International Trade Theories

International Trade Theories Mercantilism Mercantilism was a sixteenth-century economic philosophy that maintained that a country’s wealth was measured by its holdings of gold and silver (Mahoney, Trigg, Griffin, & Pustay, 1998). This recquired the countries to maximise the difference between its exports and imports by promoting exports and discouraging imports. The logic was transparent to sixteenth-century policy makers-if foreigners buy more goods from you than you buy from them, then the foreigners have to pay you the difference in gold and silver, enabling you to amass more treasure. With the treasure acquired the realm could build greater armies and navies and hence expand the nation’s global influence. Politically, mercantilism was popular with many manufactures and their workers. Export-oriented manufacturers favoured mercantilist trade policies, such as those giving subsidies or tax rebates, which stimulated their sales to foreigners.

Domestic manufacturers threatened by foreign imports endorsed mercantilist trade policies, such as those imposing tariffs or quotas, which protected them from foreign competition (Mahoney, Trigg, Griffin, & Pustay, 1998). Most members of society are hurt by such policies. Government subsidies of exports for selected industries are paid for by taxpayers. Mercantilist terminology is still used today, an example when television commentators and newspaper headlines report that a country suffered an ‘unfavourable’ balance of trade-that is, its exports were less than its imports. Mercantilist policies are still politically attractive to some firms and their workers, as mercantilism benefits certain members of society. Modern supporters of these policies are known as neo-mercantilists, or protectionists (Mahoney, Trigg, Griffin, & Pustay, 1998).

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The mercantilists were a group of economists who preceded Adam Smith. They judged the success of trade by the size of the trade balance (Lipsey, & Chrystal, 1996). Absolute Advantage The theory of absolute advantage, suggests that a country should export those goods and services for which it is more productive than other countries, and import those goods and services for which other countries are more productive than it is (Mahoney, Trigg, Griffin, & Pustay, 1998). Adam Smith was the first to come up with the theory of absolute advantage. According to Adam Smith, mercantilism’s basic problem is that it confuses the acquisition of treasure with the acquisition of wealth.

In An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith attacked the intellectual basis of mercantilism and demonstrated that mercantilism actually weakens a country. Smith maintained that a country’s true wealth is measured by the wealth of all its citizens, not just that of its monarch (Mahoney, Trigg, Griffin, & Pustay, 1998). A country is said to be more productive than another country, if it can produce more output (goods) for a given quantity of input, such as labour or energy inputs. An example is that there are only two countries, Australia and Japan. They both produce computers and wine, and only one factor of production, labour.

Japan produces 6 computers for every 1 bottle of wine, where as Australia produces only 4 computers for every 3 bottles of wine. This suggests that Australia should export some of its wine to Japan, and Japan should export some of its computers to Australia. Australia has an absolute advantage over Japan, when producing wine, and Japan has an absolute advantage over Australia, when producing computers (Gandolfo, 1998). Economists use the term absolute advantage when comparing the productivity of one person, firm or nation with that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good (Gans, King, & Mankiw, 1999).

Comparative Advantage The theory of comparative advantage, states that a country should produce and export those goods and services for which it is relatively more productive than are other countries and import those goods and services for which other countries are relatively more productive than it is (Mahoney, Trigg, Griffin, & Pustay, 1998). David Ricardo, the early nineteenth-century British economist solved the problem of the theory of absolute advantage, by developing the theory of comparative advantage. Absolute advantage suggests that no trade would occur if one country has an absolute advantage over both products. The differences between absolute and comparative advantage theories are subtle. Absolute advantage looks at absolute productivity differences, comparative advantage looks at relative productivity differences (Mahoney, Trigg, Griffin, & Pustay, 1998). Take Australia, and Japan again as examples, this time Australia is better than Japan at producing both products computers and wine, and only one factor of production, labour.

Australia produces 6 computers for every 4 bottles of wine, and Japan produces 5 computers for every 1 bottle of wine. Absolute advantage suggests that no trade should occur, because Australia is more productive than Japan in producing both goods. The theory of comparative advantage, suggests that trade should still occur, as Australia is comparatively better than Japan in wine production, whereas Japan is comparatively better than Australia in the production of computers (Gandolfo, 1998). Economists use the term comparative advantage when describing the opportunity cost of two producers. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good (Gans, King, & Mankiw, 1999). The Heckscher-Ohlin Theory of Factor Endowment It has been previously stated that the difference in relative commodity prices between two nations is evidence of their comparative advantage and forms the basis for mutually beneficial trade. Factor Endowments and the Heckscher-Ohlin theory take this one step further by analysing the effect that international trade has on the earnings of factors of production in the two trading nations (Salvatore,1999). The Heckscher-Ohlin theory presents the issue that international and interregional differences in production costs occur because of the differences in the supply of production factors (Ball, McCulloch, 1999).

Those goods that require a large amount of the abundant, thus less costly factor will have lower production costs, enabling them to be sold for less in international markets (Salvatore, 1995). Countries such as Australia with relatively large amounts of land do export land intensive products (eg, grain and cattle) whereas a country like China would export labor intensive products. There are exceptions to the Heckscher-Ohlin theory which are to do with the assumptions that Ohlin drew. One assumption was that the prices of the factor depended only on the factor endowment. This is however untrue as factor prices are not set in a perfect market.

There are such factors to consider such as legislated minimum wages and benefits force the cost of labor to rise to a point greater than the value of the product than many workers can produce (Ball, McCulloch, 1999). Many economists attempted to disprove the Heckscher-Ohlin theory. The most notable effort was by a man named Wassily Leontief. His paradox was self named (Leontief Paradox) and disputed the theory as a predictor of the direction of trade. This paradox failed to empirically validate the country based Heckschler-Ohlin theory (Mankiw, 1997).

Country Similarity Theory Country similarity theory was developed by a Swedish economist named Steffan Linder (Mahoney, Trig, Griffin, Pustay, 1998). However before the country similarity theory can be analysed it is essential to understand the concept of intra industry trade. Intra industry trade is trade between two countries of go …