Why Study Trade Theory

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Why Study Trade Theory

• Trade is a major engine of world economic growth
• Trade has an impact on our lives every day
• Trade is governed by economic principles
• Understanding the principles that rule trade
  helps us
• predict the results of policies, and
• Understand the positions of various participants
  and non-participants to trade

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Isnt trade about Predation?

• YES and NO!
• For some people and companies, trade is about
  getting the most while giving the least. This is
  profit maximization at its worst.
• But
• Trade is also about making both countries win.
• The gains are NOT necessarily evenly distributed,
  but that doesnt mean there are no gains
• The theories taught in this class help predict
  where production and consumption will occur, how
  gains are distributed

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Does Trade Theory have Implications for Policy?

• Yes!
• Standard trade theories have definite
  implications for policy, from general principles
  to technical details
• i.e. rules based agreements are most valuable to
  small countries
• trade is most valuable to the country most
  strongly affected by the ensuing price changes

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Why are trade agreements contentious?

• Trade creates winners and losers
• in the short-run producers tied to import
  competing industries lose
• consumers of exporting goods lose
• producers of exports and consumers of imports win
• in the long-run the most dynamic nations will be
  able to provide the high relative incomes to
  their people
• the gains from trade are NOT evenly distributed!

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Major trade theories

• Mercantilist - see trade as a win/loss game
• Classical trade as win-win under certain
  conditions
• Neo-classical trade as win-win under certain
  conditions, conditions often ignored
• Monopoly, oligopoly theory trade as part of
  non-competitive market, win-lose for people vs.
  countries
• Location-based, income-based trade as
  by-product of national production consumption
• Product-based trade as by-product of
  technological advances

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Mercantilism

• prevailed from 1500 to 1750 - still alive today
• describes a set of common attitudes toward
  international trade - its benefits and costs
• also reflects the prevailing definition of wealth
  of the time
• associated with the rise of the merchant class in
  early colonial times

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Mercantilism and Trade

• trade is a zero-sum game - if one country is
  gaining from trade, the other must be losing
• to win from trade a country must export more than
  it imports
• XgtM a favourable balance of trade
• MgtX an unfavourable balance of trade
• This language has survived till today!

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Mercantilism and Wealth

• Wealth is measured by the amount of gold and
  silver contained in a nations treasury! (misers
  definition of wealth)
• Exports and imports of specie (gold and silver)
  were banned and smuggling severely punished
• Monopolies were used to maximize the amount of
  specie a government could collect (East India
  Co., HBC)

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Mercantilism and Policy

• Navigation - control the waterways (monopoly)
• Trade Monopolies to increase inflow of specie
• Domestic monopolies to extract gold from people
• royal manufacturers, guilds, special privileges

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• wages set institutionally - kept low to increase
  wealth of nation as measured by precious metals
• lower classes kept poor to ensure they would
  remain productive
• war used to win power over other nations - get
  their gold
• powerful army and merchant marine seen as very
  important
• Result Rich nations (in terms of gold) had poor
  populations (in terms of consumption)

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Challenges to Mercantilism

• Early 18th century opposition to mercantilism
  arose
• Opposition grew out of historical accidents and
  new philosophies
• the conquest of the new world led to an abundance
  of gold bullion
• David Hume, Adam Smith and David Ricardo all
  presented strong counter arguments to old
  attitudes

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David Hume Price-Specie-Flow Mechanism

• Discovery of Americas brought huge sums of gold
  into Spain
• Instead of greatly increasing Spains wealth, the
  gold mainly increased the prices of goods in
  Spain
• The increase of domestic prices in Spain resulted
  in an unfavourable balance of trade - gold left
• David Hume formalized the explanation of the
  process by which this happened

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Price-specie-flow mechanism

• Start Exports gt Imports
• Step 1 Net inflow of specie
• Step 2 Increase in money supply
• Step 3 Increase in prices and wages
• Step 4 Increase in imports and decrease in
• exports
• Until Exports Imports

