Mercantilism
gold. To accumulate gold a country must run a trade surplus, i.e. export more than it
imports and be paid in gold. Therefore it accumulates gold and gets wealthier. There is a
role here for governments. Exports were encouraged and subsidised (particularly from
colonies) while imports were restricted. Having a strong navy was also important to
protect shipping fleets. Even though this was the dominant idea in the 16th and 17th
centuries, the term was coined by Adam Smith, in his book wealth of nations (1776)
Absolute Advantage
For Adam Smith there was confusion about the acquisition of gold and the acquisition of
wealth. The wealth of a nation does not lie in gold but in the goods and services available
to its citizens. These can be enhanced through trade.
But what should a country export and import The idea of absolute advantage.
absolute means a country should produce and export goods in which it is more productive
than others. It should import goods in which other countries are more efficient at
producing. This is a positive sum game in which all nations could benefit. The theory of
AA has intuitive appeal, it is however flawed. Countries trading in and following
absolute advantage system, basically share a give and take relation ship.
Comparative advantage
What happens if a country has an advantage in the production of all goods Or a country
has an advantage in nothing
If country A has an advantage in all goods, it would be self sufficient and if country B
has no advantages, then there would be no scope for trading. As the absolute advantage
system is a give and take relation, it can not be applied in the above scenario. This would
give way to comparative advantage.
Comparative advantage neo classical model
The flaw in AA theory was solved by David Ricardo and his idea of Comparative
Advantage. In the book On the Principles of Political Economy and Taxation (Ricardo,
1817).David Ricardo uses the example of Portugal and Englands trading of wine and
cloth to illustrate the benefits of specialization and trade (the concise encyclopaedia of
economics, 20100112)
It is about RELATIVE efficiency. The difference between AA and CA is therefore
subtle. AA looks at absolute productivity differences, CA looks at relative productivity
differences. It is related to the concept of opportunity cost, i.e. what is given up to get the good.
Neo classical theory
The neo classical trade model illustrates the gains from trade that occur through
specialisation. It is neo classical because it is related to the classical economists
thinking of smith and Ricardo. The model uses some economic concepts explained in the
handout and video on indifference curves and consumer behaviour.
Heckscher-Ohlin theory
The work of 2 Swedish economists (Eli Heckscher and Bertil Ohlin) took the idea of CA
and asked the question
What determines the products in which a country has CA
They proposed a theory of relative factor endowments.
The assumptions here are
Countries vary in how well endowed they are in factors of production.
Goods differ in the types of factors used in their production.
For example, one country has
many machines (capital) but few workers, while another country has a lot of workers but
few machines. They have to be work mutually in order to gain profit. neoclassical theory gives to each what he deserves.
The above models are all classical models in that they assume perfect competition and
show the gains from free markets. In this sense they assume that the gains from trade are
maximised by free markets and reject any government intervention or barriers to trade.
The New Trade Theory
Developed in the 1970s (Paul Krugman, the great unravelling (2003). Krugman looked at
trade patterns and noticed that the kind of specialisation that the neo classical model
predicted did not take place. As nations developed, similar industries grew and these
products were exported and imported to each other, e.g., cars in Europe. This should not
happen in perfect competition. Krugman talked about two types of trade. For
commodities and raw material there was trade based upon resource endowments. But for
many manufactured goods there was monopolistic competition. This is where products
are similar but slightly differentiated and there is lots of competition, e.g. builders,
restaurants. Nations develop these industries via large companies who get economies of
scale domestically and emerge dominant. But internationally, competition amongst these
firms is fierce. The benefits to a country of having these global companies are substantial
jobs, investment, spillover jobs, balance of payments, tax receipts etc.
So Krugman asked the question perfect competition does not exist, so is there a role for
government intervention in trade
the government needs to intervene in trade, to promote efficiency and equity. It might
seem unnecessary, but the government has a strong influence on both consumers and
suppliers, it regulates the economy. It can be said that the government sets up the quality
standard of the products. Krugman saw a great advantage to firms that are the first mover
in their industry. They will be the first to gain economies of scale and drive down costs,
thereby dominating the market.