, export more than it imports).• Mercantilism employed the labor theory of

value: commodities were valued relatively in terms of their relative labor content

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3 Components of Economic System

• Manufacturing sector• Rural sector• Foreign colonies

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Von Hornick’s Manifesto• Every inch of a country’s soil be utilized for

agriculture, mining or manufactoring• All raw materials found in a country be used in

domestic manufacture, since finished goods have a higher value than raw materials

• A large, working population be encouraged• All export of gold and silver be prohibited and

all domestic money be kept in circulation• All imports of foreign goods be discouraged as

much as possible

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Von Hornick’s Manifesto cont.• Where certain imports are indispensible they be

obtained at first hand, in exchange for other domestic goods instead of gold and silver

• As much as possible, imports be confined to raw materials that can be finished at home

• Opportunities be constantly sought for selling a country’s surplus manufacturers to foreigners, so far as necessary, for gold and silver

• No importation be allowed if such goods sufficiently and suitably supplied at home

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The Role of Government

• “Bullionism”: the control of government on the use and exchange of precious metals

• Substantial regulation of the domestic economy, including– governmental granting of monopolies,

and– control of labor

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The Role of Government

• Policies to ensure low wages, including–policies to discourage importation and

encourage exportation, and–policies to discourage exportation of specie.

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The Paradox of Mercantilism

To be rich, a country needed to have a lot of poor people!

Arthur Young (1771) “Everyone but an idiot knows that the lower classes must be kept poor or they will never be industrious.”

Specie was accumulated at the expense of current consumption

High spending of specie for protection

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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.

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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)• higher prices lower exports and higher imports

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Assumptions

• Formal link between money and prices as provided in the quantity theory of money Ms V = PY

• Demand for traded goods is price elastic• Perfect competition in both product and

factor markets• Gold standard exists

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Smith’s Challenge: Absolute Advantage

• Smith believed trade to be a positive-sum game.

• 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).

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Glasgow University

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Smith’s Challenge

• A nation’s wealth is reflected in its productive capacity not in its holding of precious metals.

• Growth in productive capacity was fostered best in an environment where people were free to pursue their own interests

• Little need for government control• Laissez faire (allowing individuals to pursue

their own activities within bounds of law and order and respect property rights)

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Absolute Advantage: An Example

Corn Wine

Turkey 1 hour/bu 6 hrs/bbl

Italy 3 hrs/bu 5 hrs/bbl

Autarky Price Ratios (APRs)

1W = 6C, 1C = 1/6W

1W = 5/3C, 1C = 3/5W

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Absolute Advantage: An Example

• Suppose Turkey and Italy agree to trade at a ratio of 1W = 4C (or 1C = ¼ W).

• Suppose further that Italy will specialize in wine and Turkey in corn.

• From Turkey’s perspective:–Can now buy wine at a lower price (1W = 6C

in autarky, but 1W = 4C in trade).–Can sell corn at a higher price (1C = 1/6 W in

autarky, but 1C = ¼ W in trade).

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Absolute Advantage: An Example

• From Italy’s perspective:–Can now sell wine at a higher price (1W =

5/3C in autarky, but 1W = 4C in trade).–Can buy corn at a lower price (1C = 3/5 W

in autarky, but 1C = ¼ W in trade).

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Absolute Advantage: An Example

• Bottom line: both countries gain from trade, even if certain industries (wine industry in Turkey, corn industry in Italy) 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 Wine

Turkey 1 hour/bu 5 hrs/bl

Italy 3 hrs/bu 6 hrs/bl

Autarky Price Ratios (APRs)

1W = 5C, 1C = 1/5W

1W = 2C, 1C = 1/2W

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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!