Unit 2: Trade theory

1. Theory of trade protectionism

1.1 Mercantilism
1.1.1 Mercantilists’ opinion
- In 16-18 century, in France and Britain, there was
appearance of new school of economic thoughts, called
mercantilism (capitalism had just arisen in XVI century).
- Representatives were Thomas Mun, Jame Steward
(Britain); Jean Bodin, Melon, Colbert (France).
- As real estate agents in the old gold mining area of
Colorado thoughts, mercantilists identified the precious
metals, gold and silver with true wealth.
- They argued:
 (i) exports were a blessing since they stimulate domestic industry and
lead to having more gold and silver.
  (ii) imports were a burden since they reduce the demand for the
domestic products and drain away bullion (gold and silver).
 (iii) exports and production should be encouraged by state support
and subsidies, while imports should be discouraged by protectionist
restrictions especially in industries of strategic importance.
1.1.2 Strong points of mercantilism
- When the domestic capacity to produce is bigger than
domestic demand, more exports and fewer imports is to be
welcomed.
- When a country is having difficulty in balance of payment,
hence it welcomes a surplus in foreign trade.
- Both the mercantilism and Keynesianism (later) position
can be given an element of respectability by recognizing
that it is the increase in the money supply that has
stimulating effects on business.
1.1.3 limitation of mercantilism
 - Considering gold and silver as true wealth of nations, better than
native soil.
 - Identifying money supply with prosperity of the country
 - Missing the main point of what trade is about and thereby failed to
recognize that trade is win-win game, not zero sum game.
 - Not discovering benefit and effectiveness from production
specialization and commodity exchange.
1.2 The ideology of Alexander Hamilton
Hamilton’s ideology is the representative of the 18th century
American protectionism.
- He pointed out that gains from international free trade
were not practical and viewed that foreign governments did
not hesitate to create obstacles for American export.
- He and other economists in NA tried to explore the
valuable idea of mercantilism on building infant industries.
- He proposed government intervention through various
domestic industry promoting policies, including infant
industries protection policies such as:
 (i) import restriction;
 (ii) high import tariff;
 (iii) reward to encourage creation on industrial (and agricultural)
production;
 (iv) subsidy and tax returns;
 (v) investment on invention programs and infrastructure.
- Hamilton proposed to build American domestic industries.
He argued that industrial production generated 7
advantages:
 (i) enhancing labor division;
 (ii) encouraging to apply machines;
 (iii) creating more job for the people who were not suitable for
agricultural jobs such as women and children;
  (iv) promoting immigration;
 (v) expanding opportunities for talents and encouraging the
creativeness;
 (vi) promoting “entrepreneurship”;
 (vii) expanding domestic market for agricultural products (he argued
that foreign markets were not reliable).
1.3 German nationalism
- With Hamilton, there was German Historical School like
Johann Fichte, Georg Hegel, Friedrich List in 19th century.
- According to this School, development of German
economy attributed to the German protectionism and state’s
role in national industrial orientation.
- Germany was the first country which enhanced economic
development by a systemic and comprehensive industrial
policies in the second half of 19th century.
- German nationalism emphasized the role of state as:
  (i) managing development of production system;
 (ii) supporting and enhancing the advancement of people’s spiritual,
thinking, health and socio-economic life;
 (iii) nationalizing highly monopolized industries such as
communication, transportation, public services, insurance and
banking;
 (iv) ensuring more equitable income by imposing income tax,
inheritance tax, profit tax;
 (v) controlling fees for telecommunication, railway transport, lawyer,
education to ensure that lower income person paying less for such
services;
 (vi) interfering in and adjusting economic activities through high
protectionist tariff to protect German infant industries with the view
to develop German industrial power as Great Britain.
2. Free trade theory
2.1. Adam Smith’s (1723 – 1790) absolute advantage
- In his book “The Wealth of Nations” in 1776, Adam
Smith shows that voluntary exchange between countries
brings benefits to both, without the need for one to have a
surplus (or other a deficit).
- Smith presented a very simple and intuitive theory to
explain how trade could benefit both participants.
 He supposed that a country A could produce a certain good - for
example steel - better than the rest of the world (country B),
 while the latter (country B) could produce other products - for
example cloth - better than former (country A) did.
- He concluded that
 if both countries concentrated their production on the good in which
they enjoyed an absolute advantage, world output increased and
then exported that good to their trading partners, they can both
consume more than if they refuse to trade.
 To increase consumption is the fundamental object of trading.
- Before specialization, there is total: ∑Q = 2 st. units + 2 cl.units,
- After specialization there is total: ∑Q = 3.5 st. units + 3 cl. Units:
* If term of trade is 1 st = 1 cl  ∑Q = (2.5 st + 1cl) A + (1 st +2 cl) B.

