International Trade Theories

 Gains from Trade -- a history of thought approach
1. The idea of mercantilism (1500-1750) argued that a country’s well-being is directly tied to the accumulation of gold and silver. Therefore, a country should promote exports and restrict imports to generate a trade surplus.
a. A trade surplus brings about a flow of payments back to the country.
b. Mercantilism provided the economic motivation behind colonialism of the 17th and 18th centuries.
2. Adam Smith (1776) argued that a country’s well-being depends upon its income and what it can consume. He proposed a policy of free trade so each nation can gain from trade. a. Mutual gains from voluntary exchange of existing goods allows for people to choose their preferred combination of goods and thus achieve higher utility. b. Increased competition from foreign firms lowers market prices. c. The division of labor reduces costs since each worker can specialize in a certain area or task. d. Countries can gain by exporting goods in which they are skilled at producing and importing goods in which another country is skilled at producing. It was this idea that David Ricardo picked up and formalized.
3. David Ricardo (1817) developed the theory of comparative advantage that shows that each country can increase its consumption possibilities through voluntary trade. a. An individual or country is said to have a comparative advantage if it can produce a good at a lower opportunity cost than the other. b. An individual or country is said to have an absolute advantage if it can produce more of every good than the other. c. If each country specializes in the production of the good in which they have a comparative advantage, then both countries benefit from increased consumption possibilities.
 4. The Heckscher and Ohlin (1950s) model explains why a country has a comparative advantage in the production of a certain good. a. Suppose that output is produced by two factors -- labor and capital. b. Some countries are abundant in labor, while others are abundant in capital. Q: Which countries will have low returns on labor (wage rates) and high returns on capital and which will have high returns on labor (wage rates) and low returns on capital? c. Those countries that are capital abundant will have a comparative advantage in the production of capital-intensive goods, while those countries that are labor abundant will have a comparative advantage in the production of labor-intensive goods. d. An important implication of Heckscher and Ohlin model is that trade will equalize returns on labor and capital (factor prices) across countries.

Mercantilism is an economic theory that advocates government regulation of international trade to generate wealth and strengthen national power. Merchants and the government work together to reduce the trade deficit and create a surplus. It funds corporate, military, and national growth. Mercantilism is a form of economic nationalism. It advocates trade policies that protect domestic industries. 

In mercantilism, the government strengthens the private owners of the factors of production. The four factors are entrepreneurship, capital goods, natural resources, and labor. It establishes monopolies, grants tax-free status, and grants pensions to favored industries. It imposes tariffs on imports. It also prohibits the emigration of skilled labor, capital, and tools. It doesn't allow anything that could help foreign companies.

In return, businesses funnel the riches from foreign expansion back to their governments. Its taxes pay for increase national growth and political power.

History

Mercantilism was the dominant theory in Europe between 1500 and 1800. Countries all wanted to export more than they imported. In return, they received gold. It powered the evolution of nation-states out of the ashes of feudalism. Holland, France, Spain, and England competed on the economic and military fronts. These countries created skilled labor forces and armed forces.

Before that, people focused on their local town, kingdom, or even religion. Each municipality levied its own tariff on any goods that passed through its borders. The nation-state began in 1658 with the Treaty of Westphalia. It ended the 30 Years War between the Holy Roman Empire and various German groups. 

The advent of industrialization and capitalism set the stage for mercantilism. They strengthened the need for a self-governing nation to protect business rights. Merchants supported national governments to help them beat foreign competitors. An example is The British East India Company. It defeated the princes of India with 260,000 mercenaries. It then plundered their riches. The British government protected the company's interests. Many members of Parliament owned stock in the company. As a result, its victories lined their pockets.

Mercantilism depended upon colonialism. The government would use military power to conquer foreign lands. Businesses would exploit the natural and human resources. The profits fueled further expansion benefiting both the merchants and the nation. 

Mercantilism also worked hand-in-hand with the gold standard. Countries paid each other in gold for exports. The nations with the most gold were the richest. They could hire mercenaries and explorers to expand their empires. They also funded wars against other nations who wanted to exploit them. As a result, all countries wanted a trade surplus rather than a deficit. 

Mercantilism relied upon shipping. Control of the world's waterways was vital to national interests. Countries developed strong merchant marines. They imposed high port taxes on foreign ships. England required all trade to be carried out in its vessels.

The End of Mercantilism

Democracy and free trade destroyed mercantilism in the late 1700s. American and French revolutions formalized large nations ruled by democracy. They endorsed capitalism. 

Adam Smith ended mercantilism with his 1776 publication of "The Wealth of Nations." He argued that foreign trade strengthens the economies of both countries. Each country specializes in what it produces best, giving it a comparative advantage. He also explained that a government which put business ahead of its people would not last. Smith's laissez-faire capitalism coincided with the rise of democracy in the United States and Europe. 

In 1791, mercantilism was breaking down, but free trade hadn't yet developed. Most countries still regulated free trade to enhance domestic growth. U.S. Treasury Secretary Alexander Hamilton was a proponent of mercantilism. He advocated government subsidies to protect infant industries necessary to the national interest. The industries needed government support until they were strong enough to defend themselves. Hamilton also proposed tariffs to reduce competition in those areas.