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Assumptions required for p-s-f to work perfectly

• 1. Quantity theory of Money
• MsVPY
• Ms the supply of money
• V the velocity of money
• P the price level
• Y the level of real output
• Predictions of p-s-f will be reduced if money
  supply does not increase or velocity of money
  decreases

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• 2. Demand for traded goods is price elastic
• If demand for traded goods is inelastic, then
  country that imports from Spain simply pays more
  for the goods it buys
• Sooner or later a nation will have an elastic
  demand

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3. Perfect competition in both factor and
product markets

• theoretically necessary, but not even close to
  true when mechanism came into play, and theory
  developed
• therefore, in practice, this is not required
• p-s-f effect will be reduced or slowed if
  competition does not hold
• in general monopoly leads to gains for
  monopolists and losses for all others involved in
  trade

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• 4. Gold Standard (or silver standard)
• exists
• Influx of gold must increase money supply for
  the gold itself to matter
• Gold standard underlies a fixed exchange system
• Under flexible exchange rates, prices need not
  rise at home for prices to rise with respect to
  trade partners

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Price-Specie-Flow Summary

• Theory says that unbalanced trade will lead to
  inflation / deflation
• Works if in-flow of money automatically flows
  into domestic market
• If conditions needed for mechanism to work do not
  hold perfectly, continuous imbalances are
  possible mechanism can be interpreted as a
  tendency or force toward equal trade balance
• For sustained negative balances, need cooperation
  of trading partners

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Adam Smith

• Moral philosopher
• Described the emerging capitalist system in
  detail
• Changed the definition of Wealth of Nations
• taught that economies work best when people are
  permitted to pursue own self-interest
• taught that monopoly is dangerous to prosperity

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Adam Smith

• Promoted laissez-faire approach by government
• meaning
• dont create monopolies
• dont mandate low wages for workers
• dont force people into professions based on
  ancestry
• dont allow sub-groups (merchant class or
  aristocracy) to control the economy

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Trade as a positive-sum game

• taught that trade can create wealth for all
  partners, both sides could win at the same time
• Example where one country is better at producing
  one good and another is better at producing a
  second,
• more is produced and consumed if each country
  specializes in production and trades than if each
  country produces only for its own market

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Absolute Advantage Example
Country Cloth Wine England 1 hr/yd 4
hrs/bbl Portugal 2 hrs/yd 3 hrs/bbl England has
absolute advantage in production of
cloth Portugal has absolute advantage in
production of wine If England produces its own
wine Producers of cloth can buy wine at a ratio
of 1W4C Consumers of wine can buy cloth at ratio
of 1W4C
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• Country Cloth Wine
• England 1 hr/yd 4 hrs/bbl
• Portugal 2 hrs/yd 3 hrs/bbl
• If England produces its own wine
• Producers of cloth can sell cloth at a ratio of
  1C1/4W
• Consumers of wine can buy wine at ratio of 1W4C
• Assume trade with Portugal at price 1W3C
• Producers of cloth can sell cloth at ratio of
  1C1/3 W
• Consumers of wine can buy wine at ratiof of
  1W3C, save money
• Class Reproduce example for Portugal

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Absolute Advantage 300 hrs each country

• England - produces and consumes 300 cloth or 75
  wine, or some combination
• Portugal - produces and consumes 150 cloth or 100
  wine, or some combination
• with trade
• England produces 300 cloth, consumes 100 wine
• Portugal produces 100 wine, consumes 300 cloth
• If each country consumed 1/2 its potential of its
  export product before trade, England produced 150
  C and 37.5 W, with trade consumes 150 cloth 50W

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Next Comparative Advantage

• David Ricardo
• successful stockbroker
• later became member of parliament
• opposed Britains corn laws restricting imports
  of corn
• wrote The Principles of Political Economy and
  Taxation