FUNDAMENTALS OF MERCANTILISM

1. To which of the following would mercantilists have objected?

a) free trade; b) stimulating exports; c) restricticting imports;

d) accumulation of gold by their nation.

2. How does the mercantilist concept of national wealth differ from today’s view?

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3. Why did mercantilism advocate the accumulation of gold?

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4. Why did mercantilist policy of international trade keep colonial markets poor?

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2. ADAM SMITH: THE THEORY OF ABSOLUTE ADVANTAGE

Бранил Гомера, Феокрита;

Зато читал Адама Смита

И был глубокий эконом,

То есть умел судить о том,

Как государство богатеет,

И чем живёт и почему

Не нужно золота ему,

Когда простой продукт имеет.

А. С. Пушкин “Евгений Онегин”

Key words:

basis of wealth, absolute advantage, absolute cost,

labor cost, labor productivity, specialization, export,

trade policy, free trade, gain from trade

Adam Smith (1723-1790)was Scottish philosopher and political economist. He is famous for his book The Wealth of Nations (1776). Adam Smith’s father had died before he was born and he was raised by his widowed mother. He attended Glasgow and Oxford universities before accepting the position as professor of moral philosophy at Glasgow in 1752. After living in both France and London Adam Smith returned to Scotland in 1778 when he was appointed commissioner of customs for Edinburgh. Five years later he was a founding member of the Royal Society of Edinburgh.. The Wealth of Nations became the most influential book on the political economy in the western world. When the book appeared there was a strong sentiment for free trade in both Britain and America. This new feeling had been born out of the economic hardships and poverty caused by the war. However, at the time of publication, not everybody was convinced of the advantages of free trade right away: the British public and Parliament still clung to mercantilism for many years to come. Controversial views have been expressed as to the extent of Smith's originality in The Wealth of Nations. Nevertheless, The Wealth of Nations was the first and the most important book on the subject of political ecomomy. “ … the maxim of every prudent master of a family, never to attempt to make at home what it will cost more to make, than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. What is prudence in the conduct of every private family can scarce be folly in that of a great kindom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.... ”.

In 1776, Adam Smith published his famous book The Wealth of Nation, in which he attacked the mercantilist view on trade and advocated free trade as the best policy for the nations. Smith argued that with free trade, each nation could specialize in the production of those commodities in which it had an absolute advantage (or could produce more efficiently than other nations) and import those commodities in which it had an absolute disadvantage (or could produce less efficiently).

This international specialization in production would result in an increase in world output which would be shared by the trading nations. Thus, a nation need not gain at the expense of other nations – all nations could gain simultaneously. Mutually beneficial tradecan take place if both countries specialize in production of goods with absolute advantage.

Smith explained that if each nation specialized in (or produced more than it wanted to consume domestically) the commodity in which it was more efficient and exchanged this excess for the commodity in which it was less efficient, the output of all commodities entering trade would increase. This increase would be shared by all nations that voluntary engaged in trade.

Adam Smith reasoned that international trade should not be burdened by tariffs and quotas, but should flow according to market forces with minimal government interference. The theory argues against restrictive trade policies. Free trade would cause world resources to be utilized most efficiently, maximizing world welfare. Then people obtain more goods more cheaply, raising living standards.

Specialization means that nations focus on producing the goods in which they have the most advantage while engaging in trade with other countries to obtain other goods.

The division of labor generates “the greatest improvement in the productive powers of labor…and is limited by the extent of the market.”.. So, greater trade means more opportunities for greater productivity.

Absolute advantage is the ability of a nation to produce more of goods (commodity) or service than any other nation using the same amount of resources. Adam Smith described the principle of absolute advantage in the context of international trade, using labor as the only input. If in a country it cost less labor to produce 1 unit of goods than in other countries, this country has an absolute advantage in production of the goods. A country should produce the goods in which it holds an absolute advantage and trade with others to get the goods it needs but does not produce efficiently.

The ability of each country in producing each commodity can be measured in particular by:

– Labor productivity: the number of units of output that a worker can produce in an hour;

– Labor costs, labor hours: number of hours that it takes a worker to produce one unit of output.

Assumptions

1. In the absence of trade. According to the assumptions both Ukraine and India spends ___ units of resources for the production of each product. Ukraine produces ____ tons of tea and ____ tons of sugar. And for India – ___ tons of tea and ___ tons of sugar. Since each country has only 100 units of resources, none of them can not increase the production of tea without reducing the production of sugar, and vice versa. Without foreign trade total production in Ukraine and India is ____ tons of tea and ____ tons of sugar.
2. In the case of specialization and trade between the countries. Each country will specialize in the production of goods for which it has an absolute advantage: Ukraine will produce ________ and India – _______. Ukraine will be able to produce _____ tons of _____, giving up entirely the production of ______ and India – _____ tons of ______, closing ______ production. Thus, due to specialization the total production of both commodities will ______: tea – from ____tons to _____ tons and sugar – from _____ tons to _____ tons. As a result of trade exchange, both countries will get more sugar and tea.

Production possibilities of Ukraine and India

3. DAVID RICARDO: THE THEORY OF COMPARATIVE ADVANTAGE

Key words:

basis of wealth, comparative advantage, labor cost,

labor productivity, opportunity cost, specialization,

export, trade policy, free trade, gain from trade

David Ricardo (1772-1823) David Ricardo was the third of seventeen children. Ricardo began working full-time for his father at the London Stock Exchange when he was fourteen. When he was 21 his family disinheriated him when he married a Quaker. Luckily he already had an excellent reputation in finance and he set up his own business as a dealer in government securities. He quickly became very rich. David Ricardo retired from business in 1814 and was elected into the British parliament in 1819 as an independent representing a borough in Ireland, which he served up to his death in 1823. When he died, his estate was worth over $100 million in today's dollars. Ricardo read Adam Smith's Wealth of Nations (1776) when he was in his late twenties. This sparked an interest in economics that lasted his whole life. In 1809 Ricardo began to write down his own ideas in economics for newspaper articles. His great contribution, the law of comparative cost, or comparative advantage, demonstrated the benefits of international specialisation of the commodity composition of international trade. Principles of Political Economy and Taxation 1817: “To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. “This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.”

David Ricardo, working in the early part of the 19th century, realised that absolute advantage was a limited case of a more general theory. Unlike Smith, Ricardo stated that trade could take place on the basis of comparative advantage.

Assumptions: 2 countries, 2 goods; labour is the only resource for production and is mobile within each nation and immobile between countries; traded goods are homogeneous (ie identical); no transport costs; no tariffs or other trade barriers; production equals consumption.