Fascism and totalitarianism adopted mercantilism in the 1930s and 1940s. After the stock market crash of 1929, countries used protectionism to save jobs. They reacted to the Great Depression with tariffs. The 1930 Smoot-Hawley Act slapped 40-48 percent tariffs on 900 imports. When other countries retaliated, global trade fell 65 percent, prolonging the depression. 

The Rise of Neomercantilism

World War II's devastation scared Allied nations into desiring global cooperation. They created the World Bank, the United Nations, and the World Trade Organization. They saw mercantilism as dangerous, and globalization as its salvation. 

But other nations didn't agree. The Soviet Union and China continued to promote a form of mercantilism. The main difference was that most of their businesses were state-owned. Over time, they sold many state-owned companies to private owners. This shift made those countries even more mercantilist.

Neomercantilism fit in well with their communist governments. They relied on a centrally-planned command economy. It allowed them to regulate foreign trade. They also controlled their balance of payments and foreign reserves. Their leaders selected which industries to promote. They engaged in currency wars to give their exports lower pricing power. For example, China bought U.S. Treasurys to fuel its trade with the United States. As a result, China became the largest foreign owner of U.S. debt. 

China and Russia planned for rapid economic growth. With enough financial strength, they would increase their political power on the world stage. 

Significance Today

Mercantilism laid the foundation for today's nationalism and protectionism. Nations felt they lost power as a result of globalism and the interdependence of free trade. 

The Great Recession aggravated a tendency toward mercantilism in capitalist countries. For example, in 2014, India elected Hindu nationalist Narendra Modi. In 2016, the United States chose populist Donald Trump for the presidency. Trump's policies follow a form of neo-mercantilism. 

Trump advocates expansionary fiscal policies, such as tax cuts, to help businesses. He argues for bilateral trade agreements that are between two countries. If he could, he'd enforce unilateral agreements. They allow a stronger nation to force a weaker nation to adopt trade policies that favor it. Trump agrees that multilateral agreements benefit corporations at the expense of individual countries. These are all signs of economic nationalism and mercantilism.

Mercantilism opposes immigration because it takes jobs away from domestic workers. Trump's immigration policies followed mercantilism. For example, he promised to build a wall on the border with Mexico. 

In 2018, mercantilist policies in the United States and China launched a trade war. Both sides threatened to increase tariffs on each other's imports. Trump wants China to open its domestic market to U.S. companies. China requires them to transfer their technology to Chinese companies.

Trump also wants an end to some Chinese subsidies. China is assisting 10 industries prioritized in its "Made in China 2025" plan. These include robotics, aerospace, and software. China also plans to be the world's primary artificial intelligence center by 2030. 

China is doing this as part of its economic reform. It wants to shift from a total command economy that relied on exports. It realizes it needs a domestic-driven mixed economy. But it has no plans to abandon its adoption of mercantilism.

THEORY OF COMPARATIVE ADVANTAGE

In economics, comparative advantage refers to the ability of a person or nation to produce a good or service at a lower opportunity cost than another person (or nation). This is why trade can create value for both parties—because each person can concentrate on the activity for which they have the lower opportunity cost. It also explains why Tiger Woods shouldn’t mow your lawn.

The term “comparative advantage” is usually attributed to David Ricardo. In his 1817 book On The Principles Of Political Economy And Taxation, Ricardo used the example of trade between England and Portugal.

Portugal could produce both wine and cloth with less labor than it would have taken to produce the same output in England. However, the relative costs are different (currencies have different values). From Ricardo’s point of view, England had difficulty producing wine and very little difficulty producing cloth. Portugal, however, could easily produce both wine and cloth. Ricardo concluded that while it was cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine and trade this for English cloth. England would benefit from this trade because its cost of producing cloth has not changed but it can now get wine at a lower price. Thus, each country can gain by specializing in the good that has a comparative advantage.

One of the drawbacks of trade in this way is that it creates increasing interdependence among people or nations. In Ricardo’s example, England and Portugal relied on each other for certain goods. This is possible as long as it is in the self-interest of each nation and there are no disruptions.

In the leading economics textbook, Principles of Microeconomics, Greg Mankiw offers the following:

Differences in opportunity cost and comparative advantage create the gains from trade. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a lower price than his or her opportunity cost of that good.

Real Life Examples

Should Tiger Woods Mow His Own Lawn?

Tiger is a great athlete. One of the best golfers to have every lived. Most likely he is better at other activities too. Tiger is probably in better shape than most: He can run faster, lift more, and work quicker. For example, Tiger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question we can use the concepts of opportunity cost and comparative advantage. Let’s say that Tiger can mow his lawn in 2 hours. In the same two hours he could film a television commercial for golf clubs and earn $100,000. By contrast, Joe, the kid next door can mow Tiger’s lawn in 4 hours. In that same 4 hours he could work at McDonald’s and earn $24.

In this example, Tiger’s opportunity cost is $100,000 and Joe’s is $24. Tiger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Joe has a comparative advantage because he has the lower opportunity cost. The gains in trade from this example are tremendous. Rather than mowing his own lawn, Tiger should make the commercial and hire Joe to mow his lawn. As long as Tiger pays Joe more than $24 and less than $100,000, both of them are better off.

(Another example, this one from wikipedia)

Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also, faster, better, more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of a young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will make both of them richer.