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Mercantilism and Comparative Advantage

Lecture 3


Mercantilism the oldest and most powerful

1. Rise of the modern nations in Europe during 15th and 18th centuries
i. Nations create wealth and power
ii. National security is a top priority
Need strong military
Europe fought many wars
2. Differences
i. Economics International trade
Everyone wins
Positive sum game
Free trade creates income and wealth for all participants
ii. Mercantilism one gains while another loses
Free trade is a myth
Us versus them
The goal is to capture income and wealth
3. Mercantilism state promotes exports and limits imports
i. Creates trade surplus
ii. Causes inflow of money into country, i.e. gold and silver
iii. Could cause inflation
iv. Creates wealth and power
v. Founded colonies
Colonies shipped raw materials to mother country
Mother country shipped manufactured products to colony
Manufactured goods have higher value than raw materials, creating trade suplus for
mother country
4. Expand definition
i. Nations finance industries
ii. Build roads and ports employ workers
iii. Improve record keeping, navigation and shipping
iv. States imported skilled labor to build ships and ports
v. Trade protection - financed by imposing taxes on imports
5. Who benefits?
i. King used the gold to build a strong military
Military is expensive
Wealth allows countries to buy weapons
ii. King granted licenses and permission to industry
Allowed monopolies to form
Allowed exporting firms to export products
Businessmen paid the king for these rights
iii. Gov. bureaucrats expand gov.
iv. Merchants and joint stock companies
6. Does mercantilism work?
o Japan was devastated after WWII and became the second largest economy within one
o Asian tigers and China
o Price-specie-flow doctrine
Works only in short run
Large flow of money into economy causes inflation
Higher prices reduce exports and increases imports

Absolute and Comparative Advantage

1. Law of Absolute Advantage (Adam Smith)

o Countries specialize in production where they have low costs
o Book uses labor productivity
Labor productivity amount of output each worker can produce in one hour

Productivity U.S. China

Soybeans 50 > 20

Laptops 6 < 10
o World gains from free trade
U.S. produces soybeans, while China produces laptops
Thus, the U.S. exports soybeans and imports laptops
Free commerce makes nations efficient
Encourage innovation
o Problem What if a country has an absolute advantage in all trade?
No incentive to trade
U.S. has higher productivity than China

Productivity U.S. China

Soybeans 50 > 20

Laptops 20 > 10
2. Law of Comparative Advantage (David Ricardo) - a country produces a product that has a relative
cost advantage
o Countries with absolute advantage still have an incentive to trade
o Opportunity cost to produce one more unit of soybeans, a country gives up production
on laptops
Industries shift resources, like labor, capital, materials, etc. from one industry to
o Divide productivity of one product by the productivity of another

Opportunity Costs U.S. China

Soybeans 0.4 laptops per soybeans 0.5 laptops per soybeans

Laptops 2.5 soybeans per laptop 2 soybeans per laptop

o Numbers in table are relative prices
No money; a country's exports equal its imports
If no trade, then relative prices are prices for economy
Both countries have many buyers and sellers; no market power
Arbitrage if prices differ between two markets, then traders will buy for low price
and sell for high price
No transaction cost
No transportation cost
No trade barriers
o Results
U.S. should grow soybeans and sell them to China
To grow one more unit of soybeans, the U.S. has to give up 0.4 laptop
China gives up 0.5, which is greater
U.S. has a lower opportunity cost than China
China should produce laptops and sell them to the U.S.
China has a lower opportunity costs than U.S.
World price
Price of soybeans would lie between 0.4 and 0.5
Price of laptops would lie between 2 and 2.5

Production Possibilities Curve (PPC)

1. Production Possibilities Curve (PPC) - shows country's production level given its level of
o Macroeconomics
Country can produce two products given its resources
Used to illustrate trade
o Example
Mexico and United States
Both produce tomatoes and cars

Item U.S. Mexico

Cars (max) 100 30

Tomatoes (max) 50 60
2. Draw the PPCs

The PPCs for the United States and Mexico

o Comparative advantage
o Opportunity cost is slope of the line; also called the marginal rate of transformation (MRT)

Item U.S. Mexico

Cars (max) 0.5 tomatoes per car 2 tomatoes per car

Tomatoes (max) 2 cars per tomato 0.5 cars per tomato

o Note straight line PPC means all resources are perfectly suited for both products
All labor, capital, etc. are equally productive for both products
Leads to complete specialization; country does not lose its comparative advantage
United States specializes in cars while Mexico specializes in tomatoes
4. Results
o Autarky - no free trade
Set consumption at the half way point
U.S. produces 50 cars and 25 tomatoes
Mexico produces 15 cars and 30 tomatoes
Total production is 55 cars and 55 tomatoes
o Free trade - complete specialization
U.S. produces 100 cars and no tomatoes
Mexico produces 60 tomatoes
Total production is 100 cars and 60 tomatoes
Consumption lies outside the boundary of the PPC
Cannot answer how this production is divided up
Theory of Reciprocal Demand - if one country is larger (i.e. has more
consumers), then the terms of trade will be closer to the larger country
U.S. is larger than Mexico, then U.S. may get more of the production from
Assumes trade flows are balanced; no trade surpluses or deficits

North-South Dilemma

1. Less-Developed Countries (LDCs) tend to be located south of equator

o Developed rich countries are located in the north
o Author south has lower productivity, which translates into lower wages
o Productivity the more output a worker can produce means he can earn a higher wage
2. Dependency Theory LCDs are dependent on the North America-European countries
o Exported raw materials, food, and resources
o Resources and raw material prices are volatility in the international markets
o Imported manufactured goods
o Creates a trade imbalance because manufactured goods have a higher value
Money flows out of LDCs
Keeps them in poverty
o LDCs cannot get access to technology
Tight legal controls on patents, copyrights, and licensing from Western countries
LDCs cannot gain a competitive edge

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