Why Trade

1
Why 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

3
Chapter 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.

4
Mercantilism

• 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.

5
Mercantilism

• 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

6
Mercantilist Economic System

• Three components to Economic system
• Manufacturing (new power rising)
• Rural sector (feudal lords presiding)
• Foreign colonies (newly found sources of wealth)

7
Mercantilist 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.

8
Mercantilist 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.

9
Mercantilist 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.

10
Some 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.

11
Mercantilism 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.

12
Mercantilism 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!!!)

13
Mercantilism and Trade

• Countries did not want a negative balance of
  trade, or trade balance
• Imports Exports
• (We still have a problem with this situation.)

14
Mercantilism 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

15
Mercantilism 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

16
Mercantilism 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.

17
Mercantilism 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

18
Mercantilism 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.

19
Paradox of Mercantilism

• A rich country by mercantilist standards was
  composed of many poor people.

20
Concept check

• What part of mercantilist thinking has carried
  over to our current trade terminology?
• Why would a mercantilist country want to control
  shipping?

21
Adam 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

22
Adam 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.

23
Absolute 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)

24
Absolute 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.

25
Absolute 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

26
Labour 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.

27
Labour Allocation Table

• Output Canada 10 of each good,
• China 10 of each good
• Total output 20 soybean crates, 20 toy boxes

28
Next, we let the two countries specialize and
trade

• Adam Smith assumed complete specialization
• Canada produces only soybeans
• China produces only toys

29
Labour 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?

30
Output 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

31
Output 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.

32
Output 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)

33
Output 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.

34
Distribution 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.

35
Distribution 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.

36
Note 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!

37
YOU 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.

38
Labour Requirement Table

• What is the price ratio Pw/Pc in each country
  without trade?

39
Labour 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?

40
Labour Allocation Table
41
You 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?

42
Absolute 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.

43
Absolute 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.

44
Absolute 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.

45
Absolute 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.