Country A Country B
Good
Steels 2 labor per 6 labor per
unit unit
Clothes 5 labor per 3 labor per
unit unit
Before spec. and 1st. + 1 1st. + 1
trade 1cl. cl.
After specialization 3.5 st. 3 cl.
 - Thanks to the absolute advantage and specialization, world
output increased, and thanks to trade, consumers in the world
could consume more. The absolute advantage explains benefit
sources of international trade, which is win-win game.
 2.2 Theory of comparative advantage by Ricardo (1772-1823)
 - If a country has absolute disadvantages to produce all good
compared with another country, will the former benefit from
specialization and trade?
 - By using the theory of absolute advantage it could not be
interpreted this phenomenon. But Ricardo using the theory of
comparative advantages interpreted sources of trade and
specialization even when a country has absolute disadvantages
to produce all good.
 - Ricardo argued:
 (i) Although the country A has absolute advantages to produce all
goods, but it has only comparative advantages to produce a certain
good.
  (ii) The country B has also comparative advantages to produce
another good, let call clothes, which has less disadvantage than to
produce steel.
- Let us use above example, but with assumption that
necessary quantity of labor input to produce 1 unit of steel
and cloth in country B has changed.
 Country A Country B
Steel 2 labor unit 12 labor unit
Cloth 5 labor unit 6 labor unit

 - Before specialization, there is total: ∑Q = 2 st. units + 2 cl.units,

- After specialization there is total: ∑Q = 3.5 st. units + 3 cl. Units:
 * If term of trade is 1 st = 1 cl  ∑Q = (2,5 st + 1cl) A + (1 st +2 cl)
B.
* If TOT: 1 st = 0.4 cl  1 cl = 2,5 st  ∑Q = (1 st + 1cl) A + (2,5 st
+ 2cl) B
* If TOT: 1 st = 2 cl  ∑Q = (2,5 st + 2 cl) A + (1 st + 1 cl) B
- By this assumption,
 country A has absolute advantages to produce both goods compared
with country B (2 < 12 and 5 < 6),
 but A has comparative advantages to produce steel compared with
producing cloth (2/12<5/6=10/12),
 and B has comparative advantages to produce cloth compared with
producing steel (6/5 = 1.2 < 12/2 = 6).
- Ricardo argued:
 if country A concentrated on production of steel, and country B on
production of cloth, then changed steel for cloth, world output of steel
and cloth would be increased and both A and B would be benefited.
 - Domestic exchange ratio is expressed in agreement between steel
and cloth producers change 1 unit of steel for certain quantity of cloth
units.
 - In country A, 1 steel unit can be changed for 0.4 cloth units, while in
B, can be changed for 2 cloth units => domestic exchange rate:
 2 labor/5labor =1 steel/1 cloth=> 0.4 = 1 steel/1 cloth=>1 st=0.4 cloth
- Terms of trade is exchange rate of steel and cloth between
country A and B.
- Both country A and B only could be benefited if terms of
trade is somewhere in between domestic exchange ratios of
countries, meaning that
 0.4 cloth units < 1 steel unit < 2 cloth units. If terms of trade is
beyond this limitation, one of them will refuse to trade, because trade
makes one of them be lost (1C = 2.5S) .
=> Comments on classical theories
 - Both theories only emphasized on the supply side, considered the
production to be unique source of trade (demand is also factor for
trade).
 - Price of commodities is not expressed in money, but in quantity of
another good. That is batter trade.
 - Labor is a unique production factor in every industry.
 - Supporting free international trade.
2.3 Heckscher - Ohlin theory
- To overcome limitation of one-factor model, two Swedish
economists Heckscher (1879-1952) and Ohlin (1899-1979)
gave an alternative explanation of the sources of
comparative advantage, and since then this has become the
orthodox explanation.
- The assumption of the theory that
 (i) both have identical technology;
 (ii) tastes are identical and homothetic in the two countries;
 (iii) production factors can move from one industry to another within
country, but can not move from one country to another;
 (iv) free trade and transport cost is zero;
 (v) perfect competition in both factor input and output markets.
=>Theses assumptions mean that two country differ in only
two respects: their size and the ratio K/L in which they are
endowed with labor and capital.
- The basic idea is that
 Countries differ in their relative stocks of the different factors of
production, and that these differential factor supplies influence the
costs of producing particular goods.
 Each country will produce and export the good that is intensive in its
abundant factor
 A country with a abundant supply of capital finds it relatively cheap
to produce goods whose production requires much capital and little
labor, therefore has a comparative advantage in and export such
capital-intensive goods.
 Between country A and B, if KA/LA > KB/LB then A is considered to
have abundant capital factor; if LA/KA < LB/KB, B is abundant labor
factor country.
 In A, capital intensive good will have lower opportunity cost, it will
be necessary to give up capital-intensive good in order to secure a
marginal increase in the output of the labor-intensive good.
  Conversely, the labor-intensive good will have higher opportunity
cost in A, and lower opportunity cost in B.
- Steel is considered the capital-intensive good if KS/LS >
KC/LC. Cloth is considered the labor-intensive good if LC/KC
> LS/KS.
=> A will concentrate on producing steel and B on
producing cloth. Then they trade 2 goods with each other
and two countries will be benefited.
- The production equilibrium of an economy (with 2 goods
and 2 factors) by bringing together the 2 isoquant diagrams
for the 2 goods in a diagram called the Edgeworth box
named after its inventor, the English neo-classical
economist Francis Edgeworth (1845-1926).
Isoquant curve and Edgeworth box
* At a typical point G, quantities O H of L and O J of K are
C C
sufficient to produce an output of C1. Similarly, the
remaining quantities of L and K have to be looked at from
the standpoint of S’s isoquant with the origin O S. It can be
seen that they would permit production of S 3.
* In general, any point in the Edgeworth box represent a
specific division of available factor supplies between two
industries, have specific output level of 2 goods. It assumed
that the supplies of both factors are fully utilized, that is full
employment prevails.
* The points of tangency between S and C ; S and C ; C1
0 2 3 3
and S1; C0 and S2 and so on can be joint up to form the
contract curve running from OC to OS which is the set of
efficient production points.
- An isoquant is the locus of combinations of production
factors that can efficiently produce a given level of output
of a certain good - for example S.
- An indifference curve shows the locus of combinations of
two consumer goods that will induce a given level of
satisfaction for a consumer.