1.

Introduction to Mercantilism

What is Mercantilism?
• the theory that a country’s power depended
mainly on its wealth to build strong navies
and purchase vital trade goods.
 Main Points of Mercantilism
• Promotion of National wealth and power
• Importance of trade surpluses
• Trade surplus leads to a net gold inflow, and thereby to greater national
wealth and power
• Analogy between nations and households
• Encourage domestic production and exports, discourage imports
• Tendency to see gold and “treasure” as constituting national wealth
• Emphasis on maximizing productivity and output
• Trade as a zero sum game
• Role of government in encouraging domestic manufacturing and exports
while minimizing imports
• Link between money supply and prices
 Triangular Trade
• Europeans transported
manufactured goods to the west Traders then exchanged these goods
coast of Africa
for captured Africans who were then
sold in the Americas

Merchants then bought sugar, coffee, and

tobacco in the West Indies and sailed back to
Europe to sell these products.
 Long Term Results
• global trade routes shifted over time
• the old silk routes declined
• West Asia and the Islamic world were displaced as
the centralized location of global trade
• the Atlantic and Pacific sea routes become the new
focus of global trade
 The Mercantilists’ Views on Trade

• Mercantilists measured wealth of a nation by

stock of precious metals it possessed.
• Today, we measure wealth of a nation by its
stock of human, man-made and natural
resources available for producing goods and
services.
– The greater the stock of resources, the greater the flow of
goods and services to satisfy human wants, and the higher
the standard of living.
 Absolute advantage

• Built on the ideas of Adam Smith

• Absolute advantage exists between nations when
they differ in their ability to produce goods.
– More specifically, absolute advantage exists when one
country is good at producing one item, while another
country is good at producing another item.

2-9
 Policy recommendations from absolute
advantage
• Specialization and trade advantage both
countries
• Therefore, the best policy is to allow producers
and consumers in both countries unfettered
access to goods from both countries to maximize
the number of advantageous trades that can
occur.
• In other words, laissez-faire.
– The policy of minimum government interference
with economic activity.
Absolute advantage

A country is said to have an absolute

advantage over another country in the
production of a good if it can produce a
larger amount of the good than the other
country with the same amount of resources.
Reciprocal absolute advantage

Two countries are said to have

a reciprocal absolute advantage over each
other if each country has an absolute advantage
over the other in producing one of the two goods.

© Pilot Publishing Company

Ltd. 2005
 The principle

Given that two countries have a reciprocal

absolute advantage over each other, if
each specializes in producing the good in
which it has an absolute advantage, then
the world’s total output will increase.

© Pilot Publishing Company

Ltd. 2005
Case I Food Clothing
Output of 1 unit of resources*
Country A 10 8
Country B 3 10
*1 unit of resources (a combination of labour, capital, and land)

Which country has an absolute advantage in the

production of food? Country A

Which country has an absolute advantage in the

production of clothing? Country B
© Pilot Publishing Company
Ltd. 2005
Specialization leads to increase in world’s output
If now country A shifts 1 unit of resources from the
production of clothing to the production of food.
And country B shifts 1 unit of resources from the
production of food to the production of clothing.
Food Clothing

Country A +10
10  -88
Country B -33  +10
10
World’s total output +7 +2
© Pilot Publishing Company
Ltd. 2005
 Case II Food Clothing
Output of 1 unit of resources*
Country A 100 80
Country B 3 10
*1 unit of resources ( a combination of labour, capital, and land)

Which country has an absolute advantage in the

production of food? Country A

Which country has an absolute advantage in the

production of clothing? Country A
© Pilot Publishing Company
Ltd. 2005
 Trade Based on Absolute Advantage:
Adam Smith

• Example:
– Canada is efficient in growing wheat, inefficient in
growing bananas.
– Nicaragua is efficient in growing bananas, inefficient in
growing wheat.
– Canada has absolute advantage in wheat, Nicaragua has
absolute advantage in bananas.
– Mutually beneficial trade can take place if both
countries specialize in their absolute advantage.
 Trade Based on Absolute Advantage:
Adam Smith

• Specialization and trade advantage both

countries.
• Adam Smith and other classical economists
advocated policy of laissez-faire, or minimal
government interference with economic
activity.
• Free trade would cause world resources to be
utilized most efficiently, maximizing world
welfare.
 Trade Based on Absolute Advantage:
Adam Smith

U.S. U.K.
Wheat (bushels/labor hour) 6 1
Cloth (yards/labor hour) 4 5

U.S. has absolute advantage over U.K. in wheat.

 U.K. has absolute advantage over U.S. in cloth.
 Both nations can gain from specialization in
production and trade.
 Trade Based on Absolute Advantage:
Adam Smith

No Trade Specialization Trade Trade Gain

U.S. U.K. U.S. U.K. U.S. U.K. U.S. U.K.

Wheat 6 1 12 0 6 5 - 5-1=4
Cloth 4 5 0 10 6 5 6-4=2 -

• Assuming each country has 2 unit labor hours and specialize on the
product that has Absolute Advantage
• US Specialize on Wheat then gain 2 additional Cloth
• UK Specialize on Cloth then gain 4 additional Wheat
 Criticism
• Absolute advantage requires one country to
be better at production of one product and
another country to be better at production of
another good for specialization and trade to
be mutually advantageous.
• What if one country is better at everything?
– The theory of comparative advantage provides
this answer.
Theory of Comparative Advantage
Definition
According to Wallace, "The law of comparative costs stated that if two
countries have different ratios of efficiency in a production of different
commodities, those countries will tend to produce the commodities in
which their efficiency is relatively greatest or their inefficiency is least and
they will trade with one another.“

• Assumptions
• Before we explain the theory in detail, we would do well to
enumerate the various assumptions on which it is based. Both
Ricardo and Mill had developed this theory on certain important
assumptions which are:
1. Two countries, two commodities and one factor of production 2 x
2 x 1.
2. Homogeneous units of Labor
3. Constant Costs
4. Absence of Transport Costs
5. Full Employment of all Factors
6. Two countries are of equal economic strength
and the two commodities of equal economic
value.
7. Free Trade
8. Barter Economy
Comparative advantage

A country is said to have a comparative advantage

over another country in the production of a good
if it can produce the good at a lower opportunity
cost than the other country.

© Pilot Publishing Company

Ltd. 2005
The law of comparative advantage

The law of comparative advantage or

the law of comparative cost states that
if each country specializes in the production
of the good in which it has a comparative adv.
(or a lower production cost),
the world’s total output will increase.
 Output of 1 unit of resources

Country A 100F 80C

Country B 3F 10C

Production cost of 1F Production cost of 1C

80C 100F
Country A  0.80C  1.25F
100 80
10C 3F
Country B  3.33C  0.30F
3 10
Specialization leads to an increase in world’s output
If country A produces one more unit of food
while country B produces one more unit of clothing
Food Clothing
Country A +1.0F -0.8C
Country B -0.3F +1.0C
World’s total output +0.7F +0.2C

© Pilot Publishing Company

Ltd. 2005
Absolute advantage versus comparative advantage
1. Abs. adv. and comp. adv. are unrelated.
Abs. adv. compares productivity of the two countries
(the amount of output obtained per unit of resources).
 Comp. adv. compares production costs of the two countries
(the amount of another good forgone per unit of output).

However, if two countries have a reciprocal absolute

advantage over each other, each will have a comparative
advantage in the production of the good that it has an
absolute advantage.
© Pilot Publishing Company
Ltd. 2005
 2. It is possible for a country to have an absolute
advantage in the production of all goods, but it is
impossible for the country to have a comparative
advantage in all production.

3. It is the comparative advantage (not the absolute

advantage) that determines the allocation of
resources and the direction of trade.

 However, comparative advantage does not

determine the volume of trade, the terms of trade or
the balance of trade.

© Pilot Publishing Company

Ltd. 2005
For each of the following typical cases, determine
(a) which country has an absolute advantage in the
production of
(i) food (ii) clothing
(b) which country has a comparative advantage in the
production of
(i) food (ii) clothing

© Pilot Publishing Company

Ltd. 2005
 Output of 1 unit of resources
Case 1:
Country A Country B
Food 8 10
Clothing 2 6
Output of 1 unit of resources
Case 2:
Food Clothing
Country A 8 10
Country B 2 6
© Pilot Publishing Company
Ltd. 2005
 Calculation of production costs
1. Given the amount of good X and good Y produced
per unit of resources (marginal products),
i.e., MPX and MPY:
Production cost of 1X is  MPY units of good Y
MPX

Production cost of 1Y is MPX

 units of good X
MPY

© Pilot Publishing Company

Ltd. 2005
 Calculation of production costs
2. Given the amount of resources required to produce
one unit of good X and good Y (real marginal costs in
terms of resources), i.e., MCX and MCY:
Production cost of 1X is  MCX units of good Y
MCY
Production cost of 1Y is MCY
 units of good X
MCX

© Pilot Publishing Company

Ltd. 2005
 Calculation of production costs
3. Given the amount of money required to produce one
unit of good X and good Y (nominal marginal costs in
terms of money), i.e., MCX and MCY:
Production cost of 1X is  MCX units of good Y
MCY
Production cost of 1Y is MCY
 units of good X
MCX

© Pilot Publishing Company

Ltd. 2005
 Distribution of Gains
from Trade

© Pilot Publishing Company

Ltd. 2005
Principle
Specialization raises the world’s total output, while
trade distributes the output among trading parties.

The world price (or exchange ratio or terms of trade)

of a good is determined by its D & S in the world market.

From the trading of a good, a country gains the

difference between its production cost of the good and
the good’s world price.

© Pilot Publishing Company

Ltd. 2005
Illustration
Amount of labour required to produce a unit of food
and clothing in country A and country B

Food Clothing

Country A 8 lab 10 lab

Country B 10 lab 3 lab

© Pilot Publishing Company

Ltd. 2005
Calculation of gains from trade
Production cost of 1F Production cost of 1C
8 lab 10 lab
Country A  0.80C  1.25F
10 lab 8 lab
10 lab 3 lab
Country B  3.33C  0.30F
3 lab 10 lab
Given exchange ratio: 1F=1C
World price of 1F (=1C) > Country A’s production cost
of 1F (=0.8C) Country A exports food
From each unit of food exported, country A gains
0.2C (=1C-0.8C).
© Pilot Publishing Company
Ltd. 2005
Calculation of gains from trade
Production cost of 1F Production cost of 1C
8 lab 10 lab
Country A  0.80C  1.25F
10 lab 8 lab
10 lab 3 lab
Country B  3.33C  0.30F
3 lab 10 lab
Given exchange ratio: 1F=1C
World price of 1F (=1C) < Country B’s production cost
of 1F (=3.33C) Country B imports food
From each unit of food imported, country B gains
2.33C (=3.33C-1C).
© Pilot Publishing Company
Ltd. 2005
 Theory of Comparative Advantage
Example
Commodity US UK Total
Wheat (bushels/man-hour) 6 1 7
Cloth (yard /man-hour 4 2 6

 U.K. has absolute disadvantage in both goods.

 Since U.K. labor is half as productive in cloth but six times less
productive in wheat compared to U.S., the U.K. has a comparative
advantage in cloth.
 U.S. has comparative advantage in wheat.
Each Country Specializes

Commodity US UK Total
Wheat (bushels/man- 12 12
hour)
Cloth (yard /man-hour 12 12

3-40
• US gains to the extent it can exchange 6W for
more than 4C from UK
• UK gains to the extent that it can give up less
than 12C for 6W from US
• Thus the range of mutually advantageous
trade is
• 4C<6W<12C
• The spread between 12C and 4C (i.e.8C)
represents the total gain from trade available
to be shared by the two nations by trading 6W
Production possibility schedules for wheat and cloth in the
United States and United Kingdom

United States United Kingdom

Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
 Comparative Advantage and
Opportunity Costs

• Production Possibilities Frontier

– A curve that shows alternative combinations of the two
commodities a nation can produce by fully using all
resources with best available technology.
– Constant opportunity costs arise when:
1. Resources are either perfect substitutes for each other
or used in fixed proportion in production of both
commodities, and
2. All units of the same factor are homogeneous.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 2-1 The Production Possibility Frontiers of the
United States and the United Kingdom.
 The Basis for and the Gains from Trade under
Constant Costs

• In the absence of trade, a nation’s production

possibilities frontier also represents its
consumption frontier.
• Increased output resulting from specialization
and trade represents nations’ gains from trade,
allowing nations to consume outside
production possibilities frontier.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
 FIGURE 2-2 The Gains from Trade.

Salvatore: International
Economics, 10th Edition ©
 The Basis for and the Gains from Trade under
Constant Costs

• Under constant cost conditions, nations will

completely specialize in their comparative
advantage .
• With complete specialization in both nations,
the equilibrium-relative commodity price of
each commodity lies between the pretrade
relative commodity price in each nation.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
 Trade with the PPF model
US
140
120
• This increased 100 (110W, 70C)

Cloth
80
60 Production
production would allow 40
20
each country to 0
0 20 40 60 80 100 120 140 160 180 200

consume at a point Wheat

outside of its PPF as

Production UK
indicated by the blue 140
lines in the graphs. 120
100

Cloth
80 (70W, 50C)
• The increased 60
40
20
consumption is the gains 0
0 20 40 60 80 100 120 140 160 180 200
from trade. Wheat

2 - 48
 By production possibility curve and
indifference curve
Without trade (the autarkic situation)
Clothing Clothing
Country A Country B

COA0 MCB0

POA0
MCA0 COB0

POB0

© Pilot Publishing Company

Ltd. 2005
With trade
Clothing Country A

COA1

Import of ICA1 > ICA0
country A


Export of POA1
country A

© Pilot Publishing Company

Ltd. 2005
 Clothing Country B

POB1 ICB1 > ICB0


Export of
country B COB1

Import of
country B

© Pilot Publishing Company

Ltd. 